ELV - ClearBridge Large Cap Value ESG Strategy Q1 2024 Portfolio Manager Commentary

2024-01-19 04:45:00 ET

Summary

• ClearBridge Large Cap Value Strategy exploits market inefficiencies to identify strong businesses at attractive valuations that can hold for long time periods.
• U.S. equities made solid gains in the fourth quarter as falling inflation, a dovish pivot for the Federal Reserve and a still healthy job market raised hopes of an economic “soft landing” along with interest rate cuts in 2024.
• After being roiled during a regional bank crisis earlier in the year, financials benefited from the Fed’s pivot, which relieved pressure on deposit outflows, reduced unrealized losses of mortgage-backed securities and benefited companies exposed to credit risk.
• In line with our philosophy to continually advance our ESG engagement process, ClearBridge has taken steps to better structure, measure and communicate the progress and outcomes of key engagements, and in 2022, we launched an enhanced internal engagement initiative called Engage for Impact.

By Dmitry Khaykin & Deepon Nag

Engaging Companies for Impact and Value Creation

Market Overview

U.S. equities made solid gains in the fourth quarter of 2023 as falling inflation, a dovish pivot for the Federal Reserve and a still healthy job market raised hopes of an economic "soft landing" along with interest rate cuts in 2024. While the quarter began with indexes retreating amid worries of higher-for-longer interest rates and an imminent recession, stocks reversed halfway through November after a favorable headline inflation reading drove a risk-on mentality for market participants. The broad market S&P 500 Index finished the quarter up 11.69%, while the Russell 1000 Value Index advanced 9.50%.

Following the inflation print, the market rotated toward cyclical sectors that are more sensitive to interest rates and economic activity, along with stocks that were out of favor. Real estate, industrials and financials sectors rebounded as 10-year Treasury yields fell from over 5% in October to 3.8% to finish the quarter and expectations rose for three interest rate cuts in 2024. At the same time, oil prices dropped from $88 per barrel of WTI crude to $72 amid surging Russia exports, high U.S. production and slower growth from China, leaving energy the sole sector in the S&P 500 with a negative return.

Against this backdrop, the ClearBridge Large Cap Value ESG Strategy ( LRGE ) outperformed its benchmark Russell 1000 Value Index in the fourth quarter, capping a strong year overall for relative performance.

Solidly positive stock selection drove the majority of outperformance during the quarter, in particular in the IT and financials verticals. Our largest portfolio position, Intel ( INTC ), was a strong contributor as the company's margins surprised to the upside, and it gave positive comments about its technology and product roadmap. The company should also benefit from a strong PC upgrade cycle over the next two years as Microsoft releases a new version of its Windows operating system with AI capabilities, while also ending support for its Windows 10 operating system. Ongoing geopolitical uncertainty supporting a U.S. domestic focus on semiconductor capabilities is also supportive for the stock, which remains attractively valued in our view.

Semiconductor capital equipment company Lam Research (LRCX) also advanced strongly in the quarter as the memory semiconductor capex cycle looks to be troughing, setting up for a period of growth. Memory pricing is improving, usually a good indicator, while data center and AI growth are also supporting fundamentals.

After being roiled during a regional bank crisis earlier in the year, financials benefited from the Fed's dovish pivot in the fourth quarter. Ten-year Treasury yields fell, which relieved pressure on deposit outflows at Charles Schwab and reduced unrealized losses on Bank of America's portfolio of longer-duration mortgage-backed securities. The market's more positive view of the economy's ability to narrowly dodge a recession ("the soft landing" scenario) also benefited companies exposed to credit risk such as American Express and U.S. Bancorp.

Detractors were largely idiosyncratic, with Charter Communications ( CHTR ) reporting a softer quarter for broadband subscriptions and guiding to a slightly more negative fourth quarter. Cable peer Comcast ( CMCSA ) also trailed the market. As we have highlighted before, cable multiples have compressed on fears of heightened competition in their core broadband business from fixed wireless and fiber providers. While these competitors are making inroads, we believe that Comcast and Charter can continue to deliver modest growth as they expand their broadband footprints into rural and adjacent markets as well as gain market share in the wireless market. The companies continue to generate substantial free cash flow, and their stable recurring revenue streams and undemanding valuations look valuable in a potentially volatile 2024.

Portfolio Positioning

During the quarter, we continued executing our fundamentally based bottom-up investment process of identifying mispriced high-quality franchises operating in attractively structured end markets. We continue to recycle capital out of areas that have done well over time and where fundamentals look to be at risk and redeploy it into areas where valuations have been reset or where fundamentals look to be improving. With that in mind we exited Vertiv ( VRT ) as its valuation became full, and trimmed Meta Platforms ( META ) and Progressive (PGR) after strong reratings. Softer agricultural market fundamentals led us to trim Deere ( DE ), while slowing electric vehicle adoption and concerns around the affordability of new automotive purchases resulted in us paring back our TE Connectivity ( TEL ) position.

On the flip side, we were able to find several new attractive opportunities that we believe will offer superior returns over the next three to five years on a risk-adjusted basis. For example, within the health care space, we initiated positions in CVS Health (CVS) and Thermo Fisher Scientific (TMO).

CVS is one of the largest providers of health care benefits in the industry but it has struggled in recent years due to reimbursement pressures at its retail pharmacies and execution missteps in its Medicare Advantage business. However, we see some evidence of improvement on both fronts, as it recently announced a bold plan to stabilize margins in its pharmacy business as it moves to a "cost plus" model on scripts fulfilled. While the plan isn't without risk, we would note that CVS's largest competitor Walgreens has endorsed the approach and given the combined market share of the two companies (~40% of the U.S. pharmacy market), increased regulatory scrutiny around price transparency and continued shortage of pharmacists in the U.S., we believe plan sponsors will be amenable. Similarly, we see evidence that the company has improved the quality of its Medicare Advantage service, as demonstrated by improved "Star Ratings," something we believe will be reflected in a growing margin profile of the business through 2025. Steady free cash flows also give CVS valuable defensive characteristics. We funded the purchase partially with trims to UnitedHealth Group ( UNH ) and Elevance Health ( ELV ), wishing to lower our managed care exposure while taking advantage of a valuation discrepancy and a hopefully derisked CVS investment profile.

Thermo Fischer Scientific is a well-run, high-quality health care tools business whose valuation became attractive due to a cyclical correction in its channel. It should also offer defensive characteristics with less economic sensitivity than many other businesses.

We also initiated a position in Veralto (VLTO), which was recently spun out of Danaher, a company somewhat similar to Thermo Fischer Scientific. Veralto operates in the industrials sector and is a leader in the stable and growing global water treatment and filtration markets. It also holds a strong position in packaging printing solutions that include traceability applications for food and beverage, consumer packaged goods and pharmaceutical products. Veralto trades at a reasonable valuation, in our view, and should enjoy mid-single-digit organic growth to be augmented by tuck-in acquisitions while also offering margin expansion opportunities.

Outlook

The equity market in 2023 was dominated by the "Magnificent Seven" stocks (Alphabet, Amazon.com , Apple, Meta Platforms, Microsoft, Nvidia and Tesla), which accounted for ~60% of the S&P 500's return for the year. This allowed growth stocks to handily outperform value stocks for the year, after a period of underperformance in 2022. Going forward, we see several reasons that the historic outperformance of value could resume in the coming years. First, we would note that several of the deflationary forces that drove much of the zero-interest-rate environment of the past decade (particularly globalization and global austerity) are reversing or coming to an end. Second, growth stocks continue to be priced near record levels when compared to value stocks, which we view as unsustainable. Finally, we believe the outsize earnings growth experienced by the Magnificent Seven in 2023 (~35%) is unlikely to persist into 2024.

Going forward, the market appears to be anticipating a "soft landing" scenario, with the market action exiting the year resembling more of an early cycle, risk-on environment. However, we would caution that this is certainly not a foregone conclusion. In addition to being human tragedies of enormous scale, geopolitics of the Middle East conflict combined with a protracted war in Ukraine, now approaching its third year, are adding yet another layer of uncertainty.

In our experience it hasn't been a fruitful or profitable endeavor to make a bet on an economic scenario (particularly given the market's recent waffling on the topic). Instead, we continue to consistently execute our longer-term investment philosophy of identifying durable and defensible franchises operating in structurally sound industries and trading at discounts to their intrinsic values. We believe this balanced approach will provide attractive long-term returns combined with healthy downside risk management, regardless of the macroeconomic environment.

Portfolio Highlights

The ClearBridge Large Cap Value ESG Strategy outperformed its Russell 1000 Value Index benchmark during the fourth quarter. On an absolute basis, the Strategy had positive contributions from 10 of the 11 sectors in which it was invested for the quarter. The financials and IT sectors made the main positive contributions, while the consumer staples sector was largely flat.

On a relative basis, overall stock selection and sector allocation contributed to performance. In particular, stock selection in the IT, energy, financials, real estate and health care sectors, underweights to the energy and consumer staples sectors and an IT overweight added to relative returns. Conversely, stock selection in the communication services sector and a real estate underweight detracted.

On an individual stock basis, the largest contributors were Intel, JPMorgan Chase ( JPM ), Charles Schwab ( SCHW ), American Express ( AXP ) and Bank of America ( BAC ). Positions in Charter Communications, Becton Dickinson ( BDX ), Air Products and Chemicals ( APD ), Comcast ( CMCSA ) and Haleon (HLN) were the main detractors.

In addition to portfolio activity noted above, during the quarter we initiated a new position in WEC Energy Group ( WEC ) in the utilities sector.

ESG Highlights:

An Enhanced Internal Engagement Initiative

Engagement to drive positive change in public equities has been a longstanding part of ClearBridge's investment decision making and active ownership. As a long-term shareholder with an average stock holding period of five years, ClearBridge has cultivated strong and lasting relationships with company management teams. With this unique position and decades of industry experience, we've taken steps to better structure, measure and communicate the progress and outcomes of key engagements, and in 2022 we launched an enhanced internal engagement initiative, Engage for Impact (EFI).

The initiative encourages targeted engagements that we believe have a strong likelihood of creating positive impact, which we define as the creation of long-term positive environmental or social outcomes for the benefit of all stakeholders in public companies: their investors - our clients - and their employees, customers, suppliers and communities.

While we believe our work can often influence significant improvement at the company level, we also recognize we are one of many shareholders working to create change. In many cases this collective voice is what ultimately leads to positive, real-world impact.

As a part of this new initiative, investment team members develop specific "asks" or areas of improvement for priority target companies. Progress against these "asks" is then monitored and reported on over time.

As long-term investors, our company engagements can take place over a multiyear period. Therefore, throughout the course of the engagement, we track and categorize company progress by stages (Exhibit 1).

Exhibit 1: Engage for Impact Progress Framework

Using this framework, we can better monitor and track a company's responsiveness and progress against key performance indicators and report on these outcomes over time. EFI engagements follow a consistent structure, prioritize topics closely aligned with value creation, represent a wide variety of sustainability topics (Exhibit 2), and are often rooted in firmwide focus areas like net zero, biodiversity, human rights, as well as diversity, equity and inclusion.

Exhibit 2: Engage for Impact Asks by Category

Given this enhanced initiative is still in the early stages, most of our EFI company asks are currently categorized as early stage or in-process (Exhibit 3). Examples of company asks focused on reducing emissions, improving labor relations, expanding electric vehicles (EVs), improving board effectiveness and implementing total shareholder return (TSR) metrics convey the spirit and overall benefits of the initiative.

Exhibit 3: ClearBridge Engage for Impact Asks by Stage

Decarbonizing Aviation: United Parcel Service

Reducing emissions is a common ask among ClearBridge's company engagements broadly. For an EFI with United Parcel Service (UPS), we acted on the opportunity to formulate a specific ask for a reduction in Scope 1 and 2 emissions from its aviation fleet, which comprises ~300 planes. We actively engage with UPS on setting aggressive carbon reduction targets as its stock is held in a strategy that is in-scope for ClearBridge's net-zero commitment.

In our engagements with UPS, we have discussed how due to heavy reliance on future technologies such as sustainable aviation fuel, the company recognizes it cannot credibly set a company-wide target approved by the Science-Based Targets initiative (SBTi) at this time. However, the company has acknowledged our ask as a key area of focus over the next 10-15 years and recognizes decarbonizing its aviation fleet is a key part of the global energy transition. It also recognizes the need to align all other parts of the business with a net-zero pathway in an effort to decarbonize. Efforts currently underway include investments in electrical vertical takeoff and landing aircraft and full electrification of its ground fleet, with a 2025 goal of 40% alternative fuel for ground vehicles, up from 24% today. We will continue to engage UPS as a stage 2 EFI to monitor progress against other reduction targets and continue to urge the company to decarbonize its aviation fleet.

Bettering Driver Relations and Expanding EVs: Uber

In stage 3 of an EFI the company has acknowledged the ask and has developed a credible strategy to address it. The company may even have begun and be well along in addressing it, as is the case with Uber and two asks we have formulated to: 1) improve driver satisfaction, and 2) expand its adoption of EVs toward achieving its net-zero goal.

We've engaged Uber since its IPO in 2019 as concerns over employee classification have led to questions of worker pay and benefits that we felt overshadowed other merits of its rideshare business, for example rideshare's democratization of transportation and Uber's impressive safety record.

In December 2019, we met with the company to discuss driver earnings and shared our view that drivers should remain contractors with added benefits and pay protection. At that time, Uber had already shifted its operating philosophy to a more conciliatory approach and improved relationships with contracted partners with guaranteed pay minimums, portable benefits and bargaining rights.

We continued the conversation as part of regular meetings with the company over subsequent years, and at a January 2024 meeting with Uber's CEO, CFO and other representatives, we were pleased with progress made against both asks. Management highlighted improvements made to the driver experience, including technology, earnings and worker flexibility. Specifically related to driver earnings, the primary concern, drivers on the platform currently earn an average of ~$36 per utilized hour on a gross basis and low-$20s net of expenses and overhead. Up-front fares, which are now being rolled out globally, provide improved earnings transparency. On fairness, where drivers see anywhere from a 0% to 50% take rate (the percentage Uber takes of gross margins), Uber plans to share weekly reports with drivers clarifying take rates and distributing make-whole payments where appropriate.

To achieve its SBTi-approved net-zero goal by 2040, Uber is focusing on driver incentives and education to drive adoption of EVs across its platform. Results so far are promising and getting better: 4.7% of Uber's trip miles driven in the U.S. and Canada are completed in zero-emission vehicles, even though EVs represent just ~1% of total cars on the road in the U.S.

Enhancing Board Quality and Operational Efficiency: Comcast

Comcast is also at stage 3 in its EFI action as it is making measurable progress on EFI asks regarding 1) addressing some concerns from third-party governance research providers on overboarding and board effectiveness, 2) setting verified science-based targets and 3) addressing efficiency of operations, specifically as it relates to suppliers.

In December 2019, we engaged Comcast on a variety of ESG topics and raised the issue of board independence. We followed up in May 2020 when we discussed a proxy proposal on the split Chairman and CEO role. Following this meeting, Comcast improved the independence of its board, upping the percentage of independent director nominees from 80% in 2019 to 89% in 2022, as well as improving board diversity, from 40% of director nominees being diverse by gender or race in 2019 to 44% in 2022.

In December 2022, we continued the conversation around board effectiveness and engaged the company on its board structure, raising concerns around overboarding or having board members sit on too many boards, which may compromise their ability to serve the board effectively. This issue has been flagged by third-party governance research providers.

In a December 2023 engagement, Comcast shared that it was making progress addressing overboarding by bringing down the average tenure of its board by incorporating a policy on director overboarding into its corporate governance guidelines that limits the number of public company boards on which directors may serve. As part of the policy, no director who also serves as CEO at a public company may serve on more than three public company boards. A notable example is lead independent director Ed Breen, who is also the current CEO of DuPont de Nemours. He proactively sought to reduce the number of boards he sits on and chose not to stand for re-election to the board of International Flavors & Fragrances at the company's 2023 annual meeting.

Also at our December 2023 meeting, Comcast disclosed its Scope 3 emissions for the first time and committed to setting a verified science-based target. The company has begun engaging suppliers on committing to set a verified target, and going forward, it will set clearer targets around Scope 3 emissions. Regarding our ask around operational efficiency, Comcast has reduced the electricity needed to deliver each byte of data across its network by 36% since 2019 and is pushing its suppliers to be more efficient.

Improving Incentive Metrics and Committing to Net Zero: Western Digital

In a completed EFI journey, Western Digital has implemented a strategy to address asks we made over several engagements to 1) institute relative total shareholder return (TSR) incentive metrics to evaluate shareholder value creation compared to industry peers, 2) improve energy intensity levels of manufacturing in line with industry peers and 3) commit to a net-zero target.

Specifically, Western Digital reduced the energy intensity of manufacturing its products by >13% from FY21 to FY22. It added relative TSR metrics to its incentive comp, which we view as positive as it aligns management compensation with execution, whereas before management would benefit from the fact their industry is growing faster than the broader market. On the third ask, in June 2023 the company announced an ambitious target and has committed to net zero Scope 1 and 2 emissions across its operations by 2032. Its target includes goals to reduce Scope 1 and 2 emissions by 42% by 2030 and to reduce Scope 3 use-phase emissions/terabytes by 50% by 2030, both from a 2020 base year. Its targets were approved by SBTi in 2021, and since then Western Digital has achieved nearly 15% absolute Scope 1 and 2 emissions reductions.

We look forward to sharing more successful EFI case studies in the future as our EFI target companies continue to make measurable progress against our asks.

Dmitry Khaykin, Managing Director, Portfolio Manager

Deepon Nag, Director, Portfolio Manager

Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company ("Russell") is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell's express written consent. Russell does not promote, sponsor or endorse the content of this communication.

Performance source: Internal. Benchmark source: Standard & Poor's.

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