SBNY - ClearBridge Appreciation ESG Strategy Q1 2023 Portfolio Manager Commentary

2023-04-14 22:30:00 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.
• Although we still believe higher rates will benefit our well-diversified portfolio and lead to a sustained rebound in value stocks relative to growth, the exact opposite occurred in the first quarter; in our experience an up market driven with narrow breadth is often a warning sign of rocky times ahead.
• The industry-wide deposit flight caused by the failure of Silicon Valley Bank and Signature Bank adds significant incremental pressure to financial conditions via tighter lending standards and higher borrowing costs.
• Recent net-zero engagements across ClearBridge help us get under the hood with company-specific nuances to setting or meeting science-based emissions reduction targets and highlight the value of lesser-known enablers of the energy transition.

By Scott Glasser, Michael Kagan, & Stephen Rigo

Market Expectations Still Too High

Market Overview

A casual observer might see the S&P 500 Index’s ( SP500 ) +7.5% return in the first quarter and assume equity investors had an uneventful yet constructive start to the year. However, peel back the onion a layer and you find a spicier story. On the one hand the banking industry saw two top-30 banks fail (the second and third largest bank failures in U.S. history) while a third bank of similar size teeters. As a result, the Dow Jones U.S. Select Regional Banks Index ( DJSRBK ) plummeted 25% in the quarter.

By contrast, the world was introduced to a new application of artificial intelligence ((AI)) known as “generative AI” via Microsoft’s ( MSFT ) investment in OpenAI and collaboration with OpenAI’s ChatGPT model. In contrast to 50 years of hype about AI but relatively little real world impact, generative AI has already transformed computer programming and appears to have many other uses. Investors chased stocks perceived to benefit from the emergence of this technology, particularly in the semiconductor and interactive media industries, which rose 36% and 30%, respectively, in the quarter.

In 2022 there was a growing chorus that — after years of S&P 500 performance being dictated by a handful of mega cap technology companies — higher rates would benefit a well-diversified portfolio and lead to a sustained rebound in value stocks relative to growth. Although we still believe this to be true, the exact opposite occurred in the first quarter. Returns felt like a 2021 redux with performance driven by a narrow subset of mega cap growth stocks. Six stocks accounted for three-quarters of the S&P 500’s total first-quarter return, despite being only one-fifth of its weight. ¹ Apple alone contributed over 20% of the S&P’s total first-quarter return.

Measures of market breadth help illustrate this point. If we zoom out and look at the 3,000 largest U.S. listed companies, only 34% are trading above their 50-day moving average, well below the 54% average over the past decade (Exhibit 1). Said another way, the average stock did not participate in the rally. Our experience has been that an increase in the market driven by a narrow set of stocks is often a warning sign of rocky times ahead.

Exhibit 1: Signs of a Narrow Market

The S&P 500 was strong out of the gate and finished January +6.3%. Technology and communication services shares, which were battered in 2022, came roaring back, advancing 9.3% and 14.5%, respectively, in January alone. The rally was spurred by the combination of oversold conditions and softer-than-expected inflation data driving optimism that the Fed could still achieve a soft landing. It was the second-best quarterly performance for technology stocks (+24.1%) in the past 20 years, trailing only the snapback driven by COVID-19 stimulus in the second quarter of 2020. Communication services (+20.5%) and consumer discretionary (+16.8%) stocks also outperformed meaningfully in the quarter, the latter sector returns almost entirely explained by rallies in Tesla and Amazon.

On the flip side, financials and energy struggled. Financials paced the decline, falling 3.4%%, led by ailing banks where rising interest rates have gone from virtue to vice. Energy (-4.7%) also struggled as oil and natural gas prices fell 6% and 51%, respectively. Finally, health care (-4.3%) shares struggled as investors moved money away from 2022’s safe havens in pharmaceuticals and managed care.

It has been our view for the past two quarters that Fed interest rate hikes and balance sheet runoff are sufficient to create more restrictive financial conditions that over time should slow economic growth, create labor slack, and ultimately quell inflation. Money supply is shrinking for the first time in over 25 years (Exhibit 2), borrowing rates have increased (mortgage rates are at the highest level in 30 years), consumer savings are being spent down after the COVID stimulus surge, and capital spending intentions are in decline. To us these are all signs of slower economic growth ahead.

Exhibit 2: Money Supply Is Shrinking

The industry-wide deposit flight caused by the failure of Silicon Valley Bank and Signature Bank ( SBNY ) adds significant incremental pressure to financial conditions via tighter lending standards and higher borrowing costs, in our view. As bank funding becomes scarcer, the ability to grow becomes constrained (Exhibit 3). As their cost to fund increases, our cost to borrow will follow suit. The Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) suggested even before the bank failures that banks had started tightening lending standards. We believe these failures were a seminal event and the starting gun to a credit cycle that will make a recession all but inevitable.

Exhibit 3: U.S. Commercial Bank Deposits Become Scarce

There is scope for optimism. The idea of a Fed-induced recession is seemingly a base case outlook for investors today and partially reflected in buy-side EPS expectations (less so the more sanguine view reflected in sell-side consensus). In addition, the market’s P/E multiple is now within an earshot of historical averages. Finally, we are likely at or near the end of the Fed’s interest rate hiking cycle, which suggests we’re using near-peak discount rates when valuing stocks on the present value of future cash flows. However, just as positive EPS revisions and low interest rates supported an expensive market in 2021, we remain concerned equities in 2023 are at risk for negative EPS revisions, which could further impact the market multiple. Although the market is cheaper today, it is not cheap given the current backdrop.

Outlook

The market decline from 2021 to today largely reflects higher interest rates but not yet the lower earnings from a likely recession, in our view. Consensus seems overly optimistic that double-digit earnings growth will return late in 2023 and persist throughout 2024 (Exhibit 4), especially since the forecast requires meaningful operating leverage into what we see as a slowing global economy with sticky wages. We would be much more comfortable should EPS expectations reset to more subdued levels of growth through at least the first half of 2024.

Exhibit 4: EPS Expectations May Be Too High

We continue to believe high-quality companies with stable and growing free cash flow, ample liquidity, fortress balance sheets and shareholder-friendly capital allocation are likely to outperform. We are cautious on cyclicals that ran up in late 2022 in the hope of a soft landing, such as auto OEMs and stocks exposed to residential housing. Health care continues to look attractive to us. Pharmaceuticals did very well last year, and we will probably take some profits in order to add to medical devices. Coming out of the recession we will want to hold significant positions in growth stocks that will benefit from trends such as generative AI. But we are wary of acting too soon, as these stocks can be volatile. We do not believe the market reflects the recession we see coming, and we expect to have a better opportunity later in the year. We continue to believe base inflation remains sticky, especially wages, and that the Fed is in a tough spot between inflation fighting and ensuring the safety and soundness of our financial system. We expect Chairman Powell to maintain a restrictive policy stance longer than the market expects, barring a more systemic issue with our financial system.

Throughout 2022 we asserted investor total return expectations should be muted near-term, a stance we maintain today. Although the economy has proven more resilient to tighter financial conditions than we previously expected, we believe a recession is inevitable and potentially more severe given the stress on our banks. We expect at least a normalization of credit costs beginning in the second half of 2023, with the potential to overshoot in 2024.

We are mindful that the market is a discounting mechanism and will make its bottom before earnings and the economy trough. Rather than trying to project near-term earnings trends, we believe it is better to look out two to three years and make investment decisions based on the longer-term, sustainable growth rates of companies. As expectations moderate for growth stocks, we would be more comfortable adding risk to the portfolio.

Portfolio Highlights

The ClearBridge Appreciation ESG Strategy underperformed the benchmark in the first quarter. On an absolute basis, the Strategy had gains in five of 11 sectors in which it was invested. The IT, communication services and consumer staples sectors were the main positive contributors, while the health care sector was the main detractor.

On a relative basis, overall stock selection and sector allocation effects detracted. In particular, stock selection in the consumer discretionary, industrials, communication services and health care sectors, underweights to the IT and consumer discretionary sectors and overweights to the financials and consumer staples sectors detracted the most. Conversely, stock selection in the financials and consumer staples sectors and an underweight to the energy sector proved beneficial.

On an individual stock basis, the largest contributors were Microsoft, Apple ( AAPL ), Nvidia ( NVDA ), Amazon.com ( AMZN ) and Costco ( COST ). The main detractors were UnitedHealth Group ( UNH ), Pfizer ( PFE ), Johnson & Johnson ( JNJ ), Honeywell ( HON ) and Bank of America ( BAC ).

During the quarter, we exited a position in General Motors ( GM ) in the consumer discretionary sector.

ESG Highlights: ClearBridge Engagements Zero In on Net Zero

Climate change, and its associated investment opportunities and risks, remains a priority for ClearBridge, both in our active stock selection across portfolios and in our engagements with C-suite leaders of the companies we invest in. Our interest in the topic across sectors and portfolios coincides with growing interest in climate mitigation across the country: as of December 2022, 33 U.S. states had released a climate action plan or were in the process of revising or developing one, according to the Center for Climate and Energy Solutions.

In 2021 we joined the Net Zero Asset Managers (NZAM) initiative — a group of more than 300 asset managers with nearly $60 trillion in assets under management committed to getting the world to net-zero carbon emissions by 2050 — and we have designed our net-zero approach around high-touch engagement with portfolio companies on their decarbonization strategies.

We are making progress on our goal of assessing each portfolio company’s emissions trajectory and determining its alignment with the pathway required to achieve global net-zero emissions by 2050 (Exhibit 5). We are ahead of schedule in confirming the net-zero alignment of our initial in-scope assets (43% we deem to be net-zero aligned versus a goal of 39% as of December 2022), and are conducting either in-depth or exploratory engagements with unaligned portfolio companies across the firm.

Exhibit 5: Tracking Progress Toward Targets for In-Scope Assets

Recent net-zero engagements across ClearBridge portfolio companies reveal how company- and sector-specific conditions shape decarbonization efforts, help us get under the hood with challenges to setting and meeting science-based emissions reduction targets and highlight the value of lesser-known enablers of the energy transition.

Semiconductor Growth Sets High Bar for Renewable Energy Capacity

ASML makes semiconductor manufacturing equipment and is a leading supplier of lithography systems to the semiconductor industry. It has set science-based targets to achieve net-zero Scope 1 (direct from sources controlled or owned by a company) and Scope 2 (indirect, through the purchase of power, heat, cooling, etc.) emissions by 2025, and zero emissions in the supply chain or Scope 3, by 2030. We consider ASML’s emissions reduction pathway to be net zero aligned.

While ASML seems on track to meet its net-zero goals, in January 2023 we met with its CEO to discuss, among other topics, potential hurdles it might encounter along the way. Among these might include ASML’s own success as it works to build a renewable energy grid for its Veldhoven headquarters in the Netherlands fast enough to keep up with its own growth. ASML is investing in solar and wind and working with energy generation companies to build its own renewable energy capacity in order to support its fast-growing production capacity. The company also cited a goal of 75% reduction in gas use as another key lever in meeting its Scope 1 and 2 goals, which we find credible.

While ASML works to lower its own emissions, it is also enabling its customers to lower theirs. As a semiconductor capital equipment provider, ASML directly improves the energy efficiency of semiconductor chip manufacturing. Its extreme ultraviolet (EUV) lithography systems, which took ASML more than two decades to develop, enable semiconductor manufacturers to make chips that use less energy and/or have higher performance. More power-efficient chips have an emissions reduction multiplier effect down the semiconductor supply chain. ASML directly enables chip manufacturers serving rapidly growing data center and AI businesses, as well as auto and industrial markets, and even smart phones to make more powerful chips using less energy.

Navigating Spotty EV Penetration

Casey’s General Stores ( CASY ) is one of the largest gas station and convenience store owners and operators in the U.S., with over 2,400 stores predominately in the Midwest. Most of Casey’s sales and profits come from the sale of gasoline, prepared foods (pizza, sandwiches and breakfast items) and grocery and other convenience items. Its stores are well-located and have significant brand recognition. Casey’s tends to have dominant market share in the states and the markets in which it operates. As such, its business is stable and cash generative. Also, its small market presence gives Casey’s pricing power and provides for a wide moat against would-be competitors.

One of the risks to Casey’s is the slow but accelerating shift from internal combustion engine cars to electric vehicles (EVs). This will slowly eat into the company’s sales of gasoline and some traffic into the stores. We have encouraged Casey’s to be a leader in the rollout of EV charging stations at its stores. To this end, currently Casey’s has installed EV charging stations at 29 of its 2,400+ gas station and convenience stores. Management has shared with us that the stores with EV chargers average roughly 390 fuel transactions per day but average only 12 EV charges per day. That equates to a 3% penetration rate for EV demand. That data may actually overstate demand somewhat because the stores with the EV charging stations were handpicked by their charging station vendor/partner as being the stores most likely to see charging demand. EV adoption across the U.S. remains concentrated in mostly coastal states (Exhibit 6); across Casey’s entire 16-state portfolio, we think EV charging demand is roughly 0.6%. We, and the company, recognize that EV acceptance is lower in Casey’s market than in other more urban and coastal markets.

Exhibit 6: EV Penetration Across the U.S. Is Uneven

Casey’s remains committed to offering EV charging as a service, just as it offers gasoline today, but will do so at a rate that more closely aligns with the rate of EV acceptance and demand for EV charging. As EV penetration continues to rise, Casey’s will install more charging stations. We also believe that the level of service and range of goods and prepared foods offered inside Casey’s stores will make Casey’s an attractive place to pass the time required to recharge electric vehicles.

Capital-Intensive Industries Going Digital

Part of our net-zero strategy entails recognizing climate solution enablers such as Aspen Technology ( AZPN ), a pure-play industrial software leader supporting complex operations across a wide range of industry verticals, including operations, maintenance and asset optimization. The company has limited carbon emissions itself, and our engagements with it focus on how it is benefiting from the growth in renewables and sustainability investments as Aspen helps the digitalization of capital-intensive industries. Broadly, Aspen’s products help organizations streamline engineering and maintenance processes to reduce downtime and increase operational efficiency, in part helping industry to limit emissions and pollution.

Recent engagements with the company’s CEO and CFO have focused on markets opened up by Aspen’s recent transaction with Emerson Electric to acquire Emerson’s Open Systems International ((OSI)) and Subsurface Science and Engineering ((SSE)) businesses in exchange for a majority share in the combined company. OSI helps global electrification through digitalizing and optimizing transmission and distribution systems for utility companies in the power industry. In particular OSI supports smart grid initiatives, processing and analyzing millions of data points in real time from all levels of the electrical power supply chain, helping to manage the complexity of integrating renewable energy into the grid.

Aspens’ SSE business supports efficiency in the oil and gas industries and aids the development of carbon sequestration, geothermal and hydro energy.

Sustainability investments and decarbonization spending across the product suite should act as strong growth drivers for Aspen. Its technologies are also being used by Google and Meta to model emissions and heat flows at data centers, and Tesla and Rivian are now customers on battery energy flow modeling. Biofuel and hydrogen investments are expected to be modeling intensive, too, providing Aspen several avenues to deliver for shareholders and help decarbonize the operations of equities across many sectors.

Climate Initiatives Raise Awareness and Improve Disclosures

ClearBridge’s involvement with several climate initiatives — such as the Task-Force for Climate-related Financial Disclosures (TCFD), which develops consistent metrics for companies to use in disclosing financial risks associated with climate change; Climate Action 100+, an investor-led initiative to engage high emitters on lowering emissions and better disclosure; and the CDP, or Carbon Disclosure Project, which collects climate and water data from companies worldwide — further supports more acute awareness of climate risk and attests to our commitment to moving the energy transition forward.

In the interest of transparency, we provide more information on our climate-focused investing in our 2022 Climate Report and outline our approach to meeting our NZAM commitment, both on our website and via the Principles of Responsible Investment .

Scott Glasser, Chief Investment Officer, Portfolio Manager

Michael Kagan, Managing Director, Portfolio Manager

Stephen Rigo, CFA, Director, Portfolio Manager

Original Post

For further details see: