EADSY - ClearBridge All Cap Value Strategy Q4 2023 Portfolio Manager Commentary

2024-01-20 10:15:00 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.
• The market’s enthusiasm for a soft landing appears to be directionally correct, but a deeper look reveals vulnerabilities and suggests continued opportunities for valuation-focused investors.
• The Strategy underperformed its benchmark for the fourth quarter, as headwinds to the energy sector and stock selection in industrials overcame positive contributions from financials.
• With the valuation of growth versus value stocks still near all-time highs, and a similar dynamic at play among small caps, we believe our value and size tilts position the Strategy well.

By Reed Cassady, CFA, Albert Grosman, Sam Peters, CFA

Deeper Dive on Soft Landing Reveals Risks

Market Update

What an ending to the year for U.S. equities. The market has become increasingly convinced of a soft landing and inflation is easing toward the Federal Reserve’s target range across total, core and consumer expectation measures. There is a real possibility the Fed can start reducing short-term interest rates to less restrictive levels in the absence of recessionary conditions that appeared at times during the past year. As economic optimism spread and rates plummeted, equity markets rallied. The S&P 500 Index ( SP500 , SPX ) ended the quarter up +11.69% on a total return basis, while the 10-year Treasury ( US10Y ) yield dropped 69 bps and the two-year fell 99 bps as investors contemplated a decline in federal-funds rates.

On the surface this reaction appears to be directionally correct, but some of the internals of this move are more surprising and suggest continued opportunities for valuation-focused investors.

A better economic outlook and possibility of lower interest rates ought to flatter cyclical companies with leverage. We would have also expected a fade in the high-interest-rate-winner cohort, specifically in the Magnificent Seven (Mag 7) who are perceived to have growth drivers capable of powering through economic weakness as well as net cash balance sheets which, in many cases, benefit from higher interest rates.

Broader growth in a solid economy ought to lead to a broadening in equity market performance, and we saw that to some extent during the quarter. The small cap Russell 2000 Index ( RTY ) outperformed the S&P 500 by 234 bps, while the Russell Midcap Index outperformed the S&P 500 by over 110 bps. Yet the Mag 7 showed nearly identical returns to small caps with +14% performance in the fourth quarter, despite a huge move in those names through the third quarter when the outlook for rates and the economy was flipped from the optimism we saw exiting the year. Underpinning small caps’ strength is a huge rally in unprofitable companies — a junk rally, if you will. One measure of this dynamic is the return of the Goldman Sachs Non-Profitable Tech Index, which screamed +22% higher during the quarter.

"We believe there is something else at play: a desire to return to the playbook that worked so well during, and prior to, the COVID-19 pandemic."

This illustrates perils of translating macro into micro factors since (even if you get the economic call correctly) the transmission into the stock market is messy and can often lead to surprisingly bad outcomes. Certainly, positioning plays a role in much of this dynamic, with very high overlap, for instance, between the most-shorted stocks and the Non-Profitable Tech Index suggesting short-covering into year-end was a factor. However, we believe there is also something else at play, evidenced by the continued and surprisingly strong results from Mag 7 through the end of the year: a desire by many market participants to return to the playbook that worked so well during, and prior to, COVID, when both interest rates and real GDP growth were low.

From our viewpoint, the huge move in the Mag 7 is obviously not a fundamental one. Some have noted that EPS revisions for that cohort is meaningfully better than the rest of the market; we don’t think a close look at the data necessarily bears this out. While estimates for 2024 EPS for the Mag 7 have been revised up approximately 25% for the group versus a 1% decline for the S&P 500, almost all of this resetting has been driven by Nvidia. By excluding the chipmaker, estimates for the remaining Mag 6 are up a much more pedestrian 3% for 2024. Despite this, the group ended increasing 105% on a price basis for 2023. Even excluding Nvidia ( NVDA ), the return of the rest of the Mag 6 was still an impressive 86% — talk about multiple expansion. Even more incredible is the profile of Tesla ( TSLA ), which more than doubled in the face of estimates for 2024 falling a staggering 41%.

Portfolio Performance

The Strategy underperformed its benchmark for the fourth quarter, as headwinds to the energy sector and our stock selection in industrials overcame positive contributions from our financials holdings.

Energy was the worst-performing sector in the benchmark and the only one to generate negative returns during the quarter, as forecasts for a mild winter, greater than anticipated supply and lackluster demand from China weighed on performance of the broader sector. As a result, our overweight allocation to the sector was the largest detractor from relative performance. However, stock selection within the sector proved positive, as several of our natural gas high-quality holdings held up substantially better than their benchmark peers. For example, natural gas producers Pioneer Natural Resources ( PXD ) and EQT saw marginal declines during the period due to higher than estimated production levels and milder winter weather forecasts but held up better than more oil-focused energy producers who saw oil prices decline during the quarter.

Our industrials stocks faced headwinds early in the quarter due to fears of a recession, which weighed on some of our more cyclical industrials such as CNH Industrial ( CNHI ), a manufacturer of tractors and construction equipment. Additionally, the Fed’s pivot and the prospect of rate cuts in 2024 helped fuel a rally in lower-quality industrials that we did not hold, further dampening the performance of our high-quality and positive contributors such as Eaton ( ETN ), Airbus ( EADSY ) and GATX .

Stock selection in the financials sector was the leading contributor to positive relative performance during the period. Banking stocks such as Wells Fargo ( WFC ) saw their share price rise as investors anticipated Fed rate cuts that would reduce deposit costs while retaining economic strength and minimizing the risk of credit losses. The sector also contained our top performing holding during the period: Block ( SQ ), whose stock price maintained its upward momentum after it announced that Square retailers saw substantial increases in holiday spending trends and transactions, and as greater optimism for a soft landing helped alleviate investor concerns over consumer spending.

Outlook

Data shows that, over time, returns of stocks consistently follow their fundamentals. As such, the ClearBridge All Cap Value Strategy will continue to stay on the path of buying high-quality companies with below-average valuations and above-average earnings growth. Through economic and market re-rating and de-rating cycles, this should lead to outperformance over time, and we continue to view the narrow performance of U.S. indexes — particularly the lack of outsize fundamental upside of the Mag 7 — with skepticism and are inclined to lean in the other direction. With the valuation of growth versus value stocks still near all-time highs and a similar dynamic at play among small caps, we believe our value and size tilts will continue to position the Strategy well.

Portfolio Highlights

The ClearBridge All Cap Value Strategy underperformed its Russell 3000 Value Index during the fourth quarter. On an absolute basis, the Strategy had gains in 10 of the 11 sectors in which it was invested during the quarter. The leading contributor was the financials sector, while the energy sector was the sole detractor.

On a relative basis, overall sector allocation effects weighed on performance while stock selection was a positive contributor. Specifically, stock selection in the industrials and consumer discretionary sectors, an overweight allocation to the energy sector and underweight allocation to the real estate sector detracted from performance. Conversely, stock selection in the financials, energy and utilities sectors and underweight allocation to the consumer staples sector benefited returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Block, Wells Fargo, Micron Technology ( MU ), AES and Fiserv ( FI ). The largest detractors from absolute returns were APA , Atlas Energy Solutions ( AESI ), Suncor Energy ( SU ), SMART Global ( SGH ) and Noble ( NE ).

During the period, existing portfolio holding NCR ( VYX ) was renamed NCR Voyix ( NCRRP ) and spun-off NCR Atleos ( NATL ), both of whose shares we retained in the portfolio.

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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