BALL - ClearBridge Appreciation ESG Strategy Q4 2023 Portfolio Manager Commentary

2024-01-20 06:15:00 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 mid-year malaise reversed emphatically in the fourth quarter as investors began to price in a Fed not only done raising interest rates, but also likely to cut them in the first half of 2024.
• The market’s powerful year-end advance was broad-based and included small cap participation — healthy attributes that were missing from the rally in the first half of the year.
• In line with our philosophy to continually advance our ESG engagement process, ClearBridge has taken steps to better structure, measure and communicate the progress and outcomes of key engagements, and in 2022 we launched an enhanced internal engagement initiative called Engage for Impact.

By Scott Glasser, Michael Kagan, & Stephen Rigo, CFA

Market Participation Broadens, but Recession Still the Base Case

Market Overview

The S&P 500 Index’s ( SP500 , SPX ) mid-year malaise reversed emphatically in November and December. After a third consecutive monthly decline in October (-2.1%), the S&P 500 roared back, jumping 14.1% from November 1 into year end. When all was said and done, the S&P 500 returned 11.7% in the fourth quarter (its best quarterly performance since the fourth quarter of 2020) and 26.3% in 2023, leaving the benchmark within an earshot of January 2022’s all-time highs.

During the quarter, 10 of 11 sectors advanced in absolute terms, with real estate leading the way as investors began to price in a Fed not only done raising interest rates, but also likely to cut them in the first half of 2024. Technology shares also outperformed meaningfully as artificial intelligence ('AI') growth opportunities continued to excite investors. Technology led all sectors in 2023, returning a whopping 60.8% and marking the ninth year out of the past 10 for tech relative outperformance (with 2022 being the outlier). Although the tech-heavy communication services sector advanced roughly in line with the index in the fourth quarter, it finished the year as another notable outperformer, returning 56.4% in 2023.

Energy, the lone sector to decline in the fourth quarter, was down 7.0%. Energy also has the notable distinction of being one of only two sectors to decline on an absolute basis in 2023. Utilities — the other — was one of two sectors to underperform the benchmark in every calendar quarter of 2023, sharing this distinction with consumer staples.

The powerful market rally to end the year was driven by a precipitous decline in interest rates as sustained disinflationary trends created an expectation that not only is the Fed finished raising rates, but rate cuts would also begin sooner and be more numerous than previously expected. The proverbial punch bowl was spiked post the December Fed meeting where Chairman Powell’s dovish press conference added to the soft landing narrative given strong current GDP growth, full employment, and a Fed pivot in sight. As a result, the 10-year Treasury ( US10Y ) yield, which peaked at nearly 5% in October, ended the year below 4%, while federal-funds futures priced in six interest rate cuts in 2024. Given the current economic backdrop and market valuation, the soft landing narrative has seemingly become consensus for equity investors.

Coming into the year we anticipated the Federal Reserve’s rapid withdrawal of liquidity would keep pressure on equities and ultimately lead to a recession. We continue to forecast at least a mild recession, as many of the key indicators we track still point in that direction. The Conference Board’s basket of leading economic indicators ('LEI') has declined sharply over the last two years (Exhibit 1) and remains disconnected with GDP growth. In addition, the yield curve has been inverted for over a year, a duration consistent with where economic weakness should become more evident (the curve tends to un-invert at recession onset). Finally, the average stock had been mired in downtrend while index gains were largely driven by the Magnificent Seven mega cap technology stocks (Alphabet, Amazon.com, Apple, Microsoft, Meta, Nvidia and Tesla). Highly concentrated equity markets tend to be unhealthy. As such, we’ve been hesitant to declare the “all clear” signal for equities.

Exhibit 1: Leading Economic Indicators

However, the market’s powerful year-end advance was broad-based and included small cap participation — healthy attributes that were missing from the rally in the first half of the year. Although it would not be unusual for markets to correct or consolidate after the impressive year-end rally, we view current internals as more supportive of a sustainable uptrend than the highly concentrated market of 1H23. To us, this suggests any recession is likely mild and dealt with by equity investors via a buyable correction.

That said, we believe investors should anticipate historically average equity market returns from here (high-single-digit total returns) versus the heady 20%+ gains seen in three of the past four years, as valuations suggest the market is already pricing in the soft landing. In the past, we’ve pointed to various valuation metrics to support a subdued total return environment, such as a 12-month forward P/E ratio and the Buffett Indicator (a ratio which measures total equity market cap as a percentage of GDP). Both of these sit over one standard deviation above their long-term average.

However, the valuation measure that stands out today is the Fed Model, which compares the S&P 500’s earnings yield (the inverse of its P/E ratio) to the 10-year Treasury yield. For the first time since the financial crisis, the risk-free yield is competitive with the earnings yield offered by the stock market. Said another way, for the first time in over a decade, stock market investors have competition from less risky alternatives (Exhibit 2).

Exhibit 2: Treasury Yields Compete with Equities

Outlook

While we believe investors remain too complacent regarding corporate profits and the economy, our prior forecasts underestimated the impact of fiscal stimulus on the U.S. financial system during the COVID years. Huge fiscal spending programs, both at the state and federal levels, materially boosted GDP this past year and their impact continues to help counteract the effects of tighter monetary conditions. In addition, structural changes in employment, again partially resulting from COVID, have made corporations reluctant to cut employees, keeping labor markets tight. As a result, consumption, which accounts for two-thirds of U.S. GDP, remains at higher levels than might be expected during more traditional tightening cycles.

That said, consumer savings are now back at pre-COVID levels, the housing market is both slow and unaffordable and employment is likely to deteriorate as employers attempt to maintain margins in the face of slowing demand. Although a recession remains our base case, we believe that the odds of a significant economic downturn are lower as the lingering effects of fiscal spending are helping cushion the impact of monetary tightening. Layer in the potential for proactive interest rate cuts ahead of lagging employment data, and the potential for a soft landing seems viable.

Historically, at the start of a new bull market, small and mid cap stocks tend to lead the way in performance, and participation is now robust across the spectrum. The improving breadth and small cap participation evident in November and December may indeed prove an early signpost for a durable expansion.

While we are optimistic about the long-term benefits generative AI will have on workplace productivity, aggressive assumptions need to be made to justify current valuations. We are positive on much of the health care sector as market expectations for medical device and life science/tool companies have come in markedly, while we find the noncyclical nature and modest valuation of pharmaceutical companies appealing. We are positive on select cyclicals such as rails and logistics companies where expectations are low and sustained economic growth would create upside. We believe easing financial conditions and the potential for rate cuts and a steeper yield curve will benefit select financial companies such as banks and other mortgage-exposed institutions. We do not expect the top-heavy market of 2023 to continue, and we believe a diversified portfolio with investments focused on durable growth at attractive valuations is best positioned in this transitioning interest rate regime.

Conclusion

Although we have become more constructive on the medium-term outlook, we believe total return expectations should be closer to long-term trend (high single digits or low double digits) versus the larger swings that have become common in the post-COVID environment.

We are long-term investors. 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 upon our assessment of a company’s longer-term, sustainable growth rate relative to what’s implied in today’s share price. Although we prefer certain cyclicals with moderate expectations today, as out year expectations moderate for growth stocks we would be comfortable adding risk to the portfolio.

Portfolio Highlights

The ClearBridge Appreciation ESG Strategy underperformed the benchmark S&P 500 Index in the fourth quarter. On an absolute basis, the Strategy had positive contributions from all 11 sectors. The information technology ('IT') and financials sectors were the main positive contributors to performance.

In relative terms, stock selection in the industrials, health care and IT sectors detracted the most, while an IT underweight and a consumer staples overweight also weighed on results. Conversely, stock selection in the consumer staples and energy sectors and an energy underweight proved beneficial.

On an individual stock basis, the biggest contributors to absolute performance during the quarter were Microsoft ( MSFT ), Costco ( COST ), Apple ( AAPL ), Amazon.com ( AMZN ) and JPMorgan Chase ( JPM ). The biggest detractors were Becton Dickinson ( BDX ), Pfizer ( PFE ), Automatic Data Processing ( ADP ), BALL and McCormick ( MKC ).

During the quarter, we initiated positions in Crown ( CCK ) and Linde ( LIN ) in the materials sector and exited positions in PayPal ( PYPL ) in the financials sector and Ball in the materials sector.

ESG Highlights

An Enhanced Internal Engagement Initiative

Engagement to drive positive change in public equities has been a longstanding part of ClearBridge’s investment decision making and active ownership. As a long-term shareholder with an average stock holding period of five years, ClearBridge has cultivated strong and lasting relationships with company management teams. With this unique position and decades of industry experience, we’ve taken steps to better structure, measure and communicate the progress and outcomes of key engagements, and in 2022 we launched an enhanced internal engagement initiative, Engage for Impact (EFI).

The initiative encourages targeted engagements that we believe have a strong likelihood of creating positive impact, which we define as the creation of long-term positive environmental or social outcomes for the benefit of all stakeholders in public companies: their investors — our clients — and their employees, customers, suppliers and communities.

While we believe our work can often influence significant improvement at the company level, we also recognize we are one of many shareholders working to create change. In many cases this collective voice is what ultimately leads to positive, real-world impact.

As a part of this new initiative, investment team members develop specific “asks” or areas of improvement for priority target companies. Progress against these “asks” is then monitored and reported on over time.

As long-term investors, our company engagements can take place over a multiyear period. Therefore, throughout the course of the engagement, we track and categorize company progress by stages (Exhibit 3).

Exhibit 3: Engage for Impact Progress Framework

Using this framework, we can better monitor and track a company’s responsiveness and progress against key performance indicators and report on these outcomes over time. EFI engagements follow a consistent structure, prioritize topics closely aligned with value creation, represent a wide variety of sustainability topics (Exhibit 4), and are often rooted in firmwide focus areas like net zero, biodiversity, human rights, as well as diversity, equity and inclusion.

Exhibit 4: Engage for Impact Asks by Category

Given this enhanced initiative is still in the early stages, most of our EFI company asks are currently categorized as early stage or in-process (Exhibit 5). Examples of company asks focused on reducing emissions, improving labor relations, expanding electric vehicles (EVs), improving board effectiveness and implementing total shareholder return (TSR) metrics convey the spirit and overall benefits of the initiative.

Exhibit 5: ClearBridge Engage for Impact Asks by Stage

Decarbonizing Aviation: United Parcel Service ( UPS )

Reducing emissions is a common ask among ClearBridge’s company engagements broadly. For an EFI with United Parcel Service (UPS), we acted on the opportunity to formulate a specific ask for a reduction in Scope 1 and 2 emissions from its aviation fleet, which comprises ~300 planes. We actively engage with UPS on setting aggressive carbon reduction targets as its stock is held in a strategy that is in-scope for ClearBridge’s net-zero commitment.

In our engagements with UPS, we have discussed how due to heavy reliance on future technologies such as sustainable aviation fuel, the company recognizes it cannot credibly set a company-wide target approved by the Science-Based Targets initiative (SBTi) at this time. However, the company has acknowledged our ask as a key area of focus over the next 10-15 years and recognizes decarbonizing its aviation fleet is a key part of the global energy transition. It also recognizes the need to align all other parts of the business with a net-zero pathway in an effort to decarbonize. Efforts currently underway include investments in electrical vertical takeoff and landing aircraft and full electrification of its ground fleet, with a 2025 goal of 40% alternative fuel for ground vehicles, up from 24% today. We will continue to engage UPS as a stage 2 EFI to monitor progress against other reduction targets and continue to urge the company to decarbonize its aviation fleet.

Bettering Driver Relations and Expanding EVs: UBER

In stage 3 of an EFI the company has acknowledged the ask and has developed a credible strategy to address it. The company may even have begun and be well along in addressing it, as is the case with Uber and two asks we have formulated to: 1) improve driver satisfaction, and 2) expand its adoption of EVs toward achieving its net-zero goal.

We’ve engaged Uber since its IPO in 2019 as concerns over employee classification have led to questions of worker pay and benefits that we felt overshadowed other merits of its rideshare business, for example rideshare’s democratization of transportation and Uber’s impressive safety record.

In December 2019, we met with the company to discuss driver earnings and shared our view that drivers should remain contractors with added benefits and pay protection. At that time, Uber had already shifted its operating philosophy to a more conciliatory approach and improved relationships with contracted partners with guaranteed pay minimums, portable benefits and bargaining rights.

We continued the conversation as part of regular meetings with the company over subsequent years, and at a January 2024 meeting with Uber’s CEO, CFO and other representatives, we were pleased with progress made against both asks. Management highlighted improvements made to the driver experience, including technology, earnings and worker flexibility. Specifically related to driver earnings, the primary concern, drivers on the platform currently earn an average of ~$36 per utilized hour on a gross basis and low-$20s net of expenses and overhead. Up-front fares, which are now being rolled out globally, provide improved earnings transparency. On fairness, where drivers see anywhere from a 0% to 50% take rate (the percentage Uber takes of gross margins), Uber plans to share weekly reports with drivers clarifying take rates and distributing make-whole payments where appropriate.

To achieve its SBTi-approved net-zero goal by 2040, Uber is focusing on driver incentives and education to drive adoption of EVs across its platform. Results so far are promising and getting better: 4.7% of Uber’s trip miles driven in the U.S. and Canada are completed in zero-emission vehicles, even though EVs represent just ~1% of total cars on the road in the U.S.

Enhancing Board Quality and Operational Efficiency: Comcast ( CMCSA )

Comcast is also at stage 3 in its EFI action as it is making measurable progress on EFI asks regarding 1) addressing some concerns from third-party governance research providers on overboarding and board effectiveness, 2) setting verified science-based targets and 3) addressing efficiency of operations, specifically as it relates to suppliers.

In December 2019, we engaged Comcast on a variety of ESG topics and raised the issue of board independence. We followed up in May 2020 when we discussed a proxy proposal on the split Chairman and CEO role. Following this meeting, Comcast improved the independence of its board, upping the percentage of independent director nominees from 80% in 2019 to 89% in 2022, as well as improving board diversity, from 40% of director nominees being diverse by gender or race in 2019 to 44% in 2022.

In December 2022, we continued the conversation around board effectiveness and engaged the company on its board structure, raising concerns around overboarding or having board members sit on too many boards, which may compromise their ability to serve the board effectively. This issue has been flagged by third-party governance research providers.

In a December 2023 engagement, Comcast shared that it was making progress addressing overboarding by bringing down the average tenure of its board by incorporating a policy on director overboarding into its corporate governance guidelines that limits the number of public company boards on which directors may serve. As part of the policy, no director who also serves as CEO at a public company may serve on more than three public company boards. A notable example is lead independent director Ed Breen, who is also the current CEO of DuPont de Nemours. He proactively sought to reduce the number of boards he sits on and chose not to stand for re-election to the board of International Flavors & Fragrances at the company’s 2023 annual meeting.

Also at our December 2023 meeting, Comcast disclosed its Scope 3 emissions for the first time and committed to setting a verified science-based target. The company has begun engaging suppliers on committing to set a verified target, and going forward, it will set clearer targets around Scope 3 emissions. Regarding our ask around operational efficiency, Comcast has reduced the electricity needed to deliver each byte of data across its network by 36% since 2019 and is pushing its suppliers to be more efficient.

Improving Incentive Metrics and Committing to Net Zero: Western Digital ( WDC )

In a completed EFI journey, Western Digital has implemented a strategy to address asks we made over several engagements to 1) institute relative total shareholder return (TSR) incentive metrics to evaluate shareholder value creation compared to industry peers, 2) improve energy intensity levels of manufacturing in line with industry peers and 3) commit to a net-zero target.

Specifically, Western Digital reduced the energy intensity of manufacturing its products by >13% from FY21 to FY22. It added relative TSR metrics to its incentive comp, which we view as positive as it aligns management compensation with execution, whereas before management would benefit from the fact their industry is growing faster than the broader market. On the third ask, in June 2023 the company announced an ambitious target and has committed to net zero Scope 1 and 2 emissions across its operations by 2032. Its target includes goals to reduce Scope 1 and 2 emissions by 42% by 2030 and to reduce Scope 3 use-phase emissions/terabytes by 50% by 2030, both from a 2020 base year. Its targets were approved by SBTi in 2021, and since then Western Digital has achieved nearly 15% absolute Scope 1 and 2 emissions reductions.

We look forward to sharing more successful EFI case studies in the future as our EFI target companies continue to make measurable progress against our asks.

Scott Glasser, Chief Investment Officer, Portfolio Manager

Michael Kagan, Managing Director, Portfolio Manager

Stephen Rigo, CFA, Director, Portfolio Manager

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