RTX - ClearBridge Dividend Strategy Q3 2023 Portfolio Manager Commentary

2023-10-15 10:25:00 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.
• After a robust second quarter, fueled by tremendous enthusiasm around AI, the S&P 500 Index receded in the third quarter as investors finally accepted that interest rates were likely to be higher for longer.
• We have deliberately worked to reduce our exposure to higher-multiple names and increase our exposure to lower-priced, high-quality dividend growers.
• As the year heads into the home stretch, we find ourselves cautious toward the broader markets but enthusiastic about the importance of dividend growers in the current environment.

By John Baldi, Michael Clarfeld, Peter Vanderlee

Dialing Up Valuation Discipline and Dividend Growth

Market Overview

After a robust second quarter, fueled by tremendous enthusiasm around AI, the S&P 500 Index receded in the third quarter as investors finally accepted that interest rates were likely to be higher for longer. The index fell 3.27%, with the Strategy modestly underperforming.

Over the last three months, the long end of the yield curve (10, 20 and 30 years) moved dramatically higher (Exhibit 1). On June 30 investors priced 10-year bonds to yield 3.8%. They are now priced to yield 4.6%!

Exhibit 1: Yield Curve Moves Higher

As of Sept. 30, 2023. Source: ClearBridge, U.S. Department of the Treasury.

As we have discussed frequently over the years, higher interest rates generally result in lower asset prices. A security’s price reflects its future cash flows discounted back to the present. We discount future cash flows to reflect the time value of money, because a dollar far in the future is worth less than a dollar today. As interest rates rise, the denominator in this discounted cash flow analysis goes up, and the present value of those future cash flows goes down.

Since the beginning of this inflation and interest rate cycle, consensus has continuously underestimated the magnitude and duration of this cycle. Rather than incorporating rising rates into its analysis, the market has “looked through” the current period of rising rates and valued assets based on the hope of lower future rates.

For those conditioned by recent experience to believe 0% rates are “normal,” anticipating a reversion to this level might make sense. But if you think, as we do, that 0% interest rates represent a historical aberration, and current rates represent more normal levels, then to assume interest rates are on the precipice of decline seems, at best, optimistic and, at worst, foolhardy. Ebullient investors do not bear all the blame, however; three decades of overly accommodative monetary policy have trained investors to believe the Fed will always ride to the rescue.

During the third quarter, as it began to dawn on investors that the next rate cuts might be more than a quarter or two away, sectors perceived as being most rate sensitive underperformed (utilities, real estate). Reflexive selling of these sectors is unsurprising. Wall Street often shoots first and asks questions later, and yield-oriented investments are often seen as being particularly tied to rates. But such thinking is facile.

Rising rates impact all asset prices. Investors accustomed to years of low rates may be inclined to dismiss the prosaic risk of rising rates on highflying stocks, but rising interest rates are the gravity of the financial system: they ultimately pull everything lower. Utilities may be the first to feel the blow, but they will not be the last. Indeed, we believe the most severe impacts will ultimately be felt by those assets whose valuations are most unmoored from rational, cash-flow-based analysis — a universe today populated primarily by growth companies and momentum stocks whose recent performance defies the specter of rising rates and is only marginally rooted in improved earnings expectations (Exhibit 2).

Exhibit 2: Growth Stocks’ Strong Performance YTD Driven Primarily by Multiple Expansion, Not Increases in Earnings’ Estimates

As of Sept. 30, 2023. Source: ClearBridge Investments, FactSet. Shows Russell 1000 Value Index and Russell 1000 Growth Index.

Focusing on Valuation Discipline and Dividend Growth Amid Higher Rates

The ClearBridge Dividend Strategy has always been built on a strong valuation discipline. Successful investing requires not only picking great companies, but also paying appropriate prices. As interest rates have soared but valuations have remained elevated, we are increasingly concerned that many high-multiple securities embed substantial risk. Consequently, we have deliberately worked to reduce our exposure to higher-multiple names and increase our exposure to lower-priced, high-quality dividend growers (Exhibit 3).

Exhibit 3: As Interest Rates Have Risen, ClearBridge Dividend Strategy Has Shifted to Lower Multiple Names

As of Sept. 30, 2023. Source: ClearBridge Investments, FactSet.

Dividend Strategy has always emphasized best-in-class companies with the ability to compound earnings and dividend growth over the long term. We favor companies with strong balance sheets, recurring/predictable revenues, and pricing power. Pricing power is particularly critical in inflationary environments like the present, as management teams can raise prices to offset cost pressures and thereby protect profitability and grow earnings. Growing earnings power growing dividends, which protect investors’ purchasing power. Over the last several years, our portfolio companies have grown their dividends at 10% on average, to us a mark of their quality and durability through market ups and downs (Exhibit 4).

Exhibit 4: Strategy Dividend Growth

As of Sept. 30, 2023. Source: ClearBridge Investments.

Portfolio Performance and Positioning

The financials sector was our best contributor and the industrials sector our biggest detractor, each dominated by one stock. Our energy overweight was also a help, though this was offset by negative effects from our underexposure within energy to commodity-sensitive exploration and production companies, and by our holding Enbridge ( ENB ), which sold off after announcing a large acquisition in the quarter.

In financials, shares of Apollo ( APO ), a longtime holding of ours, were particularly strong in the third quarter and served as a major contributor to overall performance. Apollo is the classic example of taking 10 years to become an “overnight success.” In 2009 Apollo invested a de minimis amount of money in Athene, a start-up retirement services company, and became the asset manager for Athene’s investment portfolio.

Athene sells fixed annuities: straightforward retirement products that offer guaranteed payments to their policy holders. The Global Financial Crisis had devastated the annuity industry and Athene’s founders spied opportunity. While traditional players were sidelined, Athene entered the market with a clean balance sheet and no legacy liabilities.

Fast forward 14 years, and Athene ( ATH ) is now the largest issuer of fixed annuities and one of the largest competitors in the space. Athene sold $3 billion in policies annually 10 years ago and is on track to sell over $60 billion this year. As Athene’s franchise has grown, Apollo’s asset management business and earnings have soared.

In the last six months, investors have finally begun to admire what we have long seen in Apollo: a uniquely powerful franchise, positioned to compound earnings in the teens and yet trading at a modest valuation. Apollo is up 58.8% since mid-March and rose 16.9% in the third quarter, and yet still trades at a P/E of just 11.8x. Earnings growth alone should continue to power shares higher. We believe Apollo’s multiple could expand meaningfully as well.

On the downside, shares of industrials company RTX ( RTX ) underperformed significantly. On July 25 RTX announced it had discovered a manufacturing defect in some of its jet engines. RTX would have to ground the engines, replace the parts and reimburse the airlines for the downtime.

While this development weighed on the stock, our active management of the position meaningfully reduced the size of the blow. Earlier in July we had significantly trimmed our position to reflect some cyclical risks, so we were relatively less exposed when shares sold off following the announcement. When RTX delayed a scheduled update in early September, we interpreted it as a modestly negative development and further pared our position. When the update came, the stock sold off significantly on news the debacle would amount to around $3 billion over three years — the high end of investor expectations.

As we sit here today, we think the market’s reaction to RTX is likely overdone. $3 billion is a large sum, but the company’s market cap has declined over $30 billion since first releasing the news in late July. While this is a black eye for the company and will create headwinds for some time, we think it likely that the current level will mark a durable low and see opportunities to add back a small amount of the RTX we sold at higher prices earlier in the summer.

During the quarter we initiated positions in two new names: T-Mobile ( TMUS ) and Gilead Sciences ( GILD ). T-Mobile is the best-in-class player in the wireless space, delivering the strongest growth with the lowest cost structure and the best consumer proposition. T-Mobile’s strength is rooted in its advantaged competitive position. Its superior spectrum holdings enable it to provide better wireless service at meaningfully lower cost. T-Mobile’s annual capital expenditures run about $10 billion, on the order of half the amount its peers must spend. Due to its lower cost structure, T-Mobile can undercut its competitors on price while still generating compelling profitability and returns.

This combination — superior service at lower prices — has enabled T-Mobile to outgrow its competition. In the three years since completing its merger with Sprint, T-Mobile has grown its post-paid subscriber base by about 22%. Over the same period, AT&T’s has grown by about 14%, while Verizon’s ( VZ ) by less than 5%.

"To assume interest rates are on the precipice of decline seems, at best, optimistic and, at worst, foolhardy."

Given the high fixed-cost nature of the wireless business, these steady increases in revenue growth have led to outsize increases in profits and free cash flow. Free cash flow in 2023 is expected to come in around $13.5 billion, up from less than $8 billion last year. In 2024 free cash flow is expected to grow by over 20% to approximately $17 billion — providing a 10% yield based on today’s stock price.

We have long admired T-Mobile, but until recently the stock did not pay a dividend. The company announced its inaugural dividend in September, and we bought the stock shortly thereafter. The initial yield is about 2% and it is expected to grow about 10% per year.

Gilead is a large biopharmaceutical company we have long followed given its dominant position in HIV treatment and strong intellectual property position. With pandemic-induced distortions on quarterly financials largely in the rearview mirror (Veklury — aka Remdesivir — was an overnight success as an antiviral treatment of COVID), we believe Gilead’s organic revenue growth potential over the next many years is in the mid-single digits. Gilead’s growth should be stable, as the company has no major patent expirations until the early 2030s.

While less growthy than some high-flying drug classes (e.g., diabetes/obesity), Gilead’s current valuation is undemanding, with a P/E barely in the double digits. We tend to shy away from health care investments whose valuation is dependent on pipeline drugs transforming into a large commercial opportunity, given the uncertain nature of drug discovery and the binary characteristic of the stock reactions. In Gilead’s case, we believe the market is ascribing virtually no value to its existing pipeline, in effect providing us with a “free” call option. Lastly, Gilead’s 4% (and growing) coupon should offer considerable downside support amid a more challenging market backdrop.

Outlook

As the year heads into the home stretch, we find ourselves cautious toward the broader markets but enthusiastic about the importance of dividend growers in the current environment. Earnings multiples remain elevated compared to long-term averages despite interest rates returning to normal, historic levels. There is such turbulence in the world that observers refer to the current period as a polycrisis. To our eyes the broad U.S. equity market remains complacent, even after its third-quarter setback.

We continue to emphasize investments in high-quality companies with strong balance sheets, recurring/predictable revenues, and pricing power. In a time where technology moves faster and is more disruptive than ever, we focus on companies with low risk of secular disintermediation. We expect continued robust dividend growth, driving income growth and protecting purchasing power for investors. We continue to assiduously sharpen our pencils on valuations, winnowing exposure to higher-multiple names at risk of derating and replacing them with securities whose valuations are more defensible in this new, more normal interest rate environment.

Portfolio Highlights

The ClearBridge Dividend Strategy underperformed its S&P 500 Index benchmark during the third quarter. On an absolute basis, the Strategy saw positive contributions from three of 11 sectors in which it was invested for the quarter. The financials, communication services and energy sectors were the positive contributors, while the information technology ((IT)), industrials, consumer staples and materials sectors detracted the most.

On a relative basis, stock selection detracted while sector allocation contributed positively. In particular, stock selection in the energy, industrials and materials sectors and an underweight to the communication services sector detracted. Conversely, stock selection in the financials sector, an energy overweight and an IT underweight proved beneficial.

On an individual stock basis, the main positive contributors were Apollo Global Management, Comcast ( CMCSA ), Williams Companies ( WMB ), MetLife ( MET ) and Pioneer Natural Resources ( PXD ). Positions in RTX, Microsoft ( MSFT ), Apple ( AAPL ), Vulcan Materials ( VMC ) and American Tower ( AMT ) were the main detractors from absolute returns in the quarter.

In addition to portfolio activity discussed above, we also exited Verizon in the communication services sector.

John Baldi, Managing Director, Portfolio Manager

Michael Clarfeld, CFA, Managing Director, Portfolio Manager

Peter Vanderlee, CFA, Managing Director, Portfolio Manager

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.

Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication.

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