CEM - ClearBridge Global Growth Strategy Q2 2023 Portfolio Manager Commentary

2023-07-29 11:55:00 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 U.S. and Japan drove global equity performance, the former supported by enthusiasm over AI and the latter by new policies aimed at improving corporate results and strong investor flows.
• The Strategy underperformed for the quarter due to our growth-focused exposure to Japan, a market that witnessed a robust value rally, as well as weakness in Europe.
• We are excited about the potential of generative AI, both from a current portfolio positioning standpoint and in terms of the innovative companies we are researching that could play key roles in the development of this secular growth trend.

By Elisa Mazen, Michael Testorf, & Pawel Wroblewski

Navigating a Global Economy Sending Mixed Signals

Market Overview

Global equities delivered mostly positive results in the second quarter as market breadth narrowed amid continued monetary tightening by Western central banks. The drivers of performance were the United States, carried by mega cap growth momentum related to the potential for AI, and Japan which, in addition to maintaining accommodative policy, unveiled the next phase of its effort to improve corporate governance and profitability. The benchmark MSCI All Country World Index gained 6.18% for the quarter, while the MSCI Emerging Markets Index added 0.90%, dragged down by weakness in China (-9.71%).

Growth stocks maintained their leadership during the quarter with the MSCI ACWI Growth Index (+9.20%) handily outperforming the MSCI ACWI Value Index (+2.98%).

The ClearBridge Global Growth Strategy underperformed the benchmark for the quarter, mostly due to our growth-oriented exposure to Japan, a tepid reopening in China and weakness among our European holdings.

Exhibit 1: MSCI Growth vs. Value Performance

Recent gains in Japan have been driven by several factors, including a weaker yen and policy measures. New proposed regulations introduced by the Tokyo Stock Exchange, the Financial Securities Agency and the Ministry of Economy Trade and Industry are designed to motivate companies to focus more on corporate governance, cost of capital and better corporate efficiency, with the hopes of raising share prices and, ultimately, interest in the Japanese stock market for domestic and foreign investors. The new policies should make it easier to facilitate mergers and acquisitions. The Japanese government is also urging foreign investors to engage more with companies to become more efficient.

The focus of regulators’ efforts is propping up stocks with low price-to-book ratios, a mandate boosted in June by Warren Buffett upping his investment in five of Japan’s largest trading companies. These companies are indeed cheap, but whether they truly can change and deliver long-term growth, and therefore fit into our structural growth area, remains to be seen. External pressure from foreigners has not been well-received by large Japanese conglomerates in the past, and we expect it will take longer than the market expects for these companies to become more efficient and shareholder oriented.

Flows into Japan from foreign investors were strong, pushing year-to-date flows into positive territory. While the regulatory push certainly contributed, we believe the bigger driver was the flow out of the Chinese market, due to continued political sparring between the U.S. and China over semiconductor restrictions and a slower than expected recovery from China’s zero-COVID policy due to weakness in the property sector. The Chinese consumer has begun to recover a bit, but expectations have been muted, weighing on the performance of e-commerce and payments provider Alibaba ( BABA ). Some of the large flows in the third quarter last year into Chinese equities from foreign investors have likely been redeployed into Japan.

Our stocks geared for recovery also held back performance this quarter, but we see signs of optimism for our holdings and remain invested there. These include Hong Exchanges & Clearing ( HKXCF ), which continues to build out Stock Connect to mainland China. Tencent ( TCEHY ) saw acceleration across each of its major lines of business (games, advertising and fintech) due to the restart of game approvals in the fourth quarter of 2022, as well as pent-up demand, all of which we expect to continue.

While missing out on the Japan rally impacted short-term results, we are not willing to sacrifice our growth principles to chase what could be fleeting catalysts for deep value stocks. We would only consider such companies if we saw the chance for a meaningful change that would qualify them as structural growth stories.

Performance among our U.S. holdings was a bright spot for the quarter. Enthusiasm around the opportunities presented by generative AI supported stocks viewed as key players in the build out of this emerging technology. These included mega cap cloud hyperscalers Microsoft ( MSFT ), Amazon.com ( AMZN ) and Alphabet ( GOOG , GOOGL ) as well as semiconductor makers Marvell Technology ( MRVL ), a key supplier to data centers that run AI workloads, and Nvidia ( NVDA ), the market leader in GPUs that enable the processing power needed by large language models.

Among our non-U.S. names, Dutch semiconductor equipment maker ASML is well-positioned as the primary supplier to Nvidia, Marvell and other chip makers, but performance after a strong showing in the first quarter was more muted. Tokyo Electron ( TOELF ), a Japanese semiconductor equipment and related components manufacturer we added during the quarter, participated better in the AI rally. Company management remains bullish on a gradual recovery in semiconductor capex starting in the fourth quarter. Meanwhile potential industry growth from new generative AI use cases is expected to drive chip demand and semicap equipment spending over time. We believe the secular tailwind of rising capital intensity with extreme ultraviolet lithography (EUV) proliferation driving higher spend across the value chain will support strong growth for both ASML and Tokyo Electron going forward. New addition Taiwan Semiconductor Manufacturing ( TSM ), the world’s largest chip foundry, should also see a demand uplift from AI.

Health care was another area of strength, led by U.S. pharmaceutical maker Eli Lilly ( LLY ) which is seeing strong growth in its Mounjaro treatment for diabetes and obesity. Within medical devices, DexCom ( DXCM ) benefited from a solid launch of its latest continuous glucose monitor to manage diabetes while contact lens and surgical products manufacturer Alcon ( ALC ) moved higher on signs of improving procedure growth.

Portfolio Positioning

New Zealand-based Xero ( XROLF ) represents the latest move in our gradual return to higher-beta emerging growth stocks going after large existing markets or creating new ones through innovation. The company provides cloud-based accounting software, primarily for small and midsize enterprises, and accounting practices. Xero had previously reinvested all profits to drive higher growth, but is now shifting toward balancing growth and profitability under new management. This marks a significant change for the company, which has prioritized growth since its founding and subsequent IPO. Despite achieving cash flow breakeven in 2016, Xero continued to focus solely on revenue growth and global expansion. However, Xero’s new CEO has a more balanced approach and has already taken actions such as cutting 15% of the workforce to improve profitability.

Digital payments has been a fruitful area for the Strategy in the past and we added further exposure with the purchase of Edenred ( EDNMF ), a France-based digital platform providing prepaid corporate service vouchers and other payments. The company designs and manages solutions that enable corporate customers to more effectively manage their employee benefits, expense management process and rewards programs; it also supplies corporate clients with payment solutions. We believe the market is mispricing the durability of Edenred’s growth. Today’s higher interest rates and higher inflation are good tailwinds to earnings that have not fully played out, while the company is also well-positioned to generate strong, long-term organic and acquisitive growth within the large addressable employee benefits market.

We are also selectively building exposure in emerging markets. To make way for new positions, we exited nine names during the quarter, primarily in developed markets including Europe, where we are overweight, and the U.S. Five of those were in industrials where Rentokil ( RTO ), RELX , Thomson Reuters ( TRI ) and Old Dominion Freight Line ( ODFL ) reached their valuation targets, while we sold UPS after poor quarterly results indicated its turnaround may take longer than anticipated.

Outlook

The global economy is sending mixed signals, with the U.S. seeing resilient employment and consumer spending in the thus far neutralizing impact of restrictive monetary policy. Europe and the U.K. continue to battle inflation, with the former seeing more progress. Japan is in a state of transition but remains in the easy monetary policy camp along with China, where limited stimulus, a tepid reopening from COVID-19 and lingering real estate debt issues are weighing on demand in the world’s second largest economy. We remain cautiously optimistic with Europe having successfully gotten through a period of commodity shortages and geopolitical tensions, the U.S. anticipating a soft landing and Japan taking proactive steps to attract investment capital.

As growth investors, we are always focused on new technology innovations, including the recent progress with generative AI, which is a step up from previous versions of machine learning tools. When we see these major shifts in innovation, we spend considerable research effort to analyze the impact on different industries, mapping each one to project who the winners will be, how quickly the adoption will last, and what kind of new business models could emerge. We do this to identify potentially investable ideas and then monitor these ideas for attractive entry points.

We have been researching generative AI for some time and believe it is a technology that will be adopted widely across many sectors, some faster than others depending on privacy and regulatory concerns. Productivity and efficiency should improve across many processes and industries, potentially helping margins. We are seeing interesting use cases, while many companies are still trying to figure out how to adopt it, and see a big role for companies like portfolio holding Accenture ( ACN ) to guide companies with the implementation and training of AI on their specific databases.

Beyond AI, we see ample innovation and unique business models in other industries and regions such as in luxury goods in Europe and software for machine tools in Germany and Japan. With our valuation approach to growth and constant application of risk management to the portfolio, we will continue to build new emerging growth positions on a foundation of fundamentally strong, market-leading secular growth companies and structural growth improvement stories that have supported performance over the last several years.

Portfolio Highlights

During the second quarter, the ClearBridge Global Growth Strategy underperformed its MSCI ACWI benchmark. On an absolute basis, the Strategy saw gains across five of the nine sectors in which it was invested (out of 11 total) with the IT sector as the leading contributor and consumer staples the primary detractor.

On a relative basis, overall stock selection detracted from performance but was partially offset by positive sector allocation effects. In particular, stock selection in the consumer staples, IT, industrials and communication services sectors and overweights to consumer staples and health care hurt results. On the positive side, stock selection in health care , an overweight to IT and an underweight to materials contributed to performance.

On a regional basis, stock selection in Japan, emerging markets and Europe Ex U.K. weighed on performance while stock selection in North America and an underweight to emerging markets contributed to results.

On an individual stock basis, the largest contributors to absolute returns in the quarter included Eli Lilly in the health care sector, Microsoft, Apple and Marvell Technology in the IT sector and Tesla ( TSLA ) in the consumer discretionary sector. The greatest detractors from absolute returns included positions in Estee Lauder ( EL ) in consumer staples, Daiichi Sankyo ( DSKYF ) and Thermo Fisher Scientific ( TMO ) in health care, Hong Kong Exchanges & Clearing in financials and Alibaba in consumer discretionary.

In addition to the transactions mentioned above, we initiated a position in Walt Disney ( DIS ) in communication services and Adobe ( ADBE ) in IT and closed positions in Target ( TGT ), Hoya, Raymond James Financial ( RJF ) and SolarEdge Technologies ( SEDG ).

Elisa Mazen, Managing Director, Head of Global Growth, Portfolio Manager

Michael Testorf, CFA, Managing Director, Portfolio Manager

Pawel Wroblewski, CFA, Managing Director, Portfolio Manager

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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