APO - ClearBridge Dividend Strategy Q2 2023 Portfolio Manager Commentary
2023-07-12 07:30:00 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.
- The ClearBridge Dividend Strategy participated well in the risk-on second quarter, with our energy, materials and financials holdings offering strength in a challenging market for dividend-paying companies.
- While the market’s headline performance in the first half was impressive, beneath the surface the markets were less robust, driven primarily by a handful of tech companies riding the AI wave, a scenario that could dissolve into pedestrian market returns.
- We continue to emphasize companies with pricing power sufficient to offset cost pressures and protect profitability, favoring stocks with lower multiples as we fear the impact of rising rates on higher-multiple stocks.
By John Baldi, Michael Clarfeld, Peter Vanderlee
Rally Defies Inflationary Headwinds, We Remain Circumspect
Market Overview
During the second quarter of 2023, the S&P 500 Index marched steadily higher. After a 7.5% rise in the first quarter, the S&P 500 gained an additional 8.7% from March to June, ending the first half up 17%. The ClearBridge Dividend Strategy participated well in the risk-on second quarter, trailing significantly less than in the first quarter's growth rebound. Stock selection in financials, materials, and energy aided our performance, even while the market remained fixated on a handful of information technology ((IT)), consumer discretionary, and communication services stocks.
The S&P 500's headline performance in the second quarter was impressive, but beneath the surface, as in the first quarter, the market was less robust. Seven stocks, which represent 26% of the index - Alphabet ( GOOG ) ( GOOGL ), Amazon.com ( AMZN ), Apple ( AAPL ), Meta Platforms ( META ), Microsoft ( MSFT ), Nvidia ( NVDA ), and Tesla ( TSLA ) - drove two-thirds of the overall gains of the S&P 500 in the second quarter. Indeed, excluding these seven names, the S&P 500 was up just 4.1% (Exhibit 1) for the quarter and just 5.8% for the year to date.
Exhibit 1: Seven Stocks Driving Market Gains
As of June 30, 2023. Source: ClearBridge Investments, Bloomberg Finance. Big 7: Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla.
Alphabet, Amazon, Meta, Nvidia, and Tesla do not pay meaningful dividends and thus are not suitable candidates for ClearBridge Dividend Strategy. We hold large positions in both Microsoft and Apple but, given their large size in the S&P 500, we are relatively underweight these two names. We believe our positioning is consistent with our approach to managing money. The S&P 500 is as concentrated as it has been in decades (Exhibit 2), earnings estimates are declining 1 and multiples are expanding. Couple this backdrop with a hunch that we are in the later innings of this growth stock cycle, and we believe it is appropriate to tread carefully.
Exhibit 2: Weight of Top Five Companies in S&P 500
As of June 30, 2023. Source: ClearBridge Investments, Bloomberg Finance.
Outlook
As we have said repeatedly over the last couple of years, the seeds of current economic and market conditions were sown in 2020. To cushion the blow of COVID-19 lockdowns, the federal government injected unprecedented fiscal stimulus while the Federal Reserve unleashed unprecedented monetary stimulus. These moves prevented a depression but came with a cost. Today's inflation is the price we pay for these emergency measures.
After several decades of benign inflation, rising prices have once again become a central character on the economic stage. Indeed, we believe inflation will likely play the protagonist in the current market cycle. Inflation impacts many aspects of the economy. For investors, the biggest impact is how it shapes interest rate policy. In its bid to quell inflation, the Federal Reserve has raised rates by 500 basis points over the last 16 months. This represents a step-function change in the cost of financing and the discount rate used to value investments. All else being equal, higher rates equate to lower multiples and present a meaningful headwind to capital appreciation.
In the longer term, rising rates will slow the economy, but how much and how quickly remains unclear. We do not have a strict economic forecast that drives our near-term investment positioning. Rather, we strive to embrace the inherent uncertainty involved in investing and position the portfolio for salutary outcomes under a broad range of potential economic scenarios. Nevertheless, we continue to believe that inflation and interest rates may remain higher for longer.
To date, this cycle of Fed hikes has done less to slow the economy than the consensus expected. Despite the Fed's recent pause in hiking rates, it now seems likely rates will move higher. Indeed, Fed futures no longer reflect interest rate cuts in the back half of 2023, whereas they did six months ago. If you told someone on Wall Street at the beginning of this year that interest rates were likely to remain higher throughout the year, they would not have predicted such a strong first half for the market. That the index is higher is a testament to the confined strength of the large tech stocks.
What's Driving Narrow Market Returns?
The strength in tech stocks has been driven by three forces. First, tech companies have cut costs in response to slowing growth. These cost cuts will bolster profitability and demonstrate to investors that these management teams are focused on shareholder returns, not just building the metaverse. Despite these cost cuts, however, earnings estimates for the IT sector for 2023 are still lower than they were at the beginning of the year.
The second factor is a Pavlovian market fighting the proverbial last war. Years of big returns have conditioned investors to view technology stocks as the only game in town. After big declines in 2022, investors swooped in hoping to scoop up fallen angels. In some of these names, this will have proven to be the correct move, but there is also undeniably a behavioral aspect to this. Earnings estimates for Tesla, for example, have declined by a third since the year began, but the stock is up over 100%.
The third is unbounded investor enthusiasm for all things artificial intelligence ((AI)). Excitement for AI began building in late 2022 when OpenAI released ChatGPT. After decades of being just a dream (nightmare?), AI had become real. ChatGPT can write term papers, speeches, and - so long as accuracy is not crucially important - legal briefs. ChatGPT is both cool and imperfect, but it is improving quickly and is sure to become increasingly relevant. While AI seems certain to change the world, exactly how it will do so remains to be seen. Many sectors will be impacted negatively, as AI displaces incumbent players and human workers. But who will win? Some companies seem better positioned than others, but it is way too early to know how it will play out.
AI Progress Will Likely Be Bumpy
While we acknowledge the potential of AI, we are circumspect about the narrow and one-sided nature of AI mania. It is far too early to declare winners and it seems entirely possible to us that AI could be a net negative for society. AI seems sure to displace many workers. Such a profound shift may prove both socially and politically unsettling. Economically, large AI-driven layoffs could gut aggregate demand. Such a dystopian outcome could result in lower aggregate earnings while simultaneously causing investors to employ higher discount rates and raise their required return thresholds, a double whammy for asset prices. Such a negative outcome is not our base case, but it is possible.
Hopefully, AI turns out to be a boon for humanity, but that does not mean its path will be smooth. Significant previous shifts, like the Industrial Revolution, have been profoundly disruptive and choppy. AI will create huge new winners, but their progress will inevitably be bumpy. With the market now imputing trillions of dollars of value into a small handful of perceived AI winners, it seems likely these stocks will face turbulence in the years ahead.
Portfolio Positioning
The ClearBridge Dividend Strategy's positioning remains largely consistent. We continue to emphasize companies with pricing power sufficient to offset cost pressures and protect profitability. We favor stocks with lower multiples as we fear the impact of rising rates on higher-multiple stocks (Exhibit 3). A decade of abnormally low-interest rates has caused investors to become complacent and multiples to become unmoored. Further meaningful increases in interest rates could prove disproportionately painful for high-multiple stocks. Despite rising interest rates, the war in Ukraine, and extreme political polarization, we continue to expect the economy will muddle through and do not foresee a sharp recession in the next few quarters.
Exhibit 3: Dividend Strategy Favors Lower-Multiple Names
As of May 31, 2023. Source: ClearBridge Investments, FactSet.
During the quarter we initiated a position in Public Storage ( PSA ), the largest and most profitable company in the self-storage sector. Self-storage has been one of the best segments in real estate for several decades. The business enjoys high returns on invested capital, requires little maintenance capex, and generates prodigious free cash flow. Public Storage sports a dividend north of 4%, has the highest-rated balance sheet among all publicly traded REITs, and benefits from the scale of operating the industry's largest platform. After a couple of years of strong growth, year-over-year comparisons in 2023 will prove less flattering. We look through this lull and believe that earnings growth will reaccelerate in out years. On top of comparisons becoming easier, the industry is poised to benefit from a favorable supply-demand balance. Rising interest rates and labor and material costs have raised construction costs for new facilities, restricting supply growth and boosting the value of in-place assets. Restrained supply growth, coupled with a resilient consumer, bodes well for longer-term pricing and earnings dynamics, in our view. Our position is relatively small at this point, but we hope to build it out over time.
During the quarter we continued to build out our recently initiated position in Capital One ( COF ), a leading bank and consumer credit company. Early in the second quarter, we took advantage of continued weakness in the banking sector to continue rounding out the position. Since then, shares of Capital One have recovered nicely. Whereas Silicon Valley Bank and First Republic ( FRCB ) were tripped up by their interest rate risk, Capital One has de minimis interest rate risk. Because Capital One is a large credit card issuer, however, it does undertake material consumer credit risk. We believe it is a best-in-class operator that can manage this risk adroitly, but we acknowledge Capital One's business is inherently volatile. We mitigate this risk through the size of the position in the portfolio. We believe Capital One can deliver attractive returns over the cycle as credit cards have historically been one of the most profitable areas in financial services.
During the quarter we also significantly reduced our positions in Oracle ( ORCL ), SAP ( SAP ), and United Parcel Service ( UPS ). Both Oracle and SAP remain large holdings. These stocks have performed very well year to date and have seen their valuations expand materially. We took advantage of runs in these names to take some money off the table. We reduced our position in UPS to reflect some of the current challenges in the logistics space. Volume growth in the U.S. has slowed and Asia remains weak. Despite these headwinds, UPS remains a well-run company with a formidable franchise. Its valuation is undemanding and appropriately discounts many of the risks the company faces, in our view.
After taking advantage of market ebullience to harvest some gains, we are actively looking to put some cash to work and anticipate the upcoming earnings season will provide us with sufficient opportunities to do so.
Portfolio Highlights
The ClearBridge Dividend Strategy underperformed its S&P 500 Index benchmark during the second quarter. On an absolute basis, the Strategy saw positive contributions from nine of the 11 sectors in which it was invested for the quarter. The IT, financials, and materials sectors made the strongest contributions, while the utilities sector was the main detractor.
On a relative basis, stock selection was positive for performance, while sector allocation detracted. In particular, stock selection in the materials, energy, and financials sectors contributed to relative results. Stock selection in the industrials, communication services, and consumer discretionary sectors detracted. In allocation, underweights to IT and consumer discretionary and overweights to the energy, materials, consumer staples, and utilities sectors weighed on relative performance.
On an individual stock basis, the main positive contributors were Microsoft, Vulcan Materials ( VMC ), Apollo Global Management ( APO ), Apple, and Broadcom ( AVGO ). Positions in United Parcel Service, Pfizer ( PFE ), Sempra Energy ( SRE ), Walt Disney ( DIS ), and Diageo ( DEO ) were the main detractors of absolute returns in the quarter.
Michael Clarfeld, CFA, Managing Director, Portfolio Manager
Peter Vanderlee, CFA, Portfolio Manager
1 Consensus S&P 500 earnings estimates for 2023 are down 2% since the beginning of the year.
Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results, or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.
Performance source: Internal. Benchmark source: Standard & Poor's.
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ClearBridge Dividend Strategy Q2 2023 Portfolio Manager Commentary