MELI - ClearBridge International Growth ACWI Ex-US Strategy Q3 2023  Commentary

2023-10-26 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.
• A historically wide divergence between value and growth styles, a function of a durable U.S. economy forcing interest rates higher, negatively impacted Strategy performance.
• We were active in repositioning during the quarter, focusing on upgrading our health care, financials and emerging growth exposures.
• While disappointed by recent performance, we believe the Strategy is well-positioned to deliver alpha as the headwinds of restricted global liquidity and lower-quality leadership begin to dissipate.

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

Ramping Up Activity Ahead of Rate Peak

Market Overview

International 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 Ex-U.S. Index declined 3.77% for the quarter, while the MSCI Emerging Markets Index fell 2.93% and the MSCI ACWI Ex-U.S. Small Cap Index dropped by 1.58%.

Over a three-month period reminiscent of 2022, which marked the brunt of global monetary tightening, value stocks outperformed growth by over 700 basis points (bps) with the MSCI ACWI Ex-U.S. Value Index down 0.07% compared to a 7.31% loss for the MSCI ACWI Ex-U.S. Growth Index, predominantly concentrated in the last month of the quarter (Exhibit 1).

Exhibit 1: MSCI Growth vs. Value Performance

The quarterly variance between value and growth was especially acute in the Strategy’s largest regions of investment: Europe Ex U.K. (value ahead by 840 bps), Japan (+1,400 bps) and the United Kingdom (+760 bps) (Exhibit 2). We detailed the drivers of Japan’s value resurgence in last quarter’s commentary, catalysts that continued over the last three months. Value’s outperformance in Western Europe, however, has been led by traditional value sectors: financials (predominantly banks), materials and energy stocks, which account for nearly 50% of the European value benchmark. This was driven by better-than-expected U.S. economic data, leading investors to expect a more forgiving economic environment.

Exhibit 2: Value Dominant Across Regions

The ClearBridge International Growth ACWI Ex-US Strategy underperformed the benchmark for the quarter, held back by our commitment to growth during a broad-based value rally. The drivers of value outperformance this year – rising interest rates, narrow market breadth and a resurgence in Japan – continued to weigh on relative results. 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 and lower-quality leadership begin to dissipate.

We were surprised by the resilience of the U.S. economy – something we do not attempt to predict. It has had an outsized 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, which has also hindered relative performance. Importantly, we do not think these will last.

The performance of Dutch semiconductor equipment maker ASML provides a microcosm of the negative sentiment overshadowing international growth stocks. As the leading provider of extreme ultraviolet lithography equipment to makers of graphic processing units ((GPU)) and similar semiconductors powering demand for artificial intelligence applications, the company is in a prime position to benefit from the secular AI buildout. However, unlike U.S. GPU maker Nvidia ( NVDA ) which has seen its shares triple this year, ASML has failed to benefit from AI enthusiasm, with the shares down double digits in the third quarter and basically flat for the year.

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, with our positioning moves underscoring this commitment to sourcing attractive growth franchises across international markets.

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

The repurchase of HDFC Bank ( HDB ), 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.

To make way for HDFC and as a precautionary move before expected earnings downgrades start later this year or in early 2024, we exited Italian bank Intesa Sanpaolo. European banks, in general, had a good run in 2023 with net interest income peaking in the second and third quarters.

One of our biggest moves was swapping out Swiss pharmaceutical and diagnostics maker Roche ( RHHBY ) for U.K. pharmaceutical developer AstraZeneca ( AZN ). Our original thesis for Roche was that its four large cancer franchises would not fade as quickly as market forecasts while the company built its new pipeline. The pipeline does not appear to be building, however, and we expect the stock to struggle until something significant materializes. We believe AstraZeneca has a deep, diverse pipeline of products and a patent portfolio with no material expirations until the 2030s, characteristics that should allow the company to deliver solid organic revenue growth above its pharmaceutical peers through the end of the decade.

Also within health care, we initiated a starter position in COVID-19 vaccine developer BioNTech ( BNTX ). Most of the value of the German company is in cash, which it is allocating very judiciously across projects while cutting costs and developing the pipeline for mRNA products for solid tumors. We expect clinical readouts on their neoantigen vaccine for metastatic melanoma this year, as well as other products targeting various cancers.

Emerging growth companies like BioNTech are earlier in their growth trajectory than more established and profitable secular growers, delivering faster growth but carrying higher risks. For this reason, we significantly pared back our emerging growth exposure as liquidity began to tighten and COVID-19 vaccines became available about a year into the pandemic. As valuations of these 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.

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 ( OLYMY ) 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.

The selloff in 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 we remain focused on these characteristics to eventually come to the forefront of investors mindsets. We have been invested in many names that have done quite well such as Inditex ( IDEXY ), Novo Nordisk ( NVO ), Linde ( LIN ), ( SAP ) and Safran ( SAFRF ). Rate decreases, a sign of economic weakness, will greatly benefit our consumer staples holdings which have not performed 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 International Growth ACWI Ex-US Strategy underperformed its MSCI ACWI Ex-U.S. benchmark. On an absolute basis, the Strategy saw losses across nine of the 10 sectors in which it was invested (out of 11 total) with the energy sector the lone contributor while the financials, IT and consumer discretionary sectors were the primary detractors.

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

On a regional basis, stock selection in Japan, Europe Ex U.K. and emerging markets hurt performance while stock selection in North America proved beneficial.

On an individual stock basis, the largest contributors to absolute returns in the quarter included Novo Nordisk and Argenx ( ARGX ) in the health care sector, Suncor Energy ( SU ) in the energy sector as well as Computershare ( CMSQF ) and CAE in the industrials sector. The greatest detractors from absolute returns included positions in Adyen ( ADYEY ) and AIA Group ( AAGIY ) in the financials sector, LVMHF in the consumer discretionary sector as well as ASML and Keyence ( KYCCF ) in the IT sector.

In addition to the transactions mentioned above, we participated in the IPO of Schott Pharma in the health care sector, a maker of vials and injectors for the pharmaceutical and biotech industry. We also added a position in BYD in the consumer discretionary sector and Nomura Research ( NRILY ) in the IT sector. We also exited positions in Tokyo Electron ( TOELF ) in the IT sector, Adyen in the financials sector, Rentokil ( RTO ) in the industrials sector, Alibaba ( BABA ) 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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