YLDE - ClearBridge International Value Strategy Q1 2023 Portfolio Manager Commentary

2023-04-21 06:00:00 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.
• An emphasis on quality and diversification in financials and strong idiosyncratic drivers in health care helped the Strategy offset pressures in commodity-related sectors.
• International markets overcame headwinds from elevated recessionary fears and concerns over the stability of the banking system to generate positive performance in the first quarter.
• We remain confident that China’s reopening will drive meaningful economic recovery and global growth, even if the initial pace is not as rapid as the market was hoping.

By Sean Bogda, Grace Su, & Jean Yu

Market Overview

International markets overcame headwinds from elevated recessionary fears and concerns over the stability of the banking system to generate positive performance in the first quarter, with the benchmark MSCI All Country World Ex U.S. Index returning 6.87%. Optimism over a soft landing and a potential end to central bank tightening favored growth stocks over value, with the MSCI ACWI Ex U.S. Growth Index returning 8.59% versus the 5.16% return of the MSCI ACWI Ex U.S. Value Index (Exhibit 1).

Exhibit 1: MSCI ACWI ex U.S. Value vs. Growth Performance

Stocks rose early in the quarter, as the prospects of a resurgent Chinese economy and the potential of a soft landing for global economies spurred hopes of a potential end to central bank tightening. Investor optimism began to plateau as a resilient U.S. economy buoyed long-term interest rate forecasts and economic data from China pointed to signs of a slower recovery than previously expected there. In Japan, Kazuo Ueda replaced the retiring Haruhiko Kuroda as Governor of the Bank of Japan, adding further uncertainty to international markets over whether Ueda would maintain the same low-rate policies as his predecessor. Investor fears of a more substantial recession crystalized in March, however, as the collapse of several high-profile banks in the U.S. spurred fears of a bank run contagion to international banks. While fears of a global bank run largely subsided by the end of the quarter, the casualties from the panic included Swiss bank Credit Suisse ( CS , which we did not own), which was acquired by UBS to ease investor fears.

The ClearBridge International Value Strategy outperformed its benchmark for the first quarter, driven by stock selection in financials, a rebound in the IT sector and strong idiosyncratic drivers in the health care sector.

Stock selection in the financials sector was the primary contributor to relative outperformance for the second quarter in a row, as our investments in higher-quality banks helped to insulate the portfolio from the banking crisis. This included Spanish multinational financial services company Banco Bilbao Vizcaya Argentaria ( BBVA ), last quarter’s top-performing holding. BBVA’s geographical footprint across Europe and Mexico has helped to create a strong and diverse depositor base and improve its revenues through both strong loan growth, beneficial credit spreads and growing market share in financial transactions.

The portfolio also benefited from its diversification among industries within financials. For example, Julius Baer ( JBPCF ), a Swiss-based asset manager, was another top contributor. With nearly three quarters of its revenues tied to fees and commissions, the company’s business model is relatively more insulated from the liquidity crisis than other financial institutions. We believe Baer will be a key beneficiary of Credit Suisse’s collapse as much of Credit Suisse’s high-net-worth client base will be looking for a new home. While the fallout from the banking crisis may pose short-term headwinds to banks in the form of higher deposit costs, tighter liquidity standards and more restrictive lending, we believe our basket of market-share-leading, well-capitalized banks will be net beneficiaries of the current turmoil and emerge in stronger positions.

"We continue to like the energy sector, despite the recent pullback in oil and gas prices."

Strong idiosyncratic drivers for our health care holdings also helped in the first quarter. For example, Bayer AG ( BAYZF ), a German multinational pharmaceutical, agricultural and life sciences company, rose after news broke that an activist investor had begun to advocate for a breakup of the company and sale of the company’s consumer health unit. Bayer derives approximately 40% of its revenues from its agriculture division and has faced headwinds stemming from litigation surrounding the alleged carcinogenic effects of its weedkiller product Roundup. Shares rallied over news of the proposal as separating the entities could ringfence legal liabilities into a new legal entity. The stock price also received tailwinds from the company’s upgraded projections for sales of its Nubeqa prostate cancer treatment.

French pharmaceutical company Sanofi ( SNY ) also generated positive returns after its antibody blocking drug Dupixent met all main and secondary goals of a Phase 3 trial for its ability to help treat current and former smokers suffering from chronic obstructive pulmonary disease (COPD). The prospect of Dupixent becoming the first biologic treatment for COPD offers an incredible opportunity for Sanofi to expand its market for the drug. We believe the company is poised for strong, long-term value creation potential and have high conviction in the stock.

Dissipating optimism over China’s reopening and a shift to more realistic expectations for its demand for resources weighed on companies in the materials sector. The sector contains two of our greatest individual detractors for the period, Glencore ( GLCNF ) and Anglo American ( AAUKF ). Both companies were lower as the prices of copper and coal declined over the reduction in demand estimates and elevated steel inventories in China. The companies also faced pressure after China’s National Development and Reform Commission, the country’s state planner, announced it would be reviewing measures to curb speculation related to elevated iron ore prices and imposed production limits on major steel producers due to heavy air pollution levels during the quarter. The demand outlook has weakened as the risk of a global recession has risen.

Portfolio Positioning

The industrials sector remains the largest overweight in the portfolio, as we believe companies here are beneficiaries of several important multi-year themes. Firstly, we remain confident that China’s reopening will drive meaningful economic recovery and global growth, even if the initial pace is not as rapid as the market was hoping. This should serve as a strong tailwind for manufacturing and capital goods companies. Secondly, fiscal policies such as the Inflation Reduction Act (and the EU’s Net-Zero Industry Act, soon to come) are driving a significant wave of investment into energy infrastructure and renewables, and we continue to favor companies leveraged to this theme. For example, during the quarter we initiated a position in Nexans ( NXPRF ), a French industrials company that makes cable systems for offshore wind farms, subsea interconnections, power transmission, telecom networks, fiberoptics and electrical systems. Historically, Nexans was a cyclical business highly impacted by the construction cycle. However, it is currently divesting low-growth segments such as industrial and telecom and focusing on the higher-growth, high-voltage segment of its electrification portfolio. In particular, the industry for high-voltage cables used in offshore wind farms is an oligopoly that is currently capacity constrained with multiple years of contracted backlog thanks to the strong demand for renewable power. This will accelerate Nexans’s growth and profitability improvement and should also rerate the stock.

We continue to like the energy sector, despite the recent pullback in oil and gas prices. We believe the fundamental case for undersupply remains intact: constrained capital allocation due to the ongoing energy transition, increasing demand from China as the economy reopens, and a U.S. Strategic Petroleum Reserve that has yet to be refilled. Recent supply cuts from OPEC only strengthen the bull case, and geopolitical tensions with Russia are likely to persist for some time.

In financials, we continue to have conviction in our current holdings and feel there are significant fundamental differences between U.S. and European banks that should make the latter more resilient. Firstly, regulation of the banking industry in Europe since the Global Financial Crisis has been more stringent than in the U.S. All banks in Europe, not just those exceeding $250 billion in assets, follow the same regulation with respect to liquidity coverage and net stable funding ratios, both of which are stronger than U.S. levels. Furthermore, “available-for-sale” securities are already marked-to-market under IFRS 9 accounting standards and reflected in regulatory capital ratios. In short, the harsher regulations in Europe that pressured their returns over the past decade should now make them more resilient during times of stress. Liquidity, which was a focus for U.S. banks, is not a concern with European banks, which are extremely liquid, with excess cash held at central banks totaling 15%–20% of their deposits. As a result, the risk of forced sales of underwater securities is much less likely, avoiding the type of situation seen with Silicon Valley Bank.

That said, we recognize that the risk-reward profile for banks is becoming more balanced than it was a year ago, which argues for a more selective approach. Deposit betas are likely to increase given that we are in the later innings of the rate hike cycle, and tighter lending standards could constrain overall economic growth. With this in mind, we decided to lock in some gains and decrease our overweight position in financials this quarter. We trimmed back on some investments while fully exiting our position in Barclays ( BCS ). The U.K.-based company has been plagued by persistent execution issues and struggled to improve returns on capital to an acceptable level.

Another new addition to the portfolio is BioNTech ( BNTX ), a biotechnology company developing immunotherapies for cancer and other infectious diseases. As one of the two leading mRNA vaccine platform companies, BioNTech offers tremendous upside potential due to its diverse and brimming pipeline of early-stage cancer and infectious disease medications, with 20 products already being tested in clinical studies. Additionally, the inclusion of the company helps to augment the portfolio’s downside protection due to its substantial cash reserves, amounting to approximately two-thirds of its current market cap, as well as a steady level of receivables expected from its partner, Pfizer ( PFE ). We believe that competitor Moderna’s ( MRNA ) recent success in its mRNA melanoma vaccine is proof of the potential and wide applications of mRNA treatments in cancer research and believe that BioNTech can achieve even greater results.

Outlook

As the current economic cycle potentially extends into a period of stronger headwinds, we have reduced our cyclical exposure and increased portfolio diversification. Compared to the U.S. market, however, international equities stand to benefit from a recovery in growth from China reopening and more attractive valuations. We prefer to focus on areas we believe are more decoupled from the overall macro backdrop, including the nascent COVID recovery in China and the booming investment in infrastructure/renewables, both of which we expect to persist regardless of the shape of the current rate cycle. We believe that overall inflation will be structurally higher than in the past decade, and the cost of capital should normalize accordingly. This favors companies with pricing power and those generating high returns on equity and that can self-fund through organic free cash flow. Many of the best opportunities for capital appreciation continue to be in international value stocks, bolstering our confidence that they will generate attractive returns over the coming year.

Portfolio Highlights

The ClearBridge International Value Strategy outperformed its MSCI All Country World Ex-U.S. Index benchmark during the first quarter. On an absolute basis, the Strategy had gains across eight of the 10 sectors in which it was invested (out of 11 sectors total). The industrials, consumer discretionary and financials sectors were the main contributors to performance, while the energy and real estate sectors detracted.

On a relative basis, stock selection effects positively contributed to performance, while sector allocation effects detracted. Specifically, stock selection in the financials, health care, information technology ((IT)) and industrials sectors, as well as an overweight allocation to the industrials sector aided performance. Conversely, stock selection in the materials and energy sectors, an underweight allocation to the IT sector and an overweight to energy weighed on returns.

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

On an individual stock basis, Infineon Technologies ( IFNNY ), Industria de Diseno Textil ( IDEXY ), BBVA, Holcim ( HCMLF ) and Julius Baer were the leading contributors to absolute returns during the quarter. The largest detractors were Glencore, Tenaris ( TS ), Anglo American, BAWAG ( BWAGF ) and TravelSky Technology ( TSYHY ).

During the quarter, in addition to the transactions mentioned above, the Strategy initiated a position in AstraZeneca ( AZN ) in the health care sector and received shares of Meituan ( MPNGF ) in the consumer discretionary sector as a share dividend from Tencent ( TCEHY ). The Strategy exited its position in Roche ( RHHBY ) in the health care sector.

Sean Bogda, CFA, Managing Director, Portfolio Manager

Grace Su, Managing Director, Portfolio Manager

Jean Yu, CFA, PhD, Managing Director, Portfolio Manager

Original Post

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

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