TSCO - ClearBridge Large Cap Growth Strategy Q1 2023 Portfolio Manager Commentary

2023-04-14 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.
• In anticipation of a likely recession and to further support our risk management efforts, we added new positions in stable growth companies in the health care and utilities sectors while further paring back the portfolio’s consumer exposure.
• 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.

By Peter Bourbeau & Margaret Vitrano

Tech Takes Turn Doing the Heavy Lifting

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 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 over 300 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 982 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 ( CRM ) 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 ).

The likelihood of a macro slowdown later in the year motivated the addition of another stable growth company in NextEra Energy ( NEE ). NextEra operates an integrated utility business with a regulated utility operating in Florida and is the largest generator of wind-based energy in the U.S. The purchase increases our exposure to the secular growth of renewables while also adding to the defensiveness of the portfolio. NextEra is a strong operator with a well-respected management team that has consistently met or beat growth goals. On the regulated side, Florida’s population growth and favorable regulatory environment have helped the business grow revenue faster than a typical utility. The state has also been supportive of NextEra’s modernization of its infrastructure and achieving double-digit returns on those projects. On the unregulated side, the company brings strong execution, a knowledge of renewables projects, and a solid balance sheet that can help lower its cost of capital to grow a healthy backlog of projects. We see NextEra as a leader in renewable power generation amid an environment supportive of a shift away from traditional energy sources.

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.

Exhibit 2: Leadership To and Through Recessions

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).

Portfolio Highlights

The ClearBridge Large Cap Growth Strategy outperformed its benchmark in the first quarter. On an absolute basis, the Strategy posted gains across nine of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the IT, communication services and industrials 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 ), Advance Auto Parts ( AAP ), Intuitive Surgical ( ISRG ), Sherwin-Williams ( SHW ) and Raytheon Technologies ( RTX ).

Peter Bourbeau, Managing Director, Portfolio Manager

Margaret Vitrano, Managing Director, Portfolio Manager

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