MSFT - ClearBridge Dividend Strategy Q1 2023 Portfolio Manager Commentary

2023-04-14 01:20:00 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.
• Growth stocks — many of which do not pay dividends, and which lagged significantly in 2022 — bounced back sharply in the first quarter in a highly concentrated rally.
• As a bank crisis revealed interest rate risk to be more urgent than credit risk, we quickly repositioned our bank holdings to better reflect the new paradigm and capture appropriate risk-adjusted returns.
• We still worry inflation may be harder to contain than consensus expects, and so believe interest rates may be higher for longer, making our emphasis on high-quality dividend compounders particularly well-suited for the current environment.

By John Baldi, Michael Clarfeld, Peter Vanderlee

Bank Crisis Motivates Refined Focus on Financials

After strong outperformance in 2022, ClearBridge Dividend Strategy lagged the broader market in the first quarter of 2023. Growth stocks - many of which do not pay dividends, and which lagged significantly in 2022 - bounced back sharply. The benchmark S&P 500 Index's ( SP500 ) performance was primarily driven by increases in just seven stocks (Apple, Nvidia, Microsoft, Meta Platforms, Tesla, Amazon.com and Alphabet). These companies represent 24% of the index and were up on average 43%. The remaining 76% of the S&P 500 on average returned 3%. Historically, such narrow performance is not a constructive indicator for future returns. The healthiest markets are generally typified by broad participation.

Exhibit 1: Narrow Market Leadership in First Quarter

Interest Rate Risks Catch Market Off Guard

Of course, as we sit here at the end of the first quarter, the pressing question is not value versus growth or dividend payers versus non-payers. The issue of the day is clearly the banking crisis. What does it mean for our portfolio, for the economy, for the market?

Heading into the second half of 2022, we held four bank stocks - Bank of America ( BAC ), JPMorgan Chase ( JPM ), PNC Financial ( PNC ) and U.S. Bancorp ( USB ) - and were modestly overweight the bank exposure of the benchmark. Our positioning was predicated upon three key pillars: 1) the benefit of rapidly rising short-term interest rates had yet to be fully reflected in earnings power (including expectations for further increases in the back half of the year); 2) these institutions were among the best positioned to handle any credit quality disruptions stemming from the Fed's tightening; and 3) valuations were reasonable, given the returns on capital being generated.

Post third-quarter results, we refined our bank exposure. We liquidated our holdings in U.S. Bancorp and redeployed the proceeds into JPMorgan Chase. Our sale of U.S. Bancorp did not reflect any fundamental concerns about its health. Rather, we concentrated our exposure in those banks with the most robust earnings power. At the time, bank investors were most concerned with increasing credit costs, and robust earnings are the best bulwark against rising credit losses.

For the first two months of 2023, investors in financial services stocks remained squarely focused on credit risk as the risk. As the Fed raised rates to slow the economy, investors positioned for a coming recession and sold the most credit-sensitive names. In our view, these credit-sensitive stocks began to discount higher unemployment and a weaker economy than either our expectations or than was reflected in other sectors. In January, we took advantage of this selloff to start to build a position in Capital One ( COF ), a leading bank and consumer credit company that we have long admired. Unfortunately, the stock took off before we could build a meaningful position and so we quickly exited the position.

While the market was focused on credit risk, it was interest rate risk that should have worried investors. It was not credit risk that took down Silicon Valley Bank ( SVB ). SVB held high-quality assets that are money good - at maturity they will repay at par. As interest rates rose, however, the value of these assets declined and wiped out SVB's equity. In an instant, the market's focus changed from credit risk to interest rate risk.

At the onset of SVB's troubles we quickly repositioned our bank holdings to better reflect the new paradigm and capture appropriate risk-adjusted returns. Significantly, we exited a large and long-standing position in Bank of America (BAC). While we see little risk of deposit pressures or financial distress at BAC - in fact, it is likely a beneficiary of the struggles of its smaller peers - we are concerned that the perception of interest rate risk will put a ceiling on its valuation. Of the largest banks, BAC has the biggest proportion of long-duration bonds in its securities portfolio (Exhibit 2). These bonds have declined in value over the past 15 months as the Fed has raised rates.

Exhibit 2: Held-to-Market Securities a Liability in Rising Rate Environment

While the "mark-to-market" losses on these held-to-maturity securities ¹ has no impact on how BAC management runs the firm, we believe investors may grow increasingly uncomfortable with the "face value" of these losses, especially if interest rates continue their upward trajectory. Despite these near-term headwinds, we continue to believe BAC is one of the long-term winners in the space and is generally well run. At the right price, and as we move further through this banking crisis, we would consider buying it back.

We used the proceeds from BAC and took advantage of the broad selloff in banks to rebuy Capital One - at significantly better prices than we'd paid just weeks earlier. Unlike most banks, which take both interest rate and credit risk, Capital One's interest rate risk is minimal. Most of its securities are available-for-sale (AFS) and are therefore marked to market; their prices on Capital One's books fully reflect the impact of rising rates. Further, its assets are concentrated in shorter-duration consumer loans. These consumer loans, of course, contain credit risk and will suffer losses as the economy slows. We believe, however, that Capital One is a shrewd and disciplined operator and that much of this risk is already discounted in the stock. Shares are off nearly 50% from their mid-2021 high. Over time, we believe Capital One can be a great holding for us. It operates a high-return business in an industry, credit cards, that has been one of the most profitable areas in financial services. Its earnings stream will be lumpy, as earnings decline significantly and quickly during recessions, but we believe we can manage that volatility through position size.

As we look forward, we expect the current fever besetting banks will break. The significant rise in interest rates exposed weaknesses in a small number of banks with concentrated deposit bases mismatched with long-duration assets. Broadly speaking, we believe the banking sector is in decent shape and we do not expect anything like a repeat of the Global Financial Crisis. That said, the ramifications of this episode will be broad-based and long lasting. We see three clear takeaways:

1. First, while we do not expect a huge macro downshift due to the SVB fallout, the economy will clearly be somewhat weaker than it otherwise would have been. Certain pockets of the economy, like commercial real estate ((CRE)), which was already suffering, and which is predominantly financed by smaller banks, will feel increased pressure.
2. Second, we expect deposits will continue to migrate to the largest banks, bolstering them while weakening the smallest ones, and likely resulting in increased consolidation.
3. Third, regulation will be increased, which, by definition, will reduce both the aggregate return profile of banks and the attractiveness of their shares for investment.

Our overall positioning remains relatively consistent. Despite the current banking woes, we suspect the economy will muddle through. Consequently, we still worry that inflation may be harder to contain than consensus expects, and so believe interest rates may be higher for longer than the market believes. Higher interest rates pose elevated risk for higher-multiple stocks. After the recent bounce of these stocks in the first quarter, we believe investors remain complacent with these names. We continue to emphasize high-quality dividend compounders and believe they are particularly well-suited for the current environment. While rising yields have made fixed-rate bonds a reasonable investment alternative, healthy dividends provide cushion in volatile markets and can benefit from dividend growth to offset inflation and preserve purchasing power.

Portfolio Highlights

The ClearBridge Dividend Strategy underperformed its S&P 500 Index benchmark during the first quarter. On an absolute basis, the Strategy saw positive contributions from six of the 11 sectors in which it was invested for the quarter. The information technology ((IT)), communication services and materials sectors made the strongest contributions, while the financials, health care and energy sectors were the main detractors.

On a relative basis, stock selection and sector allocation detracted for the quarter. In particular, stock selection in the IT, health care, consumer discretionary, financials, communication services, industrials and energy sectors detracted. Underweights to IT, consumer discretionary and communication services and overweights to the energy and financials sectors also weighed on relative results. Conversely, stock selection in the utilities sector and a health care underweight proved beneficial.

On an individual stock basis, the main positive contributors were Microsoft ( MSFT ), Apple ( AAPL ), SAP , Oracle ( ORCL ) and Linde ( LIN ). Positions in Pfizer ( PFE ), MetLife ( MET ), Johnson & Johnson ( JNJ ), American International Group ( AIG ) and UnitedHealth Group ( UNH ) were the main detractors from absolute returns in the quarter.

In addition to portfolio activity discussed above, during the quarter we initiated a position in Diageo ( DEO ) in the consumer staples sector.

John Baldi, Portfolio Manager

Michael Clarfeld, CFA, Managing Director, Portfolio Manager

Peter Vanderlee, CFA, Peter Vanderlee, CFA

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