HLMN - ClearBridge All Cap Value Strategy Q1 2023 Portfolio Manager Commentary

2023-04-22 05:00:00 ET

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• Even before the collapse of Silicon Valley Bank, we had become aware that the Fed’s rate tightening cycle had started to weigh on bank deposits and lending.
• We believe contracting credit availability will be the major consequence of the banking crisis, and it will likely result in broader economic weakness and inflate other risk measures.
• We have reduced our exposure to companies with outsized leverage and ensured that our financials holdings have best-in-class contingency plans for future market turmoil.

By Reed Cassady, Albert Grosman & Sam Peters

Beyond Banking Crisis, Credit Contraction Looms

Market Update

Even prior to the collapse of Silicon Valley Bank ( SVB ) in March, our team had begun exploring the negative impact Fed policy was having on bank funding and appetite for lending. Much has been made of the advancements in digital banking, which allowed investors to effortlessly move deposits, and the ability of social media to stoke fears in large depositors. And these factors certainly have amplified the impacts on the system from the inversion of the yield curve, driven by the rapid pace of Fed rate increases. These issues will continue to generate headwinds for the banking sector and particularly for regional banks, which will then manifest in more difficult economic conditions. But, to paraphrase Mark Twain, reports of regional banking’s death are greatly exaggerated.

Major consequences of lenders internally focused on managing their own liquidity are wider loan spreads, more difficult terms and less willingness to extend credit. With lending spreads increasing, it’s probable that other measures of funding tightness farther out on the risk spectrum such as high yield spreads will start to widen as well. A broadening in fundraising pressure should have a deflationary impact on the economy. However, to say that inflation has been vanquished is premature given the lack of investment in commodity areas such as oil, gas and mining. Particularly as consumer resiliency remains a bright spot. As a result, the path to near-term Fed rate cuts appears tenuous until something else in the system breaks, and there are several potential areas that are suspect. We think this certainly merits a more cautious posture and highlights the importance of flexibility and good stock picking.

It's important to note that the rate tightening cycle, arguably necessary for getting inflation under control, had already started to weigh on bank deposits and lending even before the crisis. The effect of rapidly accelerating rates from a near-zero starting point has been the largest inversion in the yield curve in the last 30 years (Exhibit 1).

Exhibit 1: Largest Inversion in 30 Years

While this reflects a combination of recessionary fears and the market discounting Fed easing at some point, it is unsustainable for the banking industry. When your business involves borrowing at short-term rates and lending at long-term rates, an inverted yield curve poses a challenge. However, the magnitude of liquidity taken on by banks from the COVID-19 pandemic has exacerbated the problem (Exhibit 2). Much of the stimulus, market liquidity injections and stockpiled consumer savings ended up in bank securities portfolios, where some companies bought bonds at (or near) all-time low yields. Meanwhile, longer-term yields have moved up, leaving the most aggressive buyers deeply underwater as bond values fell.

Exhibit 2: Pandemic Spurred Surge in Bank Deposits

Historically, the stability of bank deposits as a funding source has afforded investors the ability to look beyond these unrealized gains and losses, but the Fed’s aggressive tightening widened the difference between what a depositor could earn on deposits and similarly low-risk alternatives like money market funds or even Treasury bills. This spurred an outflow of deposits from the system, compounded by the Fed’s quantitative tightening. Normally banks can act to stem these outflows through raising deposit rates, but those who aggressively invested in securities prior to the tightening cycle will struggle to do so due to the risk of earning a negative spread.

Banks have huge financial incentives to avoid the forced selling of securities to meet deposit outflows, which cements losses and impairs their book value and potentially regulatory capital. Less capacity to raise deposit rates and strong desire to not sell securities strongly suggests banks will look for other avenues to manage liquidity to meet further deposit redemptions. Options include expensive borrowing and meeting redemptions with maturing securities and loans. This curtails their interest in extending new credit and demands higher spreads and more onerous terms on the loans they do make, given the higher cost of funds across the board.

We can already see examples of this starting to manifest, with a greater proportion of banks tightening their business lending (Exhibit 3). Historically, meaningful tightening in lending has coincided with a recession, with the early 2000s, the Global Financial Crisis ((GFC)) and the COVID-19 recession all characterized by increased tightening in business lending. Additionally, tighter lending has traditionally been highly correlated to high-yield spreads, as difficulty sourcing capital in bank funding markets is typically a sign of challenges obtaining funding elsewhere. Again, it is important to note that these dynamics were present before the collapse of SVB, and deposit outflows have only accelerated from small and medium-size banks as the stress has increased. We believe it is a safe assumption that banks will continue to tighten standards, further distancing high-yield spreads versus their historical relationship to bank lending conditions.

Exhibit 3: Lending Tightens but Yields Stay Put

The question for investors, then, is whether this funding stress will remain sealed within the banking industry or spread to other areas of the market. One of the most obvious potential victims is commercial real estate ((CRE)), which has relatively higher leverage and is simultaneously facing challenges from pressure on rents and occupancy rates. We agree that losses will likely rise in this asset class, particularly in the troubled office segment, but we also think the risk remains high that other rate-induced surprises are looming. This is particularly true if the Fed is forced to hold rates higher for longer due to inflation persistence. As such, we are actively managing and monitoring CRE and interest rate risk across insurance companies, asset managers and pension funds where we could see future disruption. We also remain open to the idea that the next shoe to drop could come from an unexpected corner of the market.

Market Sanguinity Overlooks Reality

What is particularly surprising is how optimistic the market is about the funding pressures despite their likelihood to spread. Volatility is relatively low, market indexes are up year-to-date and high-yield spreads have not followed loan tightening wider. A pushback to this caution is that bank credit tightening is a result of banks managing their own liquidity issues rather than reacting to economic weakness. Consumer balance sheets are healthy, the labor market remains robust and looks to potentially remain so, given shortfalls in labor availability and a reluctance of employers to downsize. These are strong arguments for optimism, but we still believe a contraction in credit availability will manifest in broader economic weakness and result in knock-on effects across other risk measures.

Nevertheless, market optimism over potential Fed rate cuts has helped to spur a rally in capital markets-dependent growth companies in the first quarter. If further funding pressures continue, these unprofitable, market-reliant companies will face substantial headwinds and may end up becoming acquisition targets of larger industry players, which should benefit the Strategy’s relative performance. Likewise, the mega cap FAANG cohort has also rallied from hopes of a return to pre-COVID monetary policy and low interest rates as investors return to last cycle’s winners. Despite their massive profitability and free cash flows, as they continue to scale, we believe their fundamentals are increasingly becoming aligned with broad macro trends, leaving them overpriced for the reality of our current situation.

Portfolio Positioning

With risks rising, we like to maintain flexibility to react to the price-value gaps that we believe will emerge. We have reduced our exposure to companies with outsized leverage and have ensured that portfolio companies with ongoing funding needs have best-in-class contingency plans for potential turmoil in the fixed income markets. Examples of this include M&T Bank ( MTB ), which has a top-notch deposit franchise and minimal securities losses, as well as OneMain Financial ( OMF ), which maintains two years of estimated liquidity access and has termed out its balance sheet. Our remaining bank exposure is in companies with unequivocally defensible deposit franchises, good credit underwriting and significantly above-average securities portfolios.

Outside of financials, our focus is on investing in companies that are self-funding, cash flow positive, well-positioned to create value through investments at the bottom of the cycle, and that have strong fundamentals to help provide resiliency even as macro pressures build. We are particularly fond of the energy and materials sectors, given a lack of investment in new production despite growing demand. We believe this could drive prices substantially higher over the next few years, while the companies maintain strong cash generation, improve balance sheets and return capital to shareholders in the intervening period. Lastly, we’re likely to maintain greater cash reserves as risks become more meaningful, but with the intention to deploy it as further turbulence results in valuation swings.

Along these lines, during the quarter, we added Noble, which provides offshore drilling services to the international oil and gas industry through its fleet of drillships, floaters and jackup rigs. The demand for drillships has grown sharply in recent years, and we believe it will continue to grow as offshore prospects get developed to meet growing global energy demand. Industry consolidation has greatly reduced the supply of deep-water drilling rigs. As a result, the company should realize strong pricing power to propel its revenue and earnings with little need for additional capital spending. We believe the current market price does not reflect this lack of capacity in offshore drilling, and Noble should be a strong, long-term compounder for the portfolio.

"We are particularly fond of energy and materials, given a lack of investment in new production despite growing demand."

We also added aerospace company Airbus ( EADSF ). Aerospace manufacturing remains one of the few areas that is still operating under the pre-COVID levels. As China reopens and international travel recovers, Airbus stands to accelerate earnings growth. We believe that challenges at its competitors have allowed Airbus to gain additional market share in the industry, further extending its opportunities. Despite continued market concerns centering around supply chain disruptions and Airbus’s ability to deliver on its production schedule, continued improvements in global supply chains should yield strong stock performance through a better earnings outlook and a decline in operational risks.

We exited General Motors ( GM ), in the consumer discretionary sector. We have become increasingly concerned about Tesla’s aggressive pricing and the potential that could have to permanently lower the profitability of GM’s soon-to-be-ramping electric vehicle ((EV)) business. While we continue to have high conviction in the long-term trends surrounding the EV market, we ultimately decided to exit the position and consolidate our exposure to companies within the EV value supply chain.

Outlook

The pressures faced by regional banks are the same as those they faced prior to the collapse of SVB, merely heightened as depositors look to diversify in addition to maximizing the rate earned on their cash. While these emerging trends pose headwinds to the banking industry, the contraction in lending will drive a broadening of the fallout from the crisis. Just as resilient as market hopes of Fed rate cuts are the factors fueling inflationary pressures: a lack of investment in commodities, elevated fiscal stimulus and labor market imbalances. These will ultimately result in a long-term inflationary environment conducive to commodity and power producers, as well as those with strong pricing power. We believe this is a core argument for value investing, and its long-term return potential in this new market cycle.

Portfolio Highlights

The ClearBridge All Cap Value Strategy underperformed its Russell 3000 Value Index during the first quarter. On an absolute basis, the Strategy had positive contributions from seven of the 11 sectors in which it was invested during the quarter. The leading contributors were the communication services and materials sectors, while the financials and health care sectors detracted the most from performance.

On a relative basis, overall stock selection effects detracted from performance. Specifically, stock selection in the financials, information technology ((IT)), health care, utilities and energy sectors, as well as an underweight to the communication services sector weighed on performance. Conversely, stock selection in the communication services, consumer staples, materials and industrials sectors as well as an overweight to the IT sector benefited returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Meta Platforms ( META ), COTY , Oracle (ORCL ), OneMain and Quanta Services ( PWR ). The largest detractors from absolute returns were Signature Bank ( SBNY ), American International Group ( AIG ), AES , Pfizer ( PFE ) and CVS Health.

In addition to the transactions listed above, we initiated positions in Zebra Technologies ( ZBRA ) and Black Knight ( BKI ) in the IT sector, AGNC Investment in the financials sector, Sensata Technologies ( ST ) and Hillman Solutions ( HLMN ) in the industrials sector and Atlas Energy Solutions ( AESI ) in the energy sector. We exited positions in Signature Bank, VOYA Financial, UNUM and Western Alliance Bancorp ( WAL ) in the financials sector, Nucor ( NUE ) in the materials sector, Weyerhaeuser ( WY ) in the real estate sector and Spirit AeroSystems ( SPR ) in the industrials sector.

Reed Cassady, CFA, Director, Portfolio Manager

Albert Grosman, Managing Director, Portfolio Manager

Sam Peters, CFA, Managing Director, Portfolio Manager

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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