CP - ClearBridge International Growth EAFE 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.
• Japan drove international equity performance, boosted by new stock exchange and government policies aimed at improving corporate governance and profitability and strong investor flows into Japanese markets.
• The Strategy underperformed for the quarter, mostly due to our lower exposure to Japan and a focus on growth-oriented stocks in a market that witnessed a robust value rally.
• We are excited about the potential of generative AI, both from a current portfolio positioning standpoint as well as in 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

Staying the Course through Limited Leadership

Market Overview

International equities delivered mixed results in the second quarter as market breadth narrowed amid continued monetary tightening by Western central banks. The outlier was Japan, which in addition to maintaining accommodative policy, unveiled the next phase of its effort to improve corporate governance and profitability. The benchmark MSCI EAFE Index gained 2.95% for the quarter, led by Japan (+6.42%), while the MSCI Emerging Markets Index added 0.90%, dragged down by weakness in China (-9.71%). The MSCI EAFE Small Cap Index, meanwhile, edged up 0.58%.

Growth and value stocks took turns leading markets during the quarter with the MSCI EAFE Value Index (+3.15%) finishing ahead of the MSCI EAFE Growth Index (+2.77%). Year to date, excitement over AI has seen growth outperform value by 490 bps.

Exhibit 1: MSCI Growth vs. Value Performance

The ClearBridge International Growth EAFE Strategy underperformed the benchmark for the quarter, mostly due to our lower exposure to Japan and a focus on growth-oriented stocks in a market that witnessed a robust value rally.

Gains in Japan have been driven by several factors, including a weaker yen and policy measures, with new proposed regulations introduced by the Tokyo Stock Exchange, the Financial Securities Agency and METI (Ministry of Economy, Trade and Industry) designed to motivate companies to focus more on corporate governance, cost of capital, better corporate efficiency with hopes to raise 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 while 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 are stocks firmly in the value camp, many with low returns on equity, poor corporate governance and returns. A rotation of European investors into the Japanese market in June supported the runup. 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 in the past by large Japanese conglomerates and we expect it will take a longer time 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 was gaining some traction with investors, 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 muted recovery from China’s zero COVID policy being lifted due to continued weakness in the property sector. The Chinese consumer has begun to recover a bit, but expectations have been muted. 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 into recovery also held back performance this quarter, but we do see good signs of recovery for our holdings and remain invested there. These include AIA Group ( AAGIY ), to which the Chinese will look for alternatives to property for their long-term savings, and Hong Kong Exchanges & Clearing, 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. Instead, the current leadership in Japan is highly cyclical and dependent on the yen remaining weak. We did reduce our Japan underweight during the quarter with the repurchases of MonotaRO ( MONOY ) in industrials and Tokyo Electron ( TOELF ) in information technology ((IT)) and a new addition of Nomura Research Institute ( NRILY ), also in IT.

In addition to the broader value move, several of our Japanese health care holdings underperformed for company-specific reasons. Olympus ( OCPNF ) is a medical equipment and precision instrument maker with dominant market share in gastrointestinal endoscopes that has been negatively impacted by COVID. The company has been in the midst of launching a major new product platform, called EVISX1, which after some delays was finally approved in May. Additionally, at the start of the year, the company received some FDA warning letters that stemmed primarily from communication protocols having no bearing on product manufacturing and quality, but nevertheless the costs to implement these protocols and systems were higher than expected and the stock lagged the upswing in the market. The company installed a new CEO in April who is working to address these issues head on, and we are very excited about the new product platform that will launch in the U.S. by the end of this year. While disappointed by the performance to date, we believe the market will appreciate Olympus for its quality and potential for higher growth than most global medtech stocks.

Pharmaceutical company Daiichi Sankyo ( DSKYF ), a leading developer of antibody drug conjugates to treat cancer, the newest area of growth in the oncology field, traded lower as it awaited data on its TROP 1 ADC in lung cancer.

While AI enthusiasm was strong in the U.S., the contribution in IT came primarily from Japanese stocks in the benchmark. Dutch semiconductor equipment maker [[ASML]] is well-positioned as the primary supplier to designers of graphics processing units crucial to AI large language models and similar chips serving the data center market, but performance after a strong showing in the first quarter was more muted. Tokyo Electron, a semiconductor equipment and related components manufacturer, 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.

We also saw mixed results in software with price weakness in Israeli call center software maker [[NICE]] offset by strength in new purchase Xero ( XROLF ). Debate is heating up around whether generative AI will benefit or impact call centers. We are bullish on NICE as we believe the demand for generative AI will accelerate cloud adoption in the call center market and increase its share of wallet through expansion of digital and AI services. Enterprises need to move to the cloud in order to take advantage of generative AI and NICE is the cloud leader by revenue and seats with over one million agents as customers.

We underperformed in industrials as the Strategy is less exposed to deep cyclicals, especially in Japan where stocks of industrial and trading conglomerates rallied strongly in the quarter. Professional services and transportations stocks, which we are overweight versus the benchmark, lagged in the quarter, but we remain optimistic about the long-term prospect of businesses that we own in this space. Companies such as [[RELX]] and Thomson Reuters ( TRI ) are well-positioned to capitalize on recent advances in machine learning. They control large sets of complex and proprietary data that will be crucial in developing industry-specific solutions. Teleperformance ( TLPFF ), a France-based provider of call center and content moderation services to companies, should be another key enabler for its clients in the implementation of company specific AI-driven automation solutions. Another holding in industrials, Canadian Pacific ( CP ) has recently completed a major acquisition of U.S.-based Kansas City Southern, a transaction that in our view should deliver material synergies and new growth opportunities that have yet to materialize and be recognized by the market. These stocks continue to have material upside, although were out of favor by the market in the quarter.

Portfolio Positioning

New Zealand-based Xero 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 into 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 expanding globally. However, the new CEO has a more balanced approach and has already taken actions such as cutting 15% of the workforce to improve profitability.

To make way for new positions, we exited three names during the quarter. We sold TE Connectivity ( TEL ) in the IT sector as growth in its core electronic component markets may be slowing and Hoya ( RIET ) in the health care sector as it reached our price target. We closed out of Irish contract research organization ICON ( ICLR ) as costs of capital tighten for its biotech and smaller pharma clients, which could hurt funding for future drug trials.

We also significantly trimmed Teleperformance, whose shares continue to suffer a hangover from taking on leverage to acquire a key competitor. We have been engaging regularly with the company on corporate governance and have seen some improvement but continue to evaluate our thesis for the stock.

Outlook

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 internally 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 may 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. We see a big role here for companies like portfolio holding Accenture 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 outside the U.S, such as in luxury goods in Europe and software for machine tools in Germany or 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 improvements stories that have supported performance over the last several years.

Portfolio Highlights

During the first quarter, the ClearBridge International Growth EAFE Strategy underperformed its MSCI EAFE Index benchmark. On an absolute basis, the Strategy saw gains across six of the 10 sectors in which it was invested (out of 11 total) with the consumer discretionary and IT sectors as the leading contributors and communication services 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 industrials, health care, utilities, communication services and financials sectors hurt results. On the positive side, stock selection in the materials sector, an underweight to materials and an overweight to IT contributed to performance.

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

On an individual stock basis, the largest contributors to absolute returns in the quarter included Inditex and Amadeus IT Group ( AMADF ) in the consumer discretionary sector, London Stock Exchange ( LDNXF ) in the financials sector, Alcon ( ALC ) in the health care sector and Tokyo Electron in the IT sector. The greatest detractors from absolute returns included positions in Teleperformance in the industrials sector, Daiichi Sankyo in the health care sector, Hong Kong Exchanges & Clearing ( HKXCF ) in the financials sector, Deutsche Telekom ( DTEGY ) in the communication services sector and Kering ( PPRUF ) in the consumer discretionary sector.

In addition to the transactions mentioned above, we initiated a position in Edenred ( EDNMF ) in the financials 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

Original Post

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

For further details see: