META - ClearBridge Large Cap Value ESG Strategy Q3 2023 Portfolio Manager Commentary

2023-07-19 08:30:00 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.
• U.S. equities continued to make gains in the second quarter, driven by excitement over generative AI and improving market sentiment supported by a resilient economy and expectations the Federal Reserve is nearing the conclusion of its tightening cycle.
• Positions bought both opportunistically and held over longer time periods supported Strategy outperformance due to their strong AI positioning, illustrating the benefits of targeting strong businesses when temporarily out of favor.
• ClearBridge takes a fundamental-driven approach to proxies, with portfolio managers bringing company-specific knowledge to bear on issues such as executive pay, use of controversial technology and biodiversity.

By Robert Feitler & Dmitry Khaykin

Targeting Strong but Temporarily Out of Favor Businesses

Market Overview

U.S. equities continued to make gains in the second quarter, driven by excitement over the growing proliferation of generative AI and improving sentiment that the Federal Reserve's tightening cycle could be nearing its conclusion while the economy remains relatively strong. The benchmark Russell 1000 Value Index returned 4.08%, trailing the Russell 1000 Growth Index in a high-beta rally that evened out somewhat in June when value and growth returns were roughly in line.

The Strategy outperformed in the quarter, benefiting from recent opportunistic additions such as Meta Platforms ( META ) as well as medium- and long-term holdings such as Vertiv ( VRT ), Oracle ( ORCL ), and Martin Marietta Materials ( MLM ). Meta was the top contributor for the second consecutive quarter after we initiated a position late in 2022. The stock rebounded strongly as the company demonstrated more discipline with its investments, and revenue headwinds (driven by Apple's ( AAPL ) privacy changes as well as competition from TikTok) began to abate. Meta also has a strong position in AI, as it uses the technology to dynamically recommend content for consumers, as well as to help target and measure ad conversions. Going forward, it expects to leverage generative AI to help it generate content (including advertising content for new products like Reels) as well as in its Metaverse ambitions. While we maintain meaningful exposure to Meta, we took advantage of the stock's exceptional performance over the last six months and reduced our position in the quarter.

Vertiv is another top contributor getting a boost from AI adjacency. Vertiv is a leader in providing power and thermal management technologies for data centers, enterprises, and communication carriers globally. Vertiv's first-quarter results demonstrated management's meaningfully improved execution as the company continues to see strong end market demand while recovering from COVID-19 supply chain issues. Vertiv's differentiated product offering and more disciplined sales effort allowed it to exhibit strong pricing power as it recovers input costs and improves margins. About 70% of its business comes from data centers, an essential part of the generative AI ecosystem. AI workloads require much more power density than traditional computing workloads, which leads to a greater need for advanced cooling solutions that are expected to benefit Vertiv. Similar to Meta, we took advantage of market excitement surrounding AI and modestly reduced our exposure to Vertiv during the quarter.

Expectations that rapidly developing generative AI technology will drive another wave of cloud adoption were also a boon for Oracle ( ORCL ), the dominant provider of on-premise database software for large enterprises globally, with growing cloud and SaaS businesses. Oracle noted that generative AI cloud customers have already signed contracts to purchase more than $2 billion of cloud capacity, reflecting the strengths of its technology as well as its aggressive go-to-market strategy.

Our selection in the materials sector also helped portfolio outperformance, with Martin Marietta Materials, a leading producer of aggregates for construction, helping the portfolio manage inflation risk. While the benefits from robust pricing in aggregates and cement have lately been muted by inflation, aggregates gross margins should inflect meaningfully higher going forward as incremental pricing and lower energy costs flow through the company's income statement.

On the detractors side, industrials holding United Parcel Service ( UPS ) traded down amid concerns over a weakening macroeconomic environment as well as risks from union contract negotiations this summer. Defensive sectors were out of favor in a growth-driven market, leaving Sempra Energy, a best-in-class utility with regulated assets in California and Texas, among the top detractors.

Cisco Systems ( CSCO ), which provides IT and networking services in the form of network security, software development, and cloud computing, traded down as enterprise customers showed signs of tightening their IT spending budgets and news of cybersecurity concerns, even while it beat expectations and raised its full-year guidance. Concerns over increased competition and share loss in its core verticals led us to exit our position during the quarter as we made several moves to add to existing higher-conviction holdings or initiate new positions that we find more compelling in the long term.

Portfolio Positioning

We were fairly active in the quarter as market dislocations allowed us to be opportunistic, while focusing on companies with stronger moats, better pricing power, more predictable long-term growth and higher returns. In the materials sector, we exited PPG Industries ( PPG ) and initiated a position in Sherwin-Williams ( SHW ). While both companies operate in the paint and coating industry and are benefiting from improving margins as raw material prices have come down of late, we believe Sherwin-Williams' dominant retail footprint affords it better pricing power through the cycle. The company provided conservative 2023 guidance and has been successfully gaining market share in the pro segment. While PPG has more European and industrial exposure, Sherwin-Williams' residential and more domestic focus should also benefit the company as housing indicators appear to be troughing. Weak housing in the face of higher mortgage rates caused Sherwin-Williams stock to sell off in the first quarter, creating a compelling investment opportunity for long-term focused fundamental investors.

In the technology sector, in addition to exiting Cisco Systems, we also sold our marginal position in Qualcomm ( QCOM ), whose business is tied to wireless handsets. With the 5G cycle largely played out and competitive risks in the wireless component space rising, we see less upside for Qualcomm relative to earlier in the cycle. At the same time, we re-initiated a position in semiconductor capital equipment company Lam Research ( LRCX ), which we owned in 2020-21, and exited as its valuation hit our targets and fundamentals began to weaken. Lam's tools are an essential part of the semiconductor manufacturing process and provide decades of annuity-like cash flows from servicing and spare parts. While the business is inherently cyclical, we believe that demand for semiconductor equipment will structurally grow due to the rising capital intensity of semi manufacturing, increased silicon content across all applications and a push by governments around the world to subsidize domestic production of chips. With the memory cycle nearing a bottom, expectations reset and the company able to expand its gross margins through ramping up new lower-cost facilities and other efficiency actions, we see more compelling risk/reward here versus Qualcomm.

In health care we exited global biotechnology company Amgen ( AMGN ). Similar to many of its large cap pharma/biotech peers, Amgen is facing patent cliffs for its major drugs in the second half of the decade, while the company's pipeline has disappointed. In addition, Amgen is facing above-average pricing pressure impacting a number of its current products that compete in crowded therapeutic areas. Amgen is now relying more heavily on acquisitions to address its patent cliff and weak internal pipeline. However, Amgen's recently proposed $28 billion acquisition of Horizon Therapeutics ( HZNP ) is being challenged by the FTC, creating further uncertainty.

Also within health care, we added to McKesson ( MCK ), a holding we initiated in March. McKesson is the leading distributor of pharmaceuticals to retail drug stores, physicians' offices, and hospitals in the U.S. It also has one of the largest specialty drug and oncology businesses in the U.S., which is the fastest-growing segment within drug distribution. We continue to gain comfort with the business, which operates in a very stable industry, maintains a strong balance sheet, and trades at a reasonable valuation for a company we believe can compound earnings in the low teens, with further upside from faster organic growth than peers.

Outlook

The last several years featured a strong economy that benefited from aggressively supportive fiscal and monetary policies. In its effort to tame inflation the Fed has been tightening aggressively over the past 15 months, contributing to slower economic growth, albeit with less near-term impact than most prognosticators had forecasted, while recession expectations continue to be pushed out. We believe that economic activity will continue to slow and drive earnings expectations lower. Economic indicators paint a somewhat conflicting picture as manufacturing PMI continues a year-long deterioration, while consumer confidence has bounced back and recent employment data remains robust. We remain cautious, however. While inflation is lower, it remains above the Fed's 2% target, with tech stocks and interest-rate sensitive sectors coming under pressure since Fed Chairman Powell's testimony to Congress in mid-June.

In a deteriorating economic environment that can cause dislocations, we are asserting our longer-term views on individual stocks and maintaining our emphasis on quality companies as we try to be nimble when the market presents opportunities.

We have done so recently with Charles Schwab ( SCHW ), which got caught up in investor concerns over regional banks, due to the perception of an asset/liability mismatch on Schwab's balance sheet. While there are similarities with regional banks, Schwab has minimal credit risk and far higher organic growth than traditional banks. In addition, Schwab's mostly retail customers are not pulling money out of its ecosystem. On the contrary, the company continues to grow client assets at a mid-single-digit percentage rate despite the banking selloff. Concerned over interest rate risk, we trimmed our position last year and earlier this year. As the stock pulled back this spring, we added back aggressively. It remains an exceptionally strong franchise in terms of asset gathering and customer loyalty and runs a unique business model that continues to attract client assets; we are pleased to have the opportunity to express our differentiated view.

Portfolio Highlights

The ClearBridge Large Cap Value ESG Strategy outperformed its Russell 1000 Value Index benchmark during the second quarter. On an absolute basis, the Strategy had positive contributions from nine of the 11 sectors in which it was invested for the quarter. The industrials, financials, communication services, and IT sectors made the strongest contributions, while the utilities and real estate sectors were detractors.

On a relative basis, overall stock selection and sector allocation contributed to performance. In particular, stock selection in the materials, IT and communication services sectors added to relative returns. An underweight to the energy sector was also beneficial. Conversely, stock selection in real estate and an underweight to consumer discretionary were minimal detractors.

On an individual stock basis, the largest contributors were Meta Platforms, Vertiv, Eaton ( ETN ), JPMorgan Chase ( JPM ) and Oracle. Positions in Cisco Systems, United Parcel Service, Dish Network ( DISH ), Sempra Energy, and Progressive ( PGR ) were the main detractors.

In addition to portfolio activity noted above, during the quarter we exited our position in Dish Network in the communication services sector.

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 admi qnistrative 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 the portfolio holding Netflix's ( NFLX ) 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 ( AMZN ) 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 1) - 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 1: 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 on 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 in reforestation, and 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 of the portfolio managers in voting on proposals that fall outside the policy. ClearBridge maintains a 100% vote record.

Robert Feitler, Managing Director, Portfolio Manager

Dmitry Khaykin, Managing 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.

¹ ISS Governance, 2023 Global Proxy Season Recap Note, June 30, 2023.

² Pensions and Investments, citing ISS

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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