YLDE - ClearBridge International Value Strategy Q3 2023 Portfolio Manager Commentary

2023-10-16 05:00:00 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.
• International markets generated negative returns in the third quarter, as mixed economic signals, rising bond yields and statements from central bankers indicated that higher rates would likely persist well into 2024.
• Concerns over higher-for-longer rates had a limited impact on value stocks, which strongly outperformed growth and widened its year-to-date lead to over 500 basis points.
• The Strategy outperformed its benchmark, as our energy overweight and positioning within the consumer discretionary and energy sectors helped to overcome headwinds to our industrials investments.

By Sean Bogda, CFA, Grace Su, & Jean Yu, CFA, PhD

Despite International Retreat, Higher Rates Favor Value

Market Overview

International markets generated negative returns in the third quarter, as early optimism for rate cuts and soft economic landings soured due to stubborn inflation, a resilient U.S. economy and rising bond yields, forcing investors to confront the prospect of a higher-for-longer interest rate environment. The benchmark MSCI EAFE Index declined 4.11% for the quarter.

The rapid back up in yields was particularly harsh for long duration sectors like technology, and bond proxy sectors like utilities, enabling value sectors to generate relative outperformance in the period. Energy had large gains, a standout performance among sectors, benefiting from supply tightness as a result of OPEC+’s production cut. The MSCI EAFE Value Index returned 0.59% versus the -8.64% return of the MSCI EAFE Growth Index (Exhibit 1) and flipped value into a year-to-date outperformer versus growth by over 500 basis points.

Exhibit 1: MSCI Growth vs. Value Performance

Rising oil prices, in turn, contributed to the higher-for-longer narrative, driving further bearish sentiment in the market and concerns that the likelihood of a soft landing for the global economy was decreasing while the odds of a recession were rising. Global manufacturing data compounded these concerns by slowing as companies work off excess inventories, and even relatively strong non-manufacturing business data has begun to weaken due to concerns that higher rates could impact consumer spending.

Investors continue to carefully monitor the state of the Chinese economy, which has proved disappointingly sluggish so far this year. The largest market in Asia continued to show signs of slowing in retail sales, manufacturing production and loan growth, as well as inventory drawdowns. Additionally, China’s property market continues to be a point of concern as large property developers struggle with financing and liquidity, elevating large-scale economic risks in a country where a significant percentage of household wealth is directly tied to property value. While both the national and local governments have taken steps to support the economy, both Chinese consumers and investors are increasingly skeptical that these measures can fuel the necessary growth to spur the world’s second largest economy to meet the Chinese government’s annual 5% growth target.

European growth also showed signs of slowing during the quarter as inflation continues to erode consumer spending power. Inflation has proved particularly difficult to get under control in the U.K., although recent readings suggest it could be starting to turn the tide. While many international economies have been thankful to see signs of inflation reduction, Japan has had the opposite reaction, having finally achieved the kind of inflation its central bank has been trying to jump-start for decades. As a result, Japan is seeing substantial increases in wages and consumer spending, contributing to economic growth, increased investor attention and helping to buffer broader declines in international markets.

Against this backdrop, the ClearBridge International Value Strategy outperformed its benchmark in the third quarter, as a combination of stock selection in consumer discretionary, energy and consumer staples sectors and an overweight allocation to the energy sector helped to overcome headwinds to our industrials holdings.

"Inflation has proved particularly difficult to get under control in the U.K., although recentreadings suggest it could be starting to turn the tide."

Energy proved to be a tailwind to performance, largely due to a rebound in oil prices as OPEC+ production cuts helped to limit supply amid already low global inventories and Chinese oil demand was stronger than predicted. Oil production companies like Japan-based Inpex, France-based TotalEnergies ( TTE ) and U.K.-based Shell ( SHEL ) rallied on the back of this dynamic reflecting the potential for strong cash flows and stable earnings. On top of broader capital discipline across the industry leading to more share buybacks, we believe Shell has a strong balance sheet and is on track to achieve the top end of its dividend payout ratio guidance of 30-40%, which we believe will help the stock rerate higher.

Our consumer discretionary holdings also fared well for the second quarter in a row. The Strategy benefited from a lack of exposure to large luxury companies who came under pressure in China as consumers shifted spending away from higher-priced discretionary items amid greater economic uncertainty. Due to our sensitivity to valuation, we were largely able to avoid the segment, focusing instead on companies with strong idiosyncratic drivers that could perform across a multitude of economic outcomes. This includes companies like Vistry ( BVHMF ), a U.K. homebuilder, whose share price rose after the company announced it was narrowing its focus from the wider homebuilding market to focus on the partnerships subsector, allowing for a more capital light business model and the possibility of greater returns on capital in the future. Likewise, New Oriental Education ( EDU ), which is undergoing a transformation by redirecting its focus from K-9 tutoring to become the leader in overseas test prep, non-academic tutoring and e-commerce in China.

In industrials, construction and agriculture equipment manufacturer CNH Industrial suffered as higher crop yields led to lower agriculture commodity prices. Despite concerns of a peak in the agricultural cycle, we remain optimistic: Inventory levels of new and used equipment remain on par with long-term averages and, despite a recent decline, farmer incomes are still historically elevated, supporting the future purchase of new equipment. We think the company has a strong plan to continue to drive operational efficiencies that will manifest as more stable margins.

From a regional standpoint, Europe proved a strong performance contributor, particularly due to the performance of the financials sector. European banks, such as Banco Bilbao Vizcaya Argentaria ( BBVA ), have recovered from contagion concerns from the first quarter’s U.S. regional banking crisis, and a favorable rate backdrop combined with lower cost of risk have driven upward revisions to earnings. Our Japanese holdings also positively contributed to performance during the quarter, as our significant overweight in Japanese banks benefited from the Bank of Japan’s unexpected decision to adjust its yield curve control upper cap, lifting interest rates and creating a conducive environment for improving net interest margins.

While positive stock selection was able to mitigate our overall underweighting in Japan this quarter, our intention remains to reduce this gap to better reflect our constructive view of the structural improvements happening in the country. The key, however, is to adhere to our strict due diligence process rather than chasing recent performance returns. As such, we continue to search and evaluate opportunities where improvements in corporate governance and relatively debt-free balance sheets are enabling companies to increase shareholder returns and take advantage of global opportunities.

Portfolio Positioning

We made several adjustments to the portfolio during the period, initiating two new positions and exiting four.

We added a new position in Danone ( DANOY ), in the consumer staples sector, a French food and beverage manufacturer and distributor. Danone is a classic turnaround value opportunity, whose new CEO is already seeing early signs of success in his efforts to enhance the company’s performance. Danone’s vast array of product assortment is contributing to top line revenue growth, with the company’s flagship brands poised to introduce new offerings in the near future. Additionally, initiatives to counteract inflation, facilitate margin improvement and enable further reinvestment are helping set up the company to be a long-term value creation opportunity for the portfolio.

We also added Panasonic ( PCRFY ), in the consumer discretionary sector, which develops, manufactures and sells various electrical and electronic products. We believe the market does not appreciate the company’s rising electric vehicle (EV) battery business following the passage of the U.S. Inflation Reduction Act, which already contributes approximately 20% of the group’s operating profits and is set for further growth as Tesla’s ( TSLA ) primary batter provider. Additionally, the company is engaging with potential EV battery clients such as Mazda ( MZDAY ) and Subaru ( FUJHY ). Finally, given the rise and profitability of the division, it could provide a potential candidate for a strategic divestiture which we believe would further unlock shareholder value. Regardless, we believe there is significant potential for valuation increases even after recent stock price gains.

We exited Amorepacific, in the consumer staples sector, which is a Korean cosmetics manufacturer. We had hoped that the end of COVID-19 related restrictions in China earlier this year would help sales rebound, but the weak recovery of its Chinese business suggests there may be additional headwinds for the company in the form of market share loss to local Chinese brands.

Outlook

A rise in bond yields and tighter liquidity are typically precursors to a slower growth trajectory. The stronger U.S. dollar is an additional headwind for foreign economies whose currencies are tethered to the greenback, and the recent move higher in energy prices also puts pressure on growth. The current global backdrop warrants a heightened attention to companies with strong balance sheets and resilient cash flows. We continue to emphasize companies with internal drivers that have the potential to offset any headwinds that may evolve from slower topline growth.

We have long argued that a structural reset of inflation and rates is underway, for which most investors are inadequately prepared. Several decades of ultra-accommodative monetary policy have anchored investor expectations to low cost of capital and central bank puts, which have buoyed long duration risk assets. However, a recent confluence of factors points to the return of an inflationary backdrop even after the short-term supply chain shortages have eased: massive investments for energy transition while traditional fossil fuel sources continue to deplete, shortage and mismatch of skilled labor and reshoring of supply chains as geopolitical tensions run high.

With the normalization of the cost of capital and repricing of risk, the most important factors in stock selection become balance sheet strength and the ability to self-fund growth. We believe many of the traditional value sectors are well-positioned to continue to outperform because of strong free cash flow generation and capital discipline. For example, the energy sector continues to look attractive despite recent strength as the projections for crude into 2024 remain positive. The combined oil production of the U.S. and Russia represented approximately 85% of the supply growth over the past decade. However, output from these nations has plateaued and may soon enter a phase of long-term decline. From a demand perspective, the disruption from the EV transition is materializing slower than anticipated. Moreover, OPEC's re-established role as a swing producer offers a sturdy safety net against downward price movements.

The third quarter selloff prompted by rising interest rates has also opened the door to buying opportunities in defensive sectors. Some high-quality businesses, like regulated utilities and certain staples companies, are now trading at a discount relative to their historical valuations. While these conditions are tempting, we remain highly selective. Given our view that long-term rates will sustainably exceed levels seen over the past fifteen years, we are committed to investing only in businesses that can thrive in this new rate environment. Simply put, defensives are cheap right now, and we're seizing the chance to buy insurance when few are interested.

From a geographic perspective, we continue to be constructive on gradual change in the Japanese market. Interestingly, most of the current year’s move has been driven by cyclicals and exporters, while many quality growth businesses have lagged. This presents an interesting opportunity for us to find higher-quality names that could help compound returns beyond the initial upturn in the market. Our experience has been that if Japan is truly moving into a recovery phase after three decades of deflation, growth will broaden and expand across the economy.

Portfolio Highlights

During the period, the ClearBridge International Strategy added the MSCI Europe Australasia Far East (EAFE) index as an additional benchmark, which we believe is a more appropriate benchmark in light of the Strategy’s investment universe and is more closely aligned with the Strategy’s objectives.

The ClearBridge International Value Strategy outperformed its MSCI EAFE benchmark during the third quarter. On an absolute basis, the Strategy had gains across three of the 10 sectors in which it was invested (out of 11 sectors total). The energy sectors was the main contributor to performance, while the industrials sector was the main detractor.

On a relative basis, overall sector allocation and stock selection contributed to performance. Specifically, stock selection in the consumer discretionary, energy, consumer staples and IT sectors and an overweight allocation to the energy sector aided performance. Conversely, stock selection in the industrials sector weighed on returns.

On a regional basis, stock selection in Europe Ex U.K., Japan and North America contributed to performance. An underweight allocation to Japan weighed on performance.

On an individual stock basis, Inpex, TotalEnergies, Mitsubishi UFJ Financial ( MUFG ), Vistry Group and New Oriental Education & Technology Group were the leading contributors to absolute returns during the quarter. The largest detractors were MTU Aero Engines ( MTUAF ), AIA Group ( AAGIY ), Compass Group ( CMPGF ), CNH Industrial ( CNHI ) and Samsung Electronics ( SSNLF ).

During the quarter, in addition to the transactions mentioned above, the Strategy exited its positions in Nutrien ( NTR ) and Newcrest Mining ( NCMGF ) in the materials sector and MTU Aero Engines in the industrials 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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