QDEL - ClearBridge All Cap Value Strategy Q3 2023 Portfolio Manager Commentary

2023-10-18 03:30:00 ET

Summary

• ClearBridge All Cap Value Strategy invests in a diversified portfolio of stocks whose prices are undervalued in relation to underlying fundamentals.
• The transition to a higher rate environment has increased risks and concerns over companies accustomed to low-cost capital, but which now lack the profitability to self-fund.
• Meaningfully higher interest rates should drive multiples lower without offsetting earnings growth acceleration, and we are already seeing this in the performance of the more interest-rate-sensitive sectors like utilities.
• The Strategy outperformed its benchmark for the third quarter, as positive stock selection in the utilities and consumer discretionary sectors helped overcome headwinds from financials.

By Reed Cassady, Albert Grosman, & Sam Peters

Market Update

The yield on the 10-year Treasury rose 74 basis points (bps) in the third quarter, reaching the highest level in 16 years. This higher-rate backdrop has significant implications for companies that grew up during the zero-interest rate policy period of the last 15 years. These companies became dependent on the incredibly low cost of capital stemming from this monetary policy, creating real concerns today about business models that lack the ability to self-fund.

The attractiveness of defensive stocks like utilities and consumer staples has also diminished given the rise in interest rates and the relative attractiveness of returns investors can earn on short- and long-term government bonds, helping to explain the underperformance of those sectors. Higher financing costs add to a list of growing real-world bottlenecks hampering the build-out of renewables and AI infrastructure. This could ultimately drive a forceful change in market leadership away from the Magnificent Seven mega-cap tech stocks if the resulting growth comes in short of what is currently embedded in their share prices.

Many businesses are threatened by a higher cost of capital, but one where reality has set in, and which also touches many other growth areas of the market, is the utility company NextEra Energy ( NEE ). Over the past few years, the company developed into a growth darling thanks to its strong track record in renewable energy development and tailwinds from the global energy transition and incentives in the Inflation Reduction Act. The problem for NextEra, and the transition broadly, is that this transformation is immensely capital intensive and many renewables projects offer lower returns on that capital. This requires high capital expenditures - often resulting in negative free cash flow - to meet the growth and financing needs of companies like NextEra. To help, the company leaned on financial engineering by using a publicly traded limited partnership called NextEra Energy Partners ( NEP ), providing further capacity for its parent to continue its development plans. NEP used layers of its own financial engineering to fund its own negative free cash flow and a large, growing dividend yield that we believe it could not sustain organically. Ultimately, the higher cost of debt from rising rates led NEP to lower its own growth ambitions, driving concerns about whether NextEra can execute on its extensive backlog. As a result, the stock has declined by approximately 30% year to date.

With rising costs of capital, internally generated free cash flow has even greater value versus relying on fickle capital markets"

This is merely one example of what is happening across industries at varying degrees of magnitude and rapidity, leaving entire supply chains supporting renewable buildouts and related electrical grid infrastructure at risk. This, combined with a massive rerating in its valuation, drove our decision to exit Quanta Services ( PWR ) during the quarter despite it being one of the biggest beneficiaries of the accelerating demand for renewables and electrical grid upgrades.

Additionally, we are seeing signs of other developments that could throw up roadblocks to capital expenditures, both in renewables and elsewhere. Access to skilled labor, permitting for transmission power lines, textbook Not in My Back Yard (NIMBY) pushback against land-intensive solar and wind farms, and potential rate-payer fatigue as utilities look to pass along the costs to consumers are all potential impediments to rapid deployment.

We believe this slower reworking of our electrical infrastructure has broader implications and could result in a much bigger market impact than the selloff in utilities in the third quarter. Optimism around AI and perceptions of relative fundamental stability have helped drive a huge move higher in IT mega-caps, with the Bloomberg Magnificent 7 Index up +90% year to date compared to +13% for the S&P 500 Index and +1.67% for the Russell 3000 Value Index. Roughly half of the move higher in those mega caps has been from an increase in their forward P/E ratios, while the Russell 3000 Value's multiple is flat over the same period.

Meaningfully higher interest rates should drive multiples lower, and we are already seeing this in the performance of the more interest-rate-sensitive sectors like utilities, whose forward P/E multiple has declined approximately 16% while Treasury rates have inversely risen (Exhibit 1).

Exhibit 1: Utilities Fall as Yields Rise

Of course, rates are just one input into a forward P/E multiple, with expectations for improving earnings growth likely the major driver behind the performance of the Magnificent Seven. However, while AI and cloud infrastructure demand underpin a good bit of this optimism, both are incredibly energy-consuming and require an accelerating cadence of renewables and transmission buildouts, which look increasingly tenuous against the current interest rate backdrop. Data center builds are also very capital-intensive and subject to many of the bottlenecks described earlier. Between the significant multiple expansion of the Magnificent Seven and the downward pressures of higher rates on valuation, any pushout in data center timelines and their resulting earnings growth will likely not be well received by the market and suggests greater risks for this cohort looking forward.

Instead of increasingly capital-intensive companies with outsize expectations, we believe the best risk-reward tradeoff resides in businesses that are unquestionably self-funding, benefit from underinvestment in (rather than accelerating) capex, and stand to benefit when these major capital cycles fall short of lofty aspirations. With rising costs of capital, internally generating free cash flow adds even greater value than relying on fickle capital markets, like NextEra and many others have. Yet, rarely have those strong cash flows been as cheap as they are now versus the market.

Additionally, the longer rates stay at current levels, and especially if they continue to move higher, the more interesting defensive parts of the market become. While regulated utilities and staples companies by and large appear uninteresting against the current rate backdrop, their fundamental steadiness has appeal in a recession, and they even have valuation upside if the Fed is forced to cut rates in response.

Portfolio Performance

The Strategy outperformed its benchmark for the third quarter, as positive stock selection in the utilities, consumer discretionary, and healthcare sectors, as well as an overweight allocation to the energy sector, helped overcome headwinds from our financials holdings.

Stock selection in utilities was a positive contributor to relative performance, driven primarily by Vistra ( VST ) and Constellation Energy ( CEG ), both of whom had macro tailwinds from rising power prices and strong idiosyncratic catalysts that helped them overcome the broader sector drawdown. Vistra's stock continued to rise on the back of rising energy prices and the company's upwardly adjusted full-year guidance following its second-quarter earnings call. In addition, the Nuclear Regulatory Commission approved the transfer of operating licenses for three Energy Harbor nuclear plants to Vistra, an important step toward the company lowering its CO2 emissions profile, driving better sentiment. Likewise, Constellation saw its share price increase thanks to climbing energy prices, higher margins within the company's commercial division, and investor optimism following an upward revision to its full-year EBITDA guidance as the company continues to execute well and wring more value out of its nuclear fleet.

In the consumer discretionary sector, retail gas station and convenience store operator Murphy USA ( MUSA ) benefited from rising fuel margins thanks to the combination of rising oil and gas prices and its low-cost operating discipline. As investors grew more uncertain about the future, the company saw increased demand for its lower-cost convenience store merchandise. We believe the company's more defensive nature will remain a tailwind in an increasingly uncertain economy.

Our financials holdings faced a number of company-specific challenges during the quarter, which weighed on their performance relative to the benchmark. For example, Euronet Worldwide ( EEFT ), a global leader in providing payment and transaction processing through ATM networks, point-of-sale management, and fraud management, revised its earnings outlook lower as European economic weakness weighed on transactions at its ATM business during the peak travel season in the third quarter. This naturally led to concerns about a quickening shift from cash to electronic payments, but we believe the company will emerge a winner as this transition takes place. Its ATMs remain the most profitable and will continue to take share from legacy operators like banks that will increasingly either remove their machines from the market or look to Euronet for outsourcing their ATM operations. This will allow the company to profitably grow in mature markets as data has shown consistently that cash penetration remains healthy across jurisdictions farther along in this transition. Lastly, the company will increasingly lean into ATM deployment in emerging market tourist locations with much longer growth runways and lower risk of electronic payments mix shifts.

Portfolio Positioning

We have taken a more cautious approach since the regional banking turmoil in March by holding more cash at attractive yields, rather than leaning into traditional defensives given the lack of valuation support to owning them. Now, given the selloff in those stocks, we are actively looking at several opportunities that could be initiated as new positions in coming quarters. Candidly, we remain cautious about further potential rate-driven blowups. While we have hypotheses as to where these next may occur, particularly in private equity and commercial real estate, we remain humble because crises usually only become obvious in hindsight. Regardless, we continue to believe a cautious stance is warranted and that the odds remain in favor of value styles, which should set the Strategy up well for long-term outperformance.

During the period we added QuidelOrtho ( QDEL ), in the healthcare sector, a leading provider of in vitro diagnostic solutions for measuring and detecting a wide range of diseases and health conditions. The company, formed from the merger of Quidel and Ortho Clinical Diagnostics in 2022, is starting to show signs of synergies largely overlooked by the market. In addition to lower revenue volatility stemming from more product offerings and cross-selling opportunities, we believe the company is poised to capture additional market share as it expands its testing products across disease types and its testing facilities geographically. We believe greater consumer awareness and demand for disease and health condition testing in the wake of the COVID-19 pandemic will be a long-term revenue and margin driver.

We also exited our position in Black Knight, in the IT sector, which develops software for real estate and mortgage transactions, after the stock benefited from its announced acquisition by financial data service provider and exchange operator Intercontinental Exchange ( ICE ).

Outlook

We believe recent market movements indicate we have entered a new market cycle categorized by higher rates and higher capital costs. Despite strong year-to-date performance by the AI-driven Magnificent Seven, we believe investors are beginning to recognize the increasing vulnerability of these concentrations and their elevated valuations as the economic outlook becomes less clear. However, we have used these opportunities to find and invest in attractively priced companies with strong balance sheets and attractive cash flows that will be well-suited to a higher-for-longer rate environment, and we continue to look for opportunities to optimize our long-term returns over this new market cycle.

Portfolio Highlights

The ClearBridge All Cap Value Strategy outperformed its Russell 3000 Value Index during the third quarter. On an absolute basis, the Strategy had losses from eight of the 11 sectors in which it was invested during the quarter. The leading contributor was the energy sector, while the industrials and financials sectors were the main detractors.

On a relative basis, overall sector allocation effects and stock selection contributed to outperformance. Specifically, stock selection in the utilities, consumer discretionary, health care and communication services sectors, an overweight allocation to the energy sector, an underweight to the real estate sector and the Strategy's cash position benefited returns. Conversely, stock selection in the financials, industrials and materials sectors detracted from performance.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Vistra, Noble ( NE ), Suncor Energy ( SU ), APA ( APA ), and Constellation Energy. The largest detractors from absolute returns were Alaska Air ( ALK ), AES ( AES ), Block ( SQ ), Euronet Worldwide, and Fiserv ( FI ).

In addition to the transactions listed above, we initiated positions in Everest Group ( EG ) and Corebridge Financial ( CRBG ) in the financials sector, Performance Food Group ( PFGC ) in the consumer staples sector and Biogen ( BIIB ) in the healthcare sector. We exited positions in Pfizer ( PFE ) and CVS Health ( CVS ) in the healthcare sector.

Reed Cassady, CFA, Director, Portfolio Manager

Albert Grosman, Managing Director, Portfolio Manager

Sam Peters, CFA, Managing Director, Portfolio Manager

Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

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Performance source: Internal. Benchmark source: Standard & Poor's.

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