TRI - ClearBridge International Growth EAFE Strategy Q4 2023 Portfolio Manager Commentary

2024-01-10 11:15:00 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.
• International growth equities outperformed as market breadth improved amid signs of softening inflation and monetary tightening reaching its peak.
• The Strategy outperformed its benchmark, supported by strong contributions from our holdings in Europe and the U.K. that continue to overcome economic pressures, as well as a bid to stocks enabling generative AI.
• We were active in the quarter, initiating three positions and meaningfully adding to several others, while closing out seven names to manage risk and better position the portfolio for what we expect to be a more conducive environment for growth stocks in 2024.

By Evan Bauman, Peter Bourbeau, Aram Green, & Margaret Vitrano

Europe Holding its Own Through Headwinds

Market Overview

International equities rebounded in the fourth quarter, sparked by moderating inflation and plunging bond yields in the U.S. and Europe. The benchmark MSCI EAFE Index advanced 10.42% for the quarter, while the MSCI Emerging Markets Index added 7.87%.

In an indicator of improved market breadth, the MSCI EAFE Small Cap Index rose 11.14%. This followed the first three quarters of the year when small and mid cap stocks in Europe and other regions underperformed. While narrow leadership in international markets has not merited the same attention as the dominance of the Magnificent Seven in the U.S., outperformance in the benchmark has generally been limited to large cap companies, many with a technology bias, as well as regions like Japan benefiting from accommodative monetary policy.

A more palatable yield environment supported growth stocks, enabling the MSCI EAFE Growth Index to climb 12.72% for the quarter and outperform the MSCI EAFE Value Index by 450 basis points. Growth’s resurgence closed the full year gap between styles with the MSCI EAFE Growth Index ending 17.58% higher while the MSCI Value Index was up 18.95%.

Exhibit 1: MSCI Growth vs. Value Performance

The ClearBridge International Growth EAFE Strategy outperformed the benchmark for the quarter, supported by contributions in the traditional growth sectors of information technology ('IT') and consumer discretionary. Further, we believe conditions conducive to growth outperformance will be more prevalent in the year ahead, from factors such as a more benign rate environment and more challenging overall macro backdrop, with economies already slowing through 2023. Room for continued fiscal stimulus measures, which has benefitted a broader group of stocks, is also more constrained than previously. We continue to maintain a diversified portfolio across sectors and regions, focusing on our valuation approach to growth and risk management, a setup that should keep us well positioned to participate in a potential growth resurgence as financial conditions loosen.

Despite these risks, our holdings in Europe and the U.K. found their footing in the fourth quarter, with eight of the top 10 individual contributors coming from these regions. Irish building materials supplier CRH , which has demonstrated strong value creation through M&A and optimization of its portfolio assets over the last several quarters, rose strongly on positive sentiment after its investor day highlighted the company’s accelerating growth in the U.S.

Another welcome change has been the recognition of generative artificial intelligence ('AI') opportunities for companies outside the U.S. While our IT holdings trailed their mega cap U.S. counterparts for most of the year, semiconductor equipment makers ASML and Tokyo Electron ( TOELF ), which we consider enablers of AI, as well as enterprise software maker SAP and IT consultant Accenture ( ACN ), which we see as facilitators of AI adoption in new product lines and/or enhanced business models, rose strongly in the quarter. Additional outperformers included RELX , a publisher of law and related business trade information, and Thomson Reuters ( TRI ), a business services conglomerate with leading positions across media and other industry verticals, which own large, proprietary data sets and stand to become key beneficiaries of the processing power of the large language models that drive generative AI. These companies are rolling out new, AI-enhanced products at higher prices which should positively impact earnings in the near term.

These gains, and the tailwinds of a period of growth outperformance, were partially offset by weakness among the Strategy’s industrial and consumer staples holdings. U.K.-based pest control provider Rentokil ( RTO ) was the largest detractor for the quarter, dragged down by weaker expected third- quarter earnings which have led to earnings downgrades for 2023 and 2024 due to the slower integration of its large acquisition of Terminix. Management has had a good track record of smaller acquisitions in the past and is expected to provide the market with a more detailed roadmap. Once fully integrated, margins for Rentokil’s North American pest business are expected to trump pre-merger margins. Japanese cosmetics maker Shiseido ( SSDOY ), meanwhile, continued to be pressured by tepid tourism spending.

Portfolio Positioning

We were active in the quarter, initiating three positions while closing out seven others. The largest addition was the opportunistic repurchase of Hoya ( HOCPY ), a high-quality manufacturer of technology products and health care instruments based in Japan. Hoya maintains high rates of innovation and a strong focus on attractive market niches such as optical products critical for the manufacturing of semiconductors. We believe the market underestimates the durability of earnings growth of this franchise.

We also repurchased HDFC Bank Limited ( HDB ), an India-based retail and commercial lender, formed from the merger of HDFC Limited and HDFC Bank. The former has a big mortgage business and the latter strong deposit generation, which would offer inexpensive funding for the loan book of HDFC Limited. We expect net interest margin and return on equity will revert to pre-merger levels within a few quarters. HDFC Bank has lagged its Indian peers, creating an attractive entry point into a high-quality franchise. In addition, we initiated a position in Hexagon ( HXGBF ), in the IT sector, a Swedish designer of a broad range of technology and scientific applications including industrial control and automation, design and cyber security solutions.

Activity also included meaningful additions to several newer positions. We believe SMC, a secular grower in the industrials sector, is well-positioned for continued share gains in the growing markets of manufacturing automation for semiconductors, rechargeable batteries and others. IT and cloud services provider Nomura Research ( NRILY ), another secular growth company, is benefiting from increased spending on digital transformation among Japanese companies while its cloud-based software solution for financial services customers has the potential for higher client uptake and higher margins over time.

Emerging growth companies Shopify ( SHOP ) and MercadoLibre ( MELI ) continue to show improved operational performance. Shopify has been boosted by cost cutting measures and its exit from capital intensive logistical operations. Additionally, margins are supported by increases in prices for software subscriptions and continued growth in e-commerce and online payment volumes. Latin America e-commerce provider MercadoLibre’s investments in new services continue to drive revenue growth and margin improvement. New loyalty programs, credit services and advertising products, for example, all contributed to good business performance.

Our largest sales were Tencent ( TCEHY ) and CAE . While the business of Chinese social media, online advertising and fintech provider Tencent has recovered post-COVID, the continued regulatory uncertainty in China and weak consumer confidence have undermined the expected speed of further market improvement. We took profits in Canadian aerospace and defense training provider CAE to fund better opportunities, as the post-COVID recovery in civil pilot training has already progressed well and earnings have recovered.

We also exited Japanese employment services provider Recruit Holdings ( RCRRF ) as the shares neared our target price and in anticipation of a weakening U.S. labor market weighing on its Indeed job search business. Spanish telecommunication infrastructure provider Cellnex ( CLNXF ), meanwhile, was sold due to portfolio construction considerations and an investment thesis change. The company’s leverage has limited its ability to grow in a high interest rate environment while new management has transformed the business strategy to value preservation, significantly reducing its growth appeal.

Outlook

One of the greatest headwinds to growth stock performance over the last two years, tightening liquidity due to higher yields, could abate as the new year unfolds. The ECB and BoE are expected to commence rate cuts as early as the first half of 2024 as inflation continues to normalize toward central banks’ target range and labor costs moderate. Consumers also appear well-positioned to weather a mild economic downturn, which could lead to a pickup in demand. Areas including consumer staples, health care and other long-duration growth sectors outside the U.S. did not work in 2023. In watching for a broadening of international market leadership, we are hopeful that an extended decline in rates can start to benefit these laggard areas of growth.

Exhibit 2: International Valuations Look Attractive

However, equity performance improvement will also be dependent on earnings, which are expected to remain soft outside the U.S. through the first half of 2024 due to tough comparisons. Europe continues to face other challenges such as the fiscal spending required to continue to the secular transition to electric vehicles. Canada, which represents a meaningful allocation in the Strategy, is also flirting with contraction as its economy is more resource dependent than the services-driven U.S. Successfully navigating this environment will require vigilance of consumer behavior, policy moves and focusing our research on self-funding, cash generative businesses that can outperform through a macro transition.

We are paying particular attention to Japan, which remains an outlier among global equity markets in several ways. Among developed markets, Japan is the only one which has not raised policy rates. Inflation has been muted but is approaching the level where the Bank of Japan is likely to abandon its negative interest rate regime. Given cash rich balance sheets on the corporate side and 50% of Japanese consumer assets in cash, even a small rate rise should be beneficial.

We have discussed in past commentaries the multiple programs underway to improve profitability and encourage more equity ownership. There are several small measures coalescing and combining with the push from the government to improve capital returns to shareholders. Share buybacks are growing tremendously in Japan and are becoming a meaningful component of stock performance.

Portfolio Highlights

During the fourth quarter, the ClearBridge International Growth EAFE Strategy outperformed its MSCI EAFE Index benchmark. On an absolute basis, the Strategy experienced gains across nine of the 10 sectors in which it was invested (out of 11 total) with the IT, consumer discretionary and industrials sectors the primary contributors while the energy sector was the lone detractor.

On a relative basis, overall sector allocation was the primary contributor to performance. In particular, an overweight allocation to the IT sector, an underweight to the energy sector and stock selection in the consumer discretionary, health care and financials sectors aided results. Conversely, stock selection in the industrials and consumer staples sectors, an overweight to health care and underweight to materials detracted the most from performance.

On a regional basis, stock selection in North America, Japan and Europe Ex U.K. and an underweight allocation to Japan supported performance while an overweight to North America and stock selection in Asia Ex Japan proved detrimental.

On an individual stock basis, the largest contributors to absolute returns in the quarter included ASML and Tokyo Electron in the IT sector, London Stock Exchange Group ( LDNXF ) in the financials sector, Novo Nordisk ( NVO ) in the health care sector and CRH in the materials sector. The greatest detractors from absolute returns included positions in Rentokil in the industrials sector, Argenx ( ARGX ) in the health care sector, Shiseido in the consumer staples sector, Suncor Energy ( SU ) in the energy sector and Hong Kong Exchanges & Clearing ( HKXCF ) in the financials sector.

In addition to the transaction mentioned above, we exited positions in SolarEdge Technologies ( SEDG ) in the IT sector, Adyen ( ADYEY ) in the financials sector and Dr. Martens ( DOCMF ) in the consumer discretionary 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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