GOOGL - ClearBridge Appreciation Strategy Q1 2023 Portfolio Manager Commentary

2023-04-23 00:30:00 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.
• 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.

By Scott Glasser, Michael Kagan, & Stephen Rigo

Narrow Market Calls for Caution

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 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 ( AAPL ) 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 ( TSLA ) and Amazon ( AMZN ).

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 Strategy underperformed the benchmark S&P 500 Index in the first quarter. On an absolute basis, the Strategy had positive contributions from five of 11 sectors. The information technology ((IT)), communication services and consumer discretionary sectors were the main positive contributors to performance, while the health care and energy sectors were the main detractors.

In relative terms, stock selection and sector allocation detracted. In particular, stock selection in the consumer discretionary, communication services and industrials sectors detracted from relative returns. An underweight to the IT sector and overweight to the financials sector also weighed on relative results. Conversely, stock selection in the financials sector and a utilities underweight proved beneficial.

On an individual stock basis, the biggest contributors to absolute performance during the quarter were Apple, Microsoft, Alphabet ( GOOG , GOOGL ) , Nvidia ( NVDA ) and Amazon.com ( AMZN ). The biggest detractors were UnitedHealth Group ( UNH ), Johnson & Johnson ( JNJ ), Pfizer ( PFE ), Honeywell ( HON ) and Bank of America ( BAC ).

During the quarter, we initiated new positions in AbbVie ( ABBV ) and Bayer ( BAYZF ) in the health care sector and closed a position in General Motors ( GM ) in the consumer discretionary sector.

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.

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