CBA - ClearBridge Appreciation ESG Strategy Q2 2023 Portfolio Manager Commentary

2023-07-29 10:00:00 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.
• Although mega cap technology garners headlines given its contribution to index performance, market breadth and industry group performance suggest investors are in a risk-on mood with the prospect of a recession still in the distance.
• The current combination of increased optimism and elevated multiples suggests that patient investors will be rewarded with better buy opportunities in the future.
• ClearBridge takes a fundamental-driven approach to proxies, with portfolio managers bringing company-specific knowledge to bear on issues such as executive pay, use of controversial technology and biodiversity.

By Scott Glasser, Michael Kagan, & Stephen Rigo

A Company-Specific Approach to Voting Proxies

Market Overview

The S&P 500 Index’s ( SP500 , SPX ) 8.7% return in the second quarter felt nearly identical to its 7.5% return in the first quarter as mega cap technology continued to dominate index performance. Thematically, the same crosscurrents were also evident. On the positive side, investors remain exuberant over the potential of generative AI to revolutionize how we work and live; the economy is expanding and consumer spending resilient; and goods inflation, primarily food and energy, continues to moderate. On the negative side, the banking system remains under stress, making access to credit scarcer and more costly; wage inflation is high and sticky; the Fed is steadfast in its fight against inflation; and leading economic indicators and the yield curve suggest a recession is inevitable.

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 — that 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, it belies the reality of the past six months, in which the Nasdaq 100 posted its best first half ever, up 38.75%. Year to date, the sensational seven (Alphabet, Amazon.com, Apple, Nvidia, Meta Platforms, Microsoft and Tesla) contributed 73% of the S&P 500’s return, despite accounting for “only” 24% of the benchmark weight (Exhibit 1).

Exhibit 1: Contribution to S&P 500 Performance Year to Date

Although the quarter started strong with the S&P 500 up 2.7% in April, it was Nvidia’s ( NVDA ) eye-opening earnings report in late May that fanned the flames of the technology bull market. Nvidia shares surged 24% after guiding July quarter revenue and EPS 53% and 90% above consensus, respectively. The July quarter revenue outlook was a whopping $11 billion versus $7.2 billion consensus, the largest post-earnings upward revision in semiconductor industry history. Tech momentum carried on into June where the S&P 500 tacked on another 6.6%. In another analog to the first quarter, only three sectors outperformed the S&P 500: IT, consumer discretionary (driven by Amazon and Tesla), and communication services (driven by Alphabet, Netflix and Meta), leaving these sectors dramatically ahead of the market year to date.

On the flip side, the eight other sectors underperformed the S&P 500 for a second consecutive quarter, with energy and utility shares pacing the laggards. Energy continues to struggle as the price of oil is trying to find a bottom near year-to-date lows of $70 per barrel. Utilities appear to be a victim of higher interest rates, a heavy investment cycle and a risk-on market mentality despite reasonably strong trends in power consumption.

Although mega cap technology garners headlines given its contribution to index performance, market breadth and industry group performance suggest investors are in a risk-on mood with the prospect of a recession still in the distance. Breadth improved materially in the second quarter. Today 69% of stocks are trading above their 50-day moving average, up from a paltry 34% at the end of March (and above the long-term average of ~51%). Moreover, away from technology, economically sensitive industry groups such as homebuilders, construction materials, travel & leisure (specifically airlines and cruise lines) and machinery are outperforming, while traditionally defensive corners such as utilities, telecoms, and consumer staples are lagging. In the short term, there is little doubt the market is in an uptrend with offensive industry groups leading.

It has been our view for the past few quarters that a Fed-induced recession is a matter of “when,” not “if.” We still believe this to be true, albeit the economy’s resilience to this point has caught us by surprise. However, with wage inflation persistent (+6% YoY) and the job market still strong (the unemployment rate is only 3.6%), the Fed will need to further restrict financial conditions. Over time, this should slow economic growth, create labor slack and ultimately quell inflation. In addition, money supply is shrinking (for the first time in over 25 years), credit is more expensive and harder to access, the COVID-19-driven consumer savings glut is nearly spent, student loan repayments will shortly resume, and capital spending intentions are in decline. In the past 60 years, the rolling six-month average of leading economic indicators has never been below -0.25 without a recession. The current reading is -0.72, and it has been below -0.25 since June 2022 (Exhibit 2).

Exhibit 2: Leading Economic Indicators Suggest a Coming Recession

Although cautious, we have not been outright bearish as investor consensus had recession as the base case, which we felt was partially reflected in buy-side EPS expectations. In addition, before the current rally, the market’s P/E ratio had returned to near historic averages. However, our view is the investor base case has shifted to a soft landing or no recession while the market P/E ratio is now one standard deviation above its historic average (Exhibit 3). The gap between reported earnings and national income and product accounts (NIPA) earnings, which adjust out non-GAAP items, is the greatest ever, suggesting valuation is even more strained. The current combination of increased optimism and elevated multiples suggests that patient investors will be rewarded with better buy opportunities in the future.

Exhibit 3: S&P 500 12-Month Forward Price-Earnings Multiple

Outlook

We take Chairman Powell at his word that the Federal Reserve will continue to tighten until it achieves its 2% inflation mandate. As such, we believe higher interest rates and tighter financial conditions will ultimately create labor market slack, reduce consumer spending and ultimately lead to a recession. Increasing investor expectations for future sales and earnings (Exhibit 4) in the face of declining GDP (Exhibit 5) and elevated P/E multiples tells us the risk to equity markets has only grown year to date.

We continue to believe high-quality companies with stable and growing free cash flows, ample liquidity, fortress balance sheets and shareholder-friendly capital allocation are likely to outperform. We are cautious on cyclicals tied to credit and the consumer, such as banks, homebuilders, home improvement retailers and brand name apparel. While we are optimistic about the long-term benefits generative AI will have on workplace productivity, we believe the near-term impact is overestimated in share prices for many of the perceived beneficiaries. We are positive on property and casualty insurers due to broad-based pricing power, industrials tied to the energy transition, and materials companies —such as coatings — that benefit from moderation in raw material costs.

Exhibit 4: S&P 500 EPS Growth Year-Over-Year

Exhibit 5: Nominal GDP Growth Year-Over-Year

Conclusion

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

We are long-term investors. Rather than trying to project near-term earnings trends, we believe it is better to lookout two to three years and make investment decisions based upon our assessment of a company’s longer-term, sustainable growth rate relative to what is implied in today’s share price. As out-year expectations moderate for growth stocks we would be more comfortable adding risk to the portfolio.

As active managers, fundamental stock pickers, and believers that a diversified portfolio will deliver risk-adjusted alpha over a market cycle, we look forward to a less narrow market with normalized volatility. For the Fed to be successful in achieving its inflation mandate, we believe such an environment will have to return. In the meantime, we are building lists of stocks to own for the long term and stand ready to take advantage of the temporary price dislocations that volatility and bear markets create.

Portfolio Highlights

The ClearBridge Appreciation ESG Strategy performed in line with the benchmark in the second quarter, with negative sector allocation effects slightly overpowering positive stock selection effects. On an absolute basis, the Strategy had positive contributions from nine of 11 sectors. The information technology ((IT)), communication services and consumer discretionary sectors were the main positive contributors to performance, while the real estate and utilities sectors were the detractors.

In relative terms, stock selection in the consumer staples, IT, materials and health care sectors and an underweight to the energy sector contributed to relative returns. Conversely, underweights to the IT and consumer discretionary sectors and overweights to the consumer staples and materials sectors dragged on relative performance.

On an individual stock basis, the biggest contributors to absolute performance during the quarter were Microsoft ( MSFT ), Apple ( AAPL ), Nvidia, Amazon.com ( AMZN ) and Eli Lilly ( LLY ). The biggest detractors were Thermo Fisher Scientific ( TMO ), United Parcel Service ( UPS ), Pfizer ( PFE ), Progressive ( PGR ) and ArcelorMittal ( MT ).

During the quarter, we initiated new positions in Netflix ( NFLX ) in the communication services sector and Marvell Technology ( MRVL ) in the IT sector. We exited positions in Palo Alto Networks ( PANW ) and Enphase Energy ( ENPH ) in the IT sector, and Marriott International ( MAR ) in the consumer discretionary sector.

ESG Highlights

Why Is Proxy Voting Important?

The U.S. proxy season, most active between April and June each year, is when the majority of companies hold annual shareholder meetings. These meetings give shareholders a chance to review financial performance and to vote on resolutions made by both management and shareholders that address important issues affecting each company, called proxy votes. Broadly, issues include corporate governance, such as the election of board directors and management pay, as well as social and environmental matters that may be relevant to a company’s operations, products and services.

Shareholder proposals in 2023 have focused on a wide variety of environmental and social topics, with climate change, political spending/lobbying, human rights, diversity, equity and inclusion ((DEI)) and health/safety foremost among them. ¹

ClearBridge takes a fundamental-driven approach to proxies on behalf of clients, with portfolio managers bringing company-specific knowledge to bear on these and other issues. In voting proxies, ClearBridge is guided by general fiduciary principles. Our goal is to act prudently, solely in the best interest of the beneficial owners of the accounts we manage. We attempt to provide for the consideration of all factors that could affect the value of the investment and will vote proxies in the manner we believe will be consistent with efforts to maximize shareholder values.

At the same time, along with direct and ongoing company engagement, proxy voting is an important part of our approach to positively influencing companies through active ownership. ClearBridge’s votes on proposals filed by shareholders or by management are an effective way to signal confidence in the companies we own or to suggest the need for a change in policies, disclosures or related aspects of a company’s business.

Independent Voting, Informed by Company Fundamentals

A key part of ClearBridge’s approach to voting proxies is how portfolio managers take an active role. Some models of voting treat proxies as a largely administrative responsibility, so committees may be staffed with generalists with no investment experience. Other models simply hire a third-party proxy adviser. We would consider that an abdication of our fiduciary responsibility: we believe as fiduciaries the investment teams should have informed opinions on the proxies we vote, similar to the informed opinions we require to invest in or exit a given security. At ClearBridge, proxy voting forms an essential part of the fundamental investment and ownership process.

Pushing for Pay Equity

In some cases, our votes signal the need for companies to improve sustainability practices such as pay equity. These cases often involve voting against management, as we did in the case of portfolio holding Netflix’s proposal to ratify named executive officers’ compensation, a so-called “say on pay” vote. This was also a case where we took into consideration other stakeholder views; the Writers Guild of America reached out to us directly to share its perspective, given its current contract negotiations with major studios.

While this input did not sway our vote directly, we ultimately voted against this proposal due to 1) the magnitude of compensation, which for co-CEOs amounted to over $74 million including salary, stock and eligible bonus (the Writers Guild of America asked for $68 million for ~12,000 people), 2) the need to better tie bonuses and equity compensation to performance criteria, and 3) the ability for Netflix executives to receive an unusually high portion of their compensation in cash, instead of equity stakes, which we believe is a form of compensation more aligned with long-term value creation. Consistent with our active approach to ownership, we shared detailed feedback with Netflix on this proposal following the annual general meeting.

Supporting Biodiversity

Plastic pollution is ubiquitous, threatening ecosystems and biodiversity, a term that, in the context of sustainable investing, refers to the way ecosystems, which provide humans basic needs like food, fuel, shelter and medicine, may be positively or negatively affected by industry. This year portfolio holding Amazon received a shareholder proposal requesting it to issue a report on pollution from plastic packaging, including an assessment of its efforts to reduce the impacts on the environment.

In weighing our vote on this proposal, while we acknowledge that the company has made progress in reducing its packaging materials, we noted Amazon does not provide an overall baseline amount of plastic used throughout its supply chain. Although it disputes the filer’s claims regarding its plastic use, it does not provide competing data that allows investors to assess its progress. Meanwhile, several of Amazon’s peers have announced goals specifically around single-use plastic reduction. Although Walmart’s and Target’s sustainable packaging goals focus on private label products, we believe Amazon should be able to monitor third-party seller plastic use, given its knowledge of every item sold on its site. Amazon’s third-party marketplace has been growing faster than its first-party sales for the past several quarters, making it all the more important for the company to work with third-party sellers on surfacing their plastic usage data, even if not all of them are measuring that information today.

Concern over the environmental damage caused by plastics is rising and regulations are likely to go into force in many jurisdictions that would limit the amount of single-use plastic packaging that can be used. Additional disclosure would help shareholders gauge whether Amazon is appropriately managing risks related to the creation of plastic waste. We believed a vote for this proposal and against management was warranted in this case.

Companies Are Making Progress on Topics of Social Proposals

Proposals on pressing social topics saw less support in 2023 than in previous years, with median support for social proposals falling from 32.5% in 2021 to 24.1% in 2022 and 18.2% in 2023. ² However, this is not necessarily a sign of waning interest in these topics — indeed, the number of social proposals has been steadily increasing (Exhibit 6) — but can reflect a higher number of proposals submitted and the effect of company engagements on behalf of active owners like ClearBridge helping companies make progress on several fronts. In social topics as diverse as facial recognition, animal welfare and child labor, ClearBridge holdings have been making progress, and our votes signal our confidence in the companies we own.

Exhibit 6: Social and Environmental Proposals Continue to Increase

In 2023, a filer requested that Amazon disclose a third-party report on the company’s Rekognition facial recognition system. We found, however, Amazon’s oversight and guidelines for the technology to be sufficiently robust. Its Nominating and Corporate Governance Committee has oversight over corporate social responsibility practices, including risks related to human rights and ethical business practices, as well as risks related to operations and engagements with customers, suppliers and communities. In its Acceptable Use Policy, Amazon clearly prohibits using its services in an unlawful manner. Amazon states that it supports and has suggested guidelines for developing governmental regulations around these technologies.

Amazon has also established guidelines for customer use of facial recognition technology, specifically with reference to law enforcement agencies, including human review; a 99% confidence score; reliance on the technology as a starting point and not the sole determinant in taking action; transparent use of the technology and safeguards in place; and trained personnel using the technology. It has also published additional resources for guidelines on using facial recognition for public safety cases, and in June 2020 announced a one-year moratorium on selling the use of Rekognition to law enforcement to give Congress time to develop regulations around the technology. The company has now indefinitely extended this moratorium. In addition, Rekognition is an image analysis service, not a surveillance system, and similar tools are available from many other vendors. We believed a vote against this proposal was warranted.

Prioritizing Shareholder Benefit

Sometimes we may deem proposals to have little to no benefit for shareholders, even while we agree with the spirit of the proposal. For example, this year global snack food and beverage company Mondelez International, which operates under brands such as Oreo, Ritz, Toblerone and Cadbury, received a proposal requesting that it disclose updated cage-free egg benchmarks. The company outlines its animal welfare policies and goals, and it states its commitment to the Five Freedoms of animal welfare. It has a goal for 100% of its egg supply globally to be cage-free by 2025, excluding Ukraine and Russia. As of the end of 2021, it reports that 39% of eggs supplied globally were cage-free and 100% of the egg ingredients purchased in the U.S. and Canada were cage-free.

Overall, Mondelez appears to be making progress on its cage-free egg goal and discloses adequate information about its animal welfare policies. Although it makes interim goals for some of its other commitments, such as its climate targets, those targets tend to stretch over a longer time period, making interim goals more useful. Shareholders are unlikely to benefit from the requested update to such short-term goals, especially as Mondelez annually reports its progress toward its goal, which is set to be completed in 2025. For these reasons, we voted against this proposal.

Similarly, we voted against a proposal at Mondelez that asked the company to adopt and report on targets to eradicate child labor in its cocoa supply chain. Cocoa is a key ingredient in Mondelez’s chocolate products. ClearBridge has engaged Mondelez for several years on responsible sourcing in its cocoa supply chain, and believe it to be a leader with its Cocoa Life program, which launched in 2012 to improve sustainability in its cocoa supply chain in areas such as deforestation, improving cocoa farmer incomes and enhancing child protections. In a 2019 company engagement, we discussed its new commitment to source 100% of cocoa for its chocolate brands sustainably through Cocoa Life by 2025, up from 43% at the time. As of the end of 2022, this number is 80%.

The company also has goals for its Child Labor Monitoring and Remediation Systems (CLMRS) to cover 100% of Cocoa Life communities in West Africa; this number was at 74% in May 2022. In a late 2022 engagement we discussed Mondelez’s expanding its Cocoa Life spending by $600 million, up from $400 million. It noted farmer net incomes had increased by 15% in Ghana and 33% in Ivory Coast over the past decade, but there were still systemic challenges for cocoa farmers.

Overall, in-depth knowledge of the company and years of engagement on the topic leads us to believe Mondelez has set and progressed on meaningful targets which are not substantially different than those asked for in this proposal; for this reason we voted against it.

Proxy and Engagements Form Part of Active Ownership

ClearBridge proxy voting and company engagement go hand in hand as part of an active ownership strategy; our engagements can continue conversations with companies on sustainability topics raised by past shareholder proposals.

While engaging Mondelez on its 2023 proxy items, for example, we also caught up on topics from past proxy discussions, such as 2019’s proposal to report on deforestation in Mondelez’s supply chain. Large-scale deforestation results in reduced biodiversity (forests contain the vast majority of Earth’s amphibian, bird and mammal species) and destroys valuable carbon sinks able to help combat climate change.

ClearBridge voted against that proposal, finding the company had a comprehensive set of initiatives in place to reduce the deforestation impact of its cocoa supply chain. In 2023 the company found that, based on satellite images, there had been minimal deforestation since 2018 when it started working on pro-environmental community investments and education initiatives. It is also seeing positive progress on reforestation, growing local incomes from non-cocoa sources.

A Comprehensive Proxy Voting Policy Supports Consistent Voting

The ClearBridge Proxy Voting Committee, comprising mainly portfolio managers, analysts and legal/compliance personnel, meets at the beginning of each year to review the upcoming proxy season and to make amendments to ClearBridge’s Proxy Voting Policy to reflect our latest views on corporate governance, environmental and social proposals. The committee also meets after the proxy season to review and reflect on the proposals and votes that took place that year. Moreover, the investment teams will engage with the investee companies (and shareholder proposal proponents) throughout the year on proxy matters and vote rationales, and to ask questions.

While investor support for environmental and social proposals overall went down from 2022 to 2023, one of the more common reasons for certain votes against shareholder proposals was due to the “language” in them: proposals were poorly worded, overly prescriptive or deteriorative to shareholder value. This underscores the value of the Proxy Voting Policy to ClearBridge’s investment teams, as well as the direct involvement by the portfolio managers in voting on proposals that fall outside the policy. ClearBridge maintains a 100% vote record.

Scott Glasser, Chief Investment Officer, Portfolio Manager

Michael Kagan, Managing Director, Portfolio Manager

Stephen Rigo, CFA, Director, Portfolio Manager

Original Post

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

For further details see: