ALC - ClearBridge Large Cap Growth ESG Strategy Q2 2023 Portfolio Manager Commentary

2023-07-19 09:45:00 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.
• Market concentration reached new highs with enthusiasm over generative AI enabling mega cap growth stocks to maintain their performance momentum.
• Improved stock selection and patience with the earnings recovery of several positions enabled the Strategy to outperform the benchmark for the third straight quarter.
• Social-themed proposals from shareholders of large public companies have been increasing in recent years, requiring increased due diligence to properly weigh intentions and potential consequences.

By Peter Bourbeau & Margaret Vitrano

Holding Mega Caps to Task Via Proxies

Market Overview

Growth stocks remained in favor in the second quarter, with enthusiasm over generative AI extending gains for mega cap companies in a historically narrow market. The S&P 500 Index ( SP500 , SPX ) rose 8.74% and the Nasdaq Composite climbed 13.1% as investors took cooling inflation to mean the Federal Reserve’s tightening cycle is near its conclusion. The benchmark Russell 1000 Growth Index maintained its positive momentum, advancing 12.81% and outperforming the Russell 1000 Value Index (+4.08%). Growth is ahead of value by ~2,400 basis points year-to-date.

2023 has so far marked a return to mega cap leadership, with Apple ( AAPL ), Microsoft ( MSFT ), Alphabet ( GOOG , GOOGL ) , Amazon.com ( AMZN ) and Nvidia ( NVDA ) accounting for approximately two thirds of the benchmark return (Exhibit 1). The momentum of these growth stocks was reflected in second-quarter leadership with information technology (IT,+19.25%) the best performer while communication services (+16.26%) and consumer discretionary (+15.84%) also outperformed. Energy(-1.39%) and real estate (-1.30%) suffered losses while consumer staples (+0.03%), utilities (+0.12%), health care (+4.58%), financials (+5.72%), industrials (+6.09%) and materials (+10.26%) also underperformed.

Exhibit 1: Mega Cap Performance Illustrates Narrow Breadth

At 41.3%, the five largest stocks in the market represent the highest concentration in the 26-year history of the Russell 1000 Growth Index. Among these names, we maintain overweights to Nvidia and Amazon, underweights to Microsoft and Apple and no exposure to Alphabet.

Exhibit 2: Market Concentration Hitting Historical Levels

While such concentration had been a headwind in the past, the ClearBridge Large Cap Growth ESG Strategy has outperformed through this latest high-beta-driven period of mega cap dominance due to improved stock selection and patience. Positioning activity through the COVID-19 recovery has been focused on increasing exposure to select growth stocks that provide greater participation in up markets and balancing the portfolio with countercyclical holdings that can provide ballast during turbulent periods.

Delivering performance through fundamental, bottom-up stock selection has been a constant over our tenure managing the Strategy. We underperformed in the first half of 2022 from being too early in entering several stocks going through negative earnings revisions and have seen relative results rebound over the last 12 months due to better stock picking, especially among earnings reset names such as Netflix ( NFLX ) and Meta Platforms ( META ). The Strategy’s IT holdings also drove performance in the second quarter, led by the continued rerating of graphics chipmaker Nvidia as a key beneficiary of the generative AI boom.AI-connected holdings Microsoft and Amazon also delivered strong gains.

"Improved procedure growth should be a boon to medical device stocks, which are benefiting from easing supply chain headwinds and labor shortage bottlenecks."

Nvidia is a good example of a select growth stock bought opportunistically where our long-term thesis has bloomed. We initiated the position in the fourth quarter of 2018 knowing that inference and training in the data center was an interesting although still early-stage growth driver. We knew that GPUs could be used to solve complex computing problems, but we didn’t know how quickly the training and learning efforts by Nvidia’s mega cap customers would hit an inflection point. Volatility in the gaming business created the entry point into the stock and we have built the position accordingly over time. Since the end of 2021, the stock’s portfolio weight grew from 4.5% to a high of 7.2% earlier in the second quarter before we trimmed it to manage our overall position sizing.

We will continue to monitor and adjust Nvidia’s position sizing to manage risk. Despite the sharp run up, we believe the company’s long-term runway remains compelling due to its advantaged positioning in a very large addressable market for GPUs. The current valuation looks expensive, yet Nvidia has real earnings and cash flow and the longer-term multiple looks more reasonable because of GPU pricing power.

Supporting our widely-held names in the second quarter were solid contributions in health care, where we benefited from an overweight to medical device stocks Intuitive Surgical ( ISRG ) and Alcon ( ALC ) which moved higher on signs of improving procedure growth. Supply chain headwinds and labor shortage bottlenecks are now easing while ambulatory surgery centers are adding more surgery hours, which should be a boon to these stocks as well as to orthopedic and spine surgery products specialist Stryker ( SYK ). Newer holding Eli Lilly ( LLY ) also rose strongly on greater than expected demand for its diabetes and obesity treatment. In industrials, the Strategy has benefited from a steady climb in the shares of global rideshare leader UBER and electrical components maker Eaton ( ETN ).

Portfolio Positioning

Quarterly results were partially offset by weakness among the portfolio’s consumer holdings as well as a 900 bps IT underweight. We have been cognizant of our lower IT exposure and had purposefully been positioned this way in 2022 to manage the headwinds of rising interest rates and what we had expected to be a slowing in enterprise IT spending. AI enthusiasm may now provide more of a floor on spending than previously anticipated and as a result we are now inching toward the middle from a previously defensive positioning stance. This activity has involved consistently trimming our health care overweight over the past three quarters as well as leveraging opportunities to close the gap in our IT coverage.

Taking advantage of post-earnings weakness, we initiated a position in Intuit ( INTU ), a provider of software for small business accounting and tax preparation under the QuickBooks and TurboTax brands as well as personal finance (Credit Karma) and marketing services (Mailchimp). We see a clear path to upside earnings revisions as the company expands new products that increase its total addressable market and drive average revenue per user growth.

We increased our position in marketing and design software maker Adobe ( ADBE ). The company is protecting its leadership position by moving quickly into generative AI and license protection. It developed Firefly into a product that can be monetized, moving AI from a previously perceived risk into an opportunity. Also within shadow tech, we added back to our weighting in Meta as steady advertising trends and continued cost management should lead to improved profitability.

Outlook

The economy is sending mixed signals, with a resilient job market and better than expected consumer spending thus far neutralizing the impact of restrictive monetary policy. With labor costs still too high to support the Fed’s inflation fight, Chairman Jay Powell expects at least two more interest rate increases in the second half of the year. Meanwhile, manufacturing has contracted for eight straight months and we remain cautious as the lagged effects of aggressive tightening have yet to be fully felt across the broader economy. Companies remain cautious about earnings, with 67 in the S&P 500 Index issuing negative guidance for the second quarter compared to 46 issuing positive guidance.

We have refreshed our whiteboard and will look to take advantage of such downside earnings revisions among early cycle recovery plays in industrials and consumer discretionary. We are targeting quality themes in the consumer space where estimates have been partly de-risked, similar to the scenario that prompted the purchase of Estee Lauder ( EL ) in the fourth quarter. Such names should be well-positioned to deliver improved earnings on the other side of an eventual recession.

While positioning has become less defensive, a low growth macro environment remains our base case. Following strong participation in a narrow market the first five months of the year, we saw a modest broadening of leadership in June and believe our diversified approach across the growth spectrum is the most prudent way to invest going forward.

Portfolio Highlights

The ClearBridge Large Cap Growth ESG Strategy outperformed its benchmark in the second 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 contributor to performance was the IT sector.

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

On an individual stock basis, the leading absolute contributors were positions in Nvidia, Amazon, Microsoft, Meta Platforms and Apple. The primary detractors were Estee Lauder, Sea Limited ( SE ), Thermo Fisher Scientific ( TMO ), Nike ( NKE ) and PayPal ( PYPL ).

ESG Highlights

Why Is Proxy Voting Important?

The U.S. proxy season, most active between April and June each year, is when the majority of companies hold annual shareholder meetings. These meetings give shareholders a chance to review financial performance and to vote on resolutions made by both management and shareholders that address important issues affecting each company, called proxy votes. Broadly, issues include corporate governance, such as the election of board directors and management pay, as well as social and environmental matters that may be relevant to a company’s operations, products and services.

Shareholder proposals in 2023 have focused on a wide variety of environmental and social topics, with climate change, political spending/lobbying, human rights, diversity, equity and inclusion ((DEI)) and health/safety foremost among them. ¹

ClearBridge takes a fundamental-driven approach to proxies on behalf of clients, with portfolio managers bringing company-specific knowledge to bear on these and other issues. In voting proxies, ClearBridge is guided by general fiduciary principles. Our goal is to act prudently, solely in the best interest of the beneficial owners of the accounts we manage. We attempt to provide for the consideration of all factors that could affect the value of the investment and will vote proxies in the manner we believe will be consistent with efforts to maximize shareholder values.

At the same time, along with direct and ongoing company engagement, proxy voting is an important part of our approach to positively influencing companies through active ownership. ClearBridge’s votes on proposals filed by shareholders or by management are an effective way to signal confidence in the companies we own or to suggest the need for a change in policies, disclosures or related aspects of a company’s business.

Independent Voting, Informed by Company Fundamentals

A key part of ClearBridge’s approach to voting proxies is how portfolio managers take an active role. Some models of voting treat proxies as a largely administrative responsibility, so committees may be staffed with generalists with no investment experience. Other models simply hire a third-party proxy adviser. We would consider that an abdication of our fiduciary responsibility: we believe as fiduciaries the investment teams should have informed opinions on the proxies we vote, similar to the informed opinions we require to invest in or exit a given security. At ClearBridge, proxy voting forms an essential part of the fundamental investment and ownership process.

Pushing for Pay Equity

In some cases, our votes signal the need for companies to improve sustainability practices such as pay equity. These cases often involve voting against management, as we did in the case of portfolio holding Netflix’s proposal to ratify named executive officers’ compensation, a so-called “say on pay” vote. This was also a case where we took into consideration other stakeholder views; the Writers Guild of America reached out to us directly to share its perspective, given its current contract negotiations with major studios.

While this input did not sway our vote directly, we ultimately voted against this proposal due to 1) the magnitude of compensation, which for co-CEOs amounted to over $74 million including salary, stock and eligible bonus (the Writers Guild of America asked for $68 million for ~12,000 people), 2) the need to better tie bonuses and equity compensation to performance criteria, and 3) the ability for Netflix executives to receive an unusually high portion of their compensation in cash, instead of equity stakes, which we believe is a form of compensation more aligned with long-term value creation. Consistent with our active approach to ownership, we shared detailed feedback with Netflix on this proposal following the annual general meeting.

Supporting Biodiversity

Plastic pollution is ubiquitous, threatening ecosystems and biodiversity, a term that, in the context of sustainable investing, refers to the way ecosystems, which provide humans basic needs like food, fuel, shelter and medicine, may be positively or negatively affected by industry. This year portfolio holding Amazon received a shareholder proposal requesting it to issue a report on pollution from plastic packaging, including an assessment of its efforts to reduce the impacts on the environment.

In weighing our vote on this proposal, while we acknowledge that the company has made progress in reducing its packaging materials, we noted Amazon does not provide an overall baseline amount of plastic used throughout its supply chain. Although it disputes the filer’s claims regarding its plastic use, it does not provide competing data that allows investors to assess its progress. Meanwhile, several of Amazon’s peers have announced goals specifically around single-use plastic reduction. Although Walmart’s ( WMT ) and Target’s ( TGT ) sustainable packaging goals focus on private label products, we believe Amazon should be able to monitor third-party seller plastic use, given its knowledge of every item sold on its site. Amazon’s third-party marketplace has been growing faster than its first-party sales for the past several quarters, making it all the more important for the company to work with third-party sellers on surfacing their plastic usage data, even if not all of them are measuring that information today.

Concern over the environmental damage caused by plastics is rising and regulations are likely to go into force in many jurisdictions that would limit the amount of single-use plastic packaging that can be used. Additional disclosure would help shareholders gauge whether Amazon is appropriately managing risks related to the creation of plastic waste. We believed a vote for this proposal and against management was warranted in this case.

Companies Are Making Progress on Topics of Social Proposals

Proposals on pressing social topics saw less support in 2023 than in previous years, with median support for social proposals falling from 32.5% in 2021 to 24.1% in 2022 and 18.2% in 2023. ² However, this is not necessarily a sign of waning interest in these topics — indeed, the number of social proposals has been steadily increasing (Exhibit 3) — but can reflect a higher number of proposals submitted and the effect of company engagements on behalf of active owners like ClearBridge helping companies make progress on several fronts. In social topics as diverse as facial recognition, animal welfare and child labor, ClearBridge holdings have been making progress, and our votes signal our confidence in the companies we own.

Exhibit 3: Social and Environmental Proposals Continue to Increase

In 2023, a filer requested that Amazon disclose a third-party report on the company’s Rekognition facial recognition system. We found, however, Amazon’s oversight and guidelines for the technology to be sufficiently robust. Its Nominating and Corporate Governance Committee has oversight over corporate social responsibility practices, including risks related to human rights and ethical business practices, as well as risks related to operations and engagements with customers, suppliers and communities. In its Acceptable Use Policy, Amazon clearly prohibits using its services in an unlawful manner. Amazon states that it supports and has suggested guidelines for developing governmental regulations around these technologies.

Amazon has also established guidelines for customer use of facial recognition technology, specifically with reference to law enforcement agencies, including human review; a 99% confidence score; reliance on the technology as a starting point and not the sole determinant in taking action; transparent use of the technology and safeguards in place; and trained personnel using the technology. It has also published additional resources for guidelines on using facial recognition for public safety cases, and in June 2020 announced a one-year moratorium on selling the use of Rekognition to law enforcement to give Congress time to develop regulations around the technology. The company has now indefinitely extended this moratorium. In addition, Rekognition is an image analysis service, not a surveillance system, and similar tools are available from many other vendors. We believed a vote against this proposal was warranted.

Prioritizing Shareholder Benefit

Sometimes we may deem proposals to have little to no benefit for shareholders, even while we agree with the spirit of the proposal. For example, this year global snack food and beverage company Mondelez International ( MDLZ ), which operates under brands such as Oreo, Ritz, Toblerone and Cadbury, received a proposal requesting that it disclose updated cage-free egg benchmarks. The company outlines its animal welfare policies and goals, and it states its commitment to the Five Freedoms of animal welfare. It has a goal for 100% of its egg supply globally to be cage-free by 2025, excluding Ukraine and Russia. As of the end of 2021, it reports that 39% of eggs supplied globally were cage-free and 100% of the egg ingredients purchased in the U.S. and Canada were cage-free.

Overall, Mondelez appears to be making progress on its cage-free egg goal and discloses adequate information about its animal welfare policies. Although it makes interim goals for some of its other commitments, such as its climate targets, those targets tend to stretch over a longer time period, making interim goals more useful. Shareholders are unlikely to benefit from the requested update to such short-term goals, especially as Mondelez annually reports its progress toward its goal, which is set to be completed in 2025. For these reasons, we voted against this proposal.

Similarly, we voted against a proposal at Mondelez that asked the company to adopt and report on targets to eradicate child labor in its cocoa supply chain. Cocoa is a key ingredient in Mondelez’s chocolate products. ClearBridge has engaged Mondelez for several years on responsible sourcing in its cocoa supply chain, and believe it to be a leader with its Cocoa Life program, which launched in 2012 to improve sustainability in its cocoa supply chain in areas such as deforestation, improving cocoa farmer incomes and enhancing child protections. In a 2019 company engagement, we discussed its new commitment to source 100% of cocoa for its chocolate brands sustainably through Cocoa Life by 2025, up from 43% at the time. As of the end of 2022, this number is 80%.

The company also has goals for its Child Labor Monitoring and Remediation Systems (CLMRS) to cover 100% of Cocoa Life communities in West Africa; this number was at 74% in May 2022. In a late 2022 engagement we discussed Mondelez’s expanding its Cocoa Life spending by $600 million, up from $400 million. It noted farmer net incomes had increased by 15% in Ghana and 33% in Ivory Coast over the past decade, but there were still systemic challenges for cocoa farmers.

Overall, in-depth knowledge of the company and years of engagement on the topic leads us to believe Mondelez has set and progressed on meaningful targets which are not substantially different than those asked for in this proposal; for this reason we voted against it.

Proxy and Engagements Form Part of Active Ownership

ClearBridge proxy voting and company engagement go hand in hand as part of an active ownership strategy; our engagements can continue conversations with companies on sustainability topics raised by past shareholder proposals.

While engaging Mondelez on its 2023 proxy items, for example, we also caught up on topics from past proxy discussions, such as 2019’s proposal to report on deforestation in Mondelez’s supply chain. Large-scale deforestation results in reduced biodiversity (forests contain the vast majority of Earth’s amphibian, bird and mammal species) and destroys valuable carbon sinks able to help combat climate change.

ClearBridge voted against that proposal, finding the company had a comprehensive set of initiatives in place to reduce the deforestation impact of its cocoa supply chain. In 2023 the company found that, based on satellite images, there had been minimal deforestation since 2018 when it started working on pro-environmental community investments and education initiatives. It is also seeing positive progress on reforestation, growing local incomes from non-cocoa sources.

A Comprehensive Proxy Voting Policy Supports Consistent Voting

The ClearBridge Proxy Voting Committee, comprising mainly portfolio managers, analysts and legal/compliance personnel, meets at the beginning of each year to review the upcoming proxy season and to make amendments to ClearBridge’s Proxy Voting Policy to reflect our latest views on corporate governance, environmental and social proposals. The committee also meets after the proxy season to review and reflect on the proposals and votes that took place that year. Moreover, the investment teams will engage with the investee companies (and shareholder proposal proponents) throughout the year on proxy matters and vote rationales, and to ask questions.

While investor support for environmental and social proposals overall went down from 2022 to 2023, one of the more common reasons for certain votes against shareholder proposals was due to the “language” in them: proposals were poorly worded, overly prescriptive or deteriorative to shareholder value. This underscores the value of the Proxy Voting Policy to ClearBridge’s investment teams, as well as the direct involvement by the portfolio managers in voting on proposals that fall outside the policy. ClearBridge maintains a 100% vote record.

Peter Bourbeau, Managing Director, Portfolio Manager

Margaret Vitrano, 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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