YLDE - ClearBridge Large Cap Growth ESG Strategy Q1 2023 Portfolio Manager Commentary

2023-04-21 04:30:00 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.
• Technology and communication services holdings drove Strategy outperformance in a quarter where larger growth stocks resumed market leadership.
• The recent decline in rates that boosted growth equities could be short lived, causing us to remain cautious and fostering an ongoing focus on diversification and self-funding business models. Our health care overweight and IT underweight reflect this outlook.
• ClearBridge has designed our net-zero approach around high-touch engagement with portfolio companies on their decarbonization strategies.

By Peter Bourbeau and Margaret Vitrano

Market Overview

Equities delivered solid gains in the first quarter with a decline in yields, allocation shifts spurred by a banking crisis and a rebound from oversold levels providing a bid to growth stocks. The S&P 500 Index ( SP500 ) rose 7.50% and the Russell 1000 Index added 7.46% as investors gravitated to larger companies deemed more resilient as the removal of liquidity accelerates. The benchmark Russell 1000 Growth Index surged 14.37%, reversing the leadership trend of the last year and outperforming the Russell 1000 Value Index by over 1,300 basis points.

Interest rates were on a downward trajectory prior to the failure of Silicon Valley Bank with efforts to contain bank contagion and stabilize the financial system increasing the likelihood of a slowdown in monetary action by the Federal Reserve. Despite a 25 bps rate hike in late March and rhetoric from Fed Chairman Jerome Powell that rates will stay higher for longer, the bond market is projecting rate cuts by the end of the year. We don't see a pivot to looser policy short of a more serious shock to the banking system, a deeper than expected recession or a massive drop in inflation.

Instead, we believe rates fell in the first quarter for artificial reasons, namely flight-to-safety Treasury buying that pushed down yields, and the boost to longer-duration growth stocks in general could be short lived. The likely longer-term impact of the banking crisis is slower loan growth and less credit availability, reinforcing the importance of owning profitable growth companies with self-funding business models. This environment also continues to support our commitment to diversification and quality.

Exhibit 1: Growth Boost from Falling Yields May Not Last

The ClearBridge Large Cap Growth ESG Strategy outperformed the benchmark during the first quarter, the second straight quarter ahead of the index. We attribute these improved results to the balance of contributions across the portfolio. After benefiting from the defensive nature of our countercyclical health care holdings in the second half of 2022, our higher-beta IT and communication services positions drove performance to start the year.

The standout for the quarter was graphics chipmaker Nvidia ( NVDA ). Already the leader in the market for chips to power advanced computing, the positive sentiment around generative AI further highlighted the company's opportunities among data center and hyperscale cloud providers reliant on Nvidia's GPUs to empower digital transformation and new AI applications. We believe the secular drivers in certain parts of the semiconductor industry outweigh the cyclical risks and feel comfortable with our exposure through Nvidia and ASML , which maintains a similar dominance in the market for next generation lithography equipment vital to semiconductor production.

Microsoft ( MSFT ) was another solid contributor in the quarter. It is well-positioned to benefit from its relationship with OpenAI, the creator of the natural language processing tool ChatGPT. Microsoft began integrating ChatGPT into its Bing search engine during the quarter but sees even greater potential for generative AI in its Azure cloud offerings and across its productivity software products. We believe AI will allow the company to monetize its applications more effectively and charge a premium for higher AI-service levels. Microsoft is now the portfolio's largest position, but we remain underweight versus the benchmark by about 280 basis points.

Coupled with our underweight to Apple ( AAPL ) as well as the reclassification of payment providers PayPal ( PYPL ) and Visa ( V ) from IT to financials, we finished the quarter 1016 bps underweight IT. While diversification goals limit the Strategy from maintaining market weights in the index's largest components (Microsoft and Apple alone accounted for 23.81% of the Russell 1000 Growth Index at quarter end), our positioning also reflects caution as we anticipate further multiple compression and earnings pressure among IT and shadow tech stocks due to exposure to economically-sensitive end markets. That said, we have added several IT names to our whiteboard where market action could dictate entry into the portfolio.

Several of our select growth holdings, which target rapidly expanding areas of demand with higher growth rates and valuations than the market, delivered solid results due to progress in managing costs. During its fourth-quarter earnings call, Meta Platforms ( META ) announced sizable cuts to operating and capital expenditures and a commitment to improving efficiency. These moves come as the Instagram owner faces easier year-over-year comparisons as well as lessening competition and privacy risks. We are keeping a close eye on Meta's capital allocation decisions to determine when cash flows and returns are likely to reaccelerate. Shares of cloud software maker Salesforce also rose as management followed through on a leaner operating strategy that places greater focus on shareholder returns and expense management while de-emphasizing its previous growth by acquisition approach. Amazon.com ( AMZN ) benefited as well from a consolidation of its e-commerce workforce and fulfillment center expenditures, which should help offset an uneven outlook for consumer e-commerce spending and slowing growth in its AWS cloud business.

Portfolio Positioning

Health care has been a primary area of repositioning activity over the last 18 months and we diversified our exposure to the sector with the purchase of drug maker and stable grower Eli Lilly ( LLY ), a company that faces less supply chain and inflation risk than our medical device holdings. After being out of the biopharmaceutical space for the last year, we took advantage of a 20% selloff in Lilly shares to establish a position in a company whose diabetes-obesity treatment Mounjaro represents a blockbuster opportunity. Diabetes and obesity are massive and growing markets that the U.S. payer system has a vested interest in treating. Positive clinical readouts for Mounjaro could expand its indications to include treatment of sleep apnea, cardiovascular and other conditions related to diabetes. Beyond diabetes, Lilly has a promising pipeline in Alzheimer's, atopic dermatitis (eczema) and renal failure. A clinical readout for its Alzheimer's treatment, likely in the second quarter, could create an opportunity to further build out the position. To make room for Lilly and manage the size of our health care sector weighting, we trimmed holdings in glucose monitoring device maker DexCom ( DXCM ), animal health company Zoetis ( ZTS ), and life science tools and diagnostics provider Thermo Fisher Scientific ( TMO ).

Taking advantage of a pressured valuation, we recently initiated a position in Tesla ( TSLA ). The company has a significant structural cost advantage in battery production, electric vehicle ((EV)) manufacturing and EV selling, which gives it industry leading operating margins in EVs. As the auto cycle has softened, the stock has sold off substantially with the rest of the automakers, despite EVs continuing to have a secular growth advantage. Tesla has a clean balance sheet with negative net debt and enormous revenue growth, EBITDA growth and free cash flow generation. Its margin buffer also gives the company the ability to cut prices while still protecting earnings better than competitors, which should help support continued volume growth. There is also significant upside optionality driven by its software offerings, which we do not believe is currently priced into the stock. Risks to our thesis include increasing EV competition and macro/cyclical headwinds.

From an ESG standpoint, there are positive environmental implications for the auto industry shift away from fossil fuel powered cars. While governance at Tesla has room for improvement, we think the company has taken steps to improve internal checks and balances and maintain barriers among the various entities controlled by Elon Musk.

While retail sales have held up with continued healthy employment growth, we remain concerned about the lagged impact of quantitative tightening and an inverted yield curve on consumer spending. We further trimmed our consumer exposure with exits from rural retailer Tractor Supply ( TSCO ) and auto parts and repair chain Advance Auto Parts ( AAP ). While Tractor Supply remains fundamentally sound, we believe its self-help thesis has played out through execution of the asset optimization projects Side Lot and Fusion. Inflation has been a tailwind to comparable sales growth and revenue could now come down faster than costs, creating earnings risks. We had purchased AAP for defensive and self-help characteristics that have not been playing out as expected. The company's revenue resilience is intact but with less margin expansion because of only modest operational improvements and rival O'Reilly Automotive ( ORLY ) discounting to gain share.

Outlook

Employment drives spending and the resilient job market continues to support sales. While the Fed can make it more expensive for companies to hire, policymakers cannot control jobs and when employment finally breaks, we believe spending will pull back meaningfully. Inflation has been persistent in the economy long enough to divide the growth universe between companies that have established and maintain pricing power (and subsequently revenue growth) and those that have not. We believe goods producers, particularly softline retailers, are particularly vulnerable at this stage in the economic cycle. While we do not own any of these companies, our concern about a rollover in consumer spending has caused us to become selective in what we do own across both the consumer discretionary and consumer staples sectors. We continue to have confidence in Nike ( NKE ), which has proven to be an outlier in its ability to take price, as well as newer position Estee Lauder ( EL ), which has held up well in the beauty space but has yet to realize the growth we had expected from the reopening of China.

Another major risk we're watching is the potential spillover effect of the bank crisis into other areas of the market. The Strategy has no direct exposure to money-center banks, with our financials exposure now consisting of global insurance broker Marsh & McLennan ( MMC ), market data provider S&P Global ( SPGI ) as well as payment names Visa and PayPal. As mentioned previously, we are underweight IT, which represents a second-order risk to financing as many early-stage companies facing a cash crunch are likely to pull back on spending for IT products and services, stunting the innovation beneficial to companies across many growth sectors. Among larger IT and communications companies and the customers they sell to, we also anticipate slowing growth in cloud deployments and tepid overall revenue growth.

We continue to orient the Strategy for a base case of recession, where growth companies able to maintain revenue and earnings visibility should thrive. We believe the portfolio balance we have achieved through active positioning moves and a consistent commitment to risk management should be supportive of performance both in difficult market periods as well as strong rallies like the one to start the year. And we believe a growth allocation will be important as the pandemic-era injection of ample liquidity and a more recent boost from inflation to revenue growth began to wane. Regardless of the timing of a recession, growth stocks have historically demonstrated resilience through an economic contraction (Exhibit 2).

Exhibit 2: Leadership To and Through Recessions

Portfolio Highlights

The ClearBridge Large Cap Growth ESG Strategy outperformed its benchmark in the first quarter. On an absolute basis, the Strategy posted gains across eight of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the IT and communication services sectors.

Relative to the benchmark, overall stock selection contributed to performance. In particular, stock selection in the IT, communication services, industrials, and health care sectors supported results. Conversely, stock selection in the consumer discretionary sector, an underweight to IT as well as overweights to financials and health care detracted from performance.

On an individual stock basis, the leading absolute contributors were positions in Nvidia, Meta Platforms, Microsoft, Amazon.com and Apple. The primary detractors were UnitedHealth Group ( UNH ), Honeywell ( HON ), Advance Auto Parts, NextEra Energy ( NEE ) and Sherwin-Williams ( SHW ).

ESG Highlights

ClearBridge Engagements Zero In on Net Zero

Climate change, and its associated investment opportunities and risks, remains a priority for ClearBridge, both in our active stock selection across portfolios and in our engagements with C-suite leaders of the companies we invest in. Our interest in the topic across sectors and portfolios coincides with growing interest in climate mitigation across the country: as of December 2022, 33 U.S. states had released a climate action plan or were in the process of revising or developing one, according to the Center for Climate and Energy Solutions.

In 2021 we joined the Net Zero Asset Managers (NZAM) initiative - a group of more than 300 asset managers with nearly $60 trillion in assets under management committed to getting the world to net-zero carbon emissions by 2050 - and we have designed our net-zero approach around high-touch engagement with portfolio companies on their decarbonization strategies.

We are making progress on our goal of assessing each portfolio company's emissions trajectory and determining its alignment with the pathway required to achieve global net-zero emissions by 2050 (Exhibit 5). We are ahead of schedule in confirming the net-zero alignment of our initial in-scope assets (43% we deem to be net-zero aligned versus a goal of 39% as of December 2022), and are conducting either in-depth or exploratory engagements with unaligned portfolio companies across the firm.

Exhibit 3: Tracking Progress Toward Targets for In-Scope Assets

Recent net-zero engagements across ClearBridge portfolio companies reveal how company- and sector-specific conditions shape decarbonization efforts, help us get under the hood with challenges to setting and meeting science-based emissions reduction targets and highlight the value of lesser-known enablers of the energy transition.

Semiconductor Growth Sets High Bar for Renewable Energy Capacity

Strategy holding ASML makes semiconductor manufacturing equipment and is a leading supplier of lithography systems to the semiconductor industry. It has set science-based targets to achieve net-zero Scope 1 (direct from sources controlled or owned by a company) and Scope 2 (indirect, through the purchase of power, heat, cooling, etc.) emissions by 2025, and zero emissions in the supply chain or Scope 3, by 2030. We consider ASML's emissions reduction pathway to be net zero aligned.

While ASML seems on track to meet its net-zero goals, in January 2023 we met with its CEO to discuss, among other topics, potential hurdles it might encounter along the way. Among these might include ASML's own success as it works to build a renewable energy grid for its Veldhoven headquarters in the Netherlands fast enough to keep up with its own growth. ASML is investing in solar and wind and working with energy generation companies to build its own renewable energy capacity in order to support its fast-growing production capacity. The company also cited a goal of 75% reduction in gas use as another key lever in meeting its Scope 1 and 2 goals, which we find credible.

While ASML works to lower its own emissions, it is also enabling its customers to lower theirs. As a semiconductor capital equipment provider, ASML directly improves the energy efficiency of semiconductor chip manufacturing. Its extreme ultraviolet (EUV) lithography systems, which took ASML more than two decades to develop, enable semiconductor manufacturers to make chips that use less energy and/or have higher performance. More power-efficient chips have an emissions reduction multiplier effect down the semiconductor supply chain. ASML directly enables chip manufacturers serving rapidly growing data center and AI businesses, as well as auto and industrial markets, and even smart phones to make more powerful chips using less energy.

Navigating Spotty EV Penetration

Casey's General Stores ( CASY ) is one of the largest gas station and convenience store owners and operators in the U.S., with over 2,400 stores predominately in the Midwest. Most of Casey's sales and profits come from the sale of gasoline, prepared foods (pizza, sandwiches and breakfast items) and grocery and other convenience items. Its stores are well-located and have significant brand recognition. Casey's tends to have dominant market share in the states and the markets in which it operates. As such, its business is stable and cash generative. Also, its small market presence gives Casey's pricing power and provides for a wide moat against would-be competitors.

One of the risks to Casey's is the slow but accelerating shift from internal combustion engine cars to electric vehicles (EVs). This will slowly eat into the company's sales of gasoline and some traffic into the stores. We have encouraged Casey's to be a leader in the rollout of EV charging stations at its stores. To this end, currently Casey's has installed EV charging stations at 29 of its 2,400+ gas station and convenience stores. Management has shared with us that the stores with EV chargers average roughly 390 fuel transactions per day but average only 12 EV charges per day. That equates to a 3% penetration rate for EV demand. That data may actually overstate demand somewhat because the stores with the EV charging stations were handpicked by their charging station vendor/partner as being the stores most likely to see charging demand. EV adoption across the U.S. remains concentrated in mostly coastal states (Exhibit 4); across Casey's entire 16-state portfolio, we think EV charging demand is roughly 0.6%. We, and the company, recognize that EV acceptance is lower in Casey's market than in other more urban and coastal markets.

Exhibit 4: EV Penetration Across the U.S. Is Uneven

Casey's remains committed to offering EV charging as a service, just as it offers gasoline today, but will do so at a rate that more closely aligns with the rate of EV acceptance and demand for EV charging. As EV penetration continues to rise, Casey's will install more charging stations. We also believe that the level of service and range of goods and prepared foods offered inside Casey's stores will make Casey's an attractive place to pass the time required to recharge electric vehicles.

Capital-Intensive Industries Going Digital

Part of our net-zero strategy entails recognizing climate solution enablers such as Aspen Technology, a pure-play industrial software leader supporting complex operations across a wide range of industry verticals, including operations, maintenance and asset optimization. The company has limited carbon emissions itself, and our engagements with it focus on how it is benefiting from the growth in renewables and sustainability investments as Aspen helps the digitalization of capital-intensive industries. Broadly, Aspen's products help organizations streamline engineering and maintenance processes to reduce downtime and increase operational efficiency, in part helping industry to limit emissions and pollution.

Recent engagements with the company's CEO and CFO have focused on markets opened up by Aspen's recent transaction with Emerson Electric to acquire Emerson's Open Systems International (OSI) and Subsurface Science and Engineering (SSE) businesses in exchange for a majority share in the combined company. OSI helps global electrification through digitalizing and optimizing transmission and distribution systems for utility companies in the power industry. In particular OSI supports smart grid initiatives, processing and analyzing millions of data points in real time from all levels of the electrical power supply chain, helping to manage the complexity of integrating renewable energy into the grid.

Aspens' SSE business supports efficiency in the oil and gas industries and aids the development of carbon sequestration, geothermal and hydro energy.

Sustainability investments and decarbonization spending across the product suite should act as strong growth drivers for Aspen. Its technologies are also being used by Google and Meta to model emissions and heat flows at data centers, and Tesla and Rivian are now customers on battery energy flow modeling. Biofuel and hydrogen investments are expected to be modeling intensive, too, providing Aspen several avenues to deliver for shareholders and help decarbonize the operations of equities across many sectors.

Climate Initiatives Raise Awareness and Improve Disclosures

ClearBridge's involvement with several climate initiatives - such as the Task-Force for Climate-related Financial Disclosures (TCFD), which develops consistent metrics for companies to use in disclosing financial risks associated with climate change; Climate Action 100+, an investor-led initiative to engage high emitters on lowering emissions and better disclosure; and the CDP, or Carbon Disclosure Project, which collects climate and water data from companies worldwide - further supports more acute awareness of climate risk and attests to our commitment to moving the energy transition forward.

In the interest of transparency, we provide more information on our climate-focused investing in our 2022 Climate Report and outline our approach to meeting our NZAM commitment, both on our website and via the Principles for Responsible Investment .

Peter Bourbeau, Managing Director, Portfolio Manager

Margaret Vitrano, Managing Director, Portfolio Manager

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