YLDE - ClearBridge Global Growth Strategy Q3 2023 Portfolio Manager Commentary

2023-10-22 09:00:00 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.
• We have been surprised by the continued strength of the U.S. economy and Federal Reserve hawkishness while market breadth has narrowed considerably, making outperformance for broadly positioned portfolios like ours more challenging.
• Strategy activity was elevated during the quarter as we sought to upgrade growth exposures across industrials, financials and emerging growth names.
• We maintain our commitment to diversification across our growth buckets and believe our stocks are well-positioned to outperform in a weakening economic and moderating rate environment.

By Elisa Mazen, Michael Testorf, CFA, & Pawel Wroblewski, CFA

Staying Opportunistic As Rate Cycle Matures

Market Overview

Global equities suffered losses in the third quarter, with rising bond yields leading to a wide divergence among growth and value investment styles. The benchmark MSCI All Country World Index declined 3.40% for the quarter, while the U.S. S&P 500 Index ( SP500 , SPX ) fell 3.27%, the developed market MSCI EAFE Index retreated 4.11% and the MSCI Emerging Markets Index fell 2.93%.

Over a three-month period reminiscent of 2022, which marked the brunt of global monetary tightening, value stocks outperformed growth by over 300 basis points (bps), with the MSCI ACWI Value Index down 1.76% compared to a 4.89% loss for the MSCI ACWI Growth Index. Value dominance was most pronounced outside the U.S., where the MSCI EAFE Value Index outperformed its growth counterpart by over 900 bps.

Exhibit 1: MSCI Growth vs. Value Performance

The U.S. 10-year Treasury yield climbed 74 bps during the quarter, reaching its highest level in 16 years (Exhibit 2). Surging yields have resulted from resilient economic data and a rebound in inflation that caused the Fed to push out any hopes of a rate cut in the near future. While the central bank may be nearing or at the end of its tightening cycle, we believe the lagging impacts of 525 bps of interest rate hikes in the last 18 months will be felt on corporate and consumer balance sheets well into the future.

We were surprised by the resilience of the U.S. economy — something we do not attempt to predict. It has had an outsize impact on our style, which, combined with our broader allocation among sectors and growth groupings, historically has been beneficial to performance. The breadth of the market has narrowed quite meaningfully along with value dominance, most notably outside the U.S., which has also hindered relative performance. Importantly, we do not think these conditions will last.

Exhibit 2: Rising Yields Again Pressuring Growth Stocks

Against this backdrop, the ClearBridge Global Growth Strategy underperformed the benchmark for the quarter, held back by our commitment to growth during a value rally. While disappointed by recent performance and aware that a handful of stocks have not worked as we expected, we remain confident in the composition of the portfolio and believe it is well-positioned to deliver alpha as the headwinds of restricted global liquidity begin to dissipate.

Weakness for the quarter was centered in the financials sector, particularly in Asia. AIA Group ( AAGIY ), a Hong Kong-based life insurer catering to mainland China consumers, was impacted by very poor sentiment toward China. We have seen very strong outflows from Chinese equities as the economic recovery post-COVID has been weaker than expected. However, we believe markets in Asia offer a very good long-term growth opportunity and we continue to like AIA as a high-quality growth franchise. New addition HDFC Bank ( HDB ), a leading banking and financial services provider in India, as well as U.S. index and financial data provider S&P Global ( SPGI ), also hurt results.

The recent performance of our consumer holdings has also been disappointing as weak demand in China has made them act less defensively than we would have expected. This was true of French luxury goods maker LVMHF , U.S.-based cosmetics and fragrance makers Estee Lauder ( EL ) and COTY , as well as British spirits maker Diageo ( DEO ), which has been hurt by weaker-than-expected global alcohol consumption coming out of COVID-19. Meanwhile, Haleon ( HLN ), the U.K. health care and consumer products company spun out of GlaxoSmithKline ( GSK ) and Pfizer ( PFE ), has been held back by the share overhang of its former parents and higher-than-average debt levels from its IPO. The company is showing progress in reducing debt, with asset sales being contemplated that could further improve its balance sheet.

Regionally, our stock selection in the U.S., by far the largest allocation in the benchmark and the Strategy, was also detrimental. Here we were again hurt by our growth orientation with mega cap growth names Apple ( AAPL ) and Microsoft ( MSFT ), that dominated performance in the first half of the year, giving back gains. This weakness was partially offset by strength in Alphabet ( GOOG , GOOGL ) and positive, albeit more restrained gains from AI chipmaker Nvidia ( NVDA ). As growth investors, we continue to find attractive opportunities in the information technology ((IT)) sector, where our overweight negatively impacted performance during the quarter.

The bright spot in the quarter was our health care exposure, especially within biopharmaceuticals. U.S. drug maker Eli Lilly ( LLY ) rallied on more positive news surrounding GLP-1 treatments for diabetes and obesity that have also proven effective in treating cardiovascular conditions. Dutch biotechnology company Argenx ( ARGX ) rose on a successful launch for its myasthenia gravis drug, which it is rolling out globally. Argenx is targeting the same molecule to treat other rare diseases, with key readouts by year end or early next year. U.S. managed care provider UnitedHealth Group ( UNH ) rebounded in the quarter as the company beat expectations and raised full-year guidance, providing evidence that it can successfully navigate the recent uptick in utilization among its Medicare patients. U.S. pharmaceutical AbbVie ( ABBV ) was also up strongly as investors have looked past concerns about a patent expiration for its blockbuster Humira and pricing uncertainty for two of its newer treatments.

Portfolio Positioning

Rather than reverse course to keep up with what we view as fleeting leadership for deep value stocks, we remain committed to a disciplined valuation approach to portfolio construction that delivers diversification by investing across three types or buckets of growth companies (secular, structural and emerging). We remained active in the third quarter, establishing seven new positions while eliminating eight others, with our positioning moves underscoring this commitment to sourcing attractive growth franchises across global markets.

Our largest addition was Intuit ( INTU ), a U.S. provider of software for small business accounting and tax preparation under the QuickBooks and TurboTax brands as well as personal finance (Credit Karma) and marketing services (Mailchimp). We see a clear path to upside earnings revisions as the company expands new products that increase its total addressable market and drive average revenue per user growth. We believe Intuit’s multiple growth initiatives, combined with its market-leading core offerings, underpin its durable double-digit earnings growth profile.

We added to our secular growth bucket with the purchase of RELX , a U.K.-based information services conglomerate with strong market positions across risk and analytics, scientific and medical publishing as well as legal and business information. Over the next several years, we expect earnings to return to its historical high single-digit growth given a rising mix of the faster growing risk business, development of AI and analytics solutions in certain verticals and recovery of the COVID-19 impacted exhibitions business.

The purchase of HDFC Bank, whose muted performance this year offered an attractive entry point, increases our limited exposure to emerging markets. During the period, HDFC Bank completed its merger with India's Housing Development Finance Corporation, giving the combined entity several advantages. The latter is known for its strong mortgage origination business, but was short on deposits and had to self-finance on relative expensive terms. HDFC Bank, which continues to attract substantial deposits, will offer the combined entity a cheaper form of financing for mortgage origination. The company will also be able to leverage a larger client base for cross-selling products.

ESG is also a focus of the Strategy, with ClearBridge’s integration of ESG considerations into the fundamental research process guiding us to best-in-class ESG leaders as well as companies committed to improving their ESG profile. New purchase TREX falls into the former category and is playing a significant role in limiting the degradation of natural resources, a rising focal point for sustainability investors as biodiversity becomes a priority alongside climate change.

Trex has redefined the decking industry with a business model that addresses two key drivers of biodiversity loss, deforestation and pollution, by substituting high-impact products. Instead of relying on virgin wood, Trex makes composite decking for residential and commercial customers using 95% recycled wood fibers and plastic waste. In 2022, Trex recycled 337 million pounds of waste polyethylene, a plastic commonly used for plastic bags and bottles, as it produced its high-end decking. Wood decks stopped using arsenic treatments in 2004, which has shortened their life span, dramatically increasing the number of decks that need to be replaced. Trex’s products help fill this need in a way that preserves forests, reduces a major source of pollution in oceans, and lowers customers’ total costs of ownership, since Trex’s decks have much longer lifespans relative to natural lumber decks.

As valuations of emerging markets stocks have severely corrected, we have been selectively revisiting them. This was the case with the repurchase of Latin American e-commerce platform MercadoLibre ( MELI ). Like many work-from-home and COVID-19 beneficiaries, the company’s share price has declined since our exit in late 2020. MercadoLibre has continued to deliver good results, with revenues growing and margins improved as the business scaled and expanded into new profitable services. Its ecosystem is getting stronger with e-commerce supported by fintech, logistics and new services such as streaming subscriptions similar to Amazon Prime that generate additional marketing revenues.

Cognizant of the risks that remain across global markets, we have been tactically managing our exposure to the most economically sensitive names in the portfolio. This motivated the third-quarter sales of Japanese semiconductor equipment maker Tokyo Electron ( TOELF ) and European industrials names Safran ( SAFRF ) and Sandvik ( SDVKF ).

Outlook

So far in 2023, our structural holdings have not moved meaningfully, which has hurt our ability to keep up when value leads. Some of our structural names, such as Olympus ( OCPNF ) and Daiichi Sankyo ( DSKYF ), are time-based, meaning the catalysts we bought them for have yet to materialize. Kering Group ( PPRUF ), a luxury goods company with a new designer who showed quite well at Milan’s Fashion Week, failed to move as the entire luxury space was in sell down mode. We also believe our strategic preference to gain consumer discretionary exposure through luxury goods rather than the top-performing auto industry will lead to better long-term returns as the luxury retailers we own have better margins and cash and lower operating leverage than other stocks in the consumer discretionary space as well as a number of levers to pull in economic downturns.

The selloff in non-U.S. growth stocks is giving us a chance to evaluate quite a few new investment opportunities. Multiples in growth have come down meaningfully in areas like renewables, consumer staples, durables such as luxury goods and even materials. Many of the future opportunities are in our portfolio today and we have been increasing positions in areas that we think have been overdone to the downside.

The overall economic environment both in the U.S. and overseas is challenging, but many of the excess costs of last year are coming down, save, at least for the moment, energy. Our focus remains on companies with dominant market positions that have strong cash generation, good balance sheets and attractive valuations, and these characteristics should eventually come to the forefront of investors’ mindsets. We have been invested in many names that have done quite well, such as Lilly, Nvidia, SAP , Alphabet and Amazon. Rate decreases, a sign of economic weakness, will greatly benefit our consumer staples holdings, which did not perform well this quarter. We have seen these periods before and feel confident they will be good stocks even though they are testing investors’ patience.

Portfolio Highlights

During the third quarter, the ClearBridge Global Growth Strategy underperformed its MSCI ACWI benchmark. On an absolute basis, the Strategy saw losses across the nine sectors in which it was invested (out of 11 total) with the IT and consumer staples sectors the primary detractors.

On a relative basis, overall stock selection and sector allocation detracted from performance. In particular, stock selection in the financials, consumer staples, utilities and communication services sectors, a lack of exposure to energy and an overweight to IT weighed on results. On the positive side, stock selection in the health care and industrials sectors contributed to performance.

On a regional basis, stock selection in North America, Europe Ex U.K. and Japan hurt performance.

On an individual stock basis, the largest contributors to absolute returns in the quarter included Eli Lilly, Argenx and UnitedHealth Group in the health care sector, Alphabet in the communication services sector and Marriott International ( MAR ) in the consumer discretionary sector. The greatest detractors from absolute returns included positions in Apple and Microsoft in the IT sector, Estee Lauder in the consumer staples sector, LVMH in the consumer discretionary sector and NextEra Energy ( NEE ) in the utilities sector.

In addition to the transactions mentioned above, we initiated positions in UBER and Waste Connections WCN in the industrials sector. We also exited a position in Straumann ( SAUHF ) in the health care sector, Sensient Technologies ( SXT ) in the materials sector, Arista Networks ( ANET ) in the IT sector, Marriott International in the consumer discretionary sector and Iberdrola ( IBDSF ) in the utilities sector.

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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