TCANF - ClearBridge Large Cap Value ESG Strategy Q4 2023 Portfolio Manager Commentary

2023-10-16 03:56:00 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 pulled back from highs reached in the first half of the year due to signs of economic strain, including fears of slowing consumer spending and the prospect of a sustained period of higher interest rates.
• The Strategy held up well in this environment, with outperformance driven by communication services, health care, and industrials holdings.
• Nature-positive revenue opportunities tend to be tied to companies with products that either substitute for a high-impact product or reduce impact from existing economic activity, and both are well-represented in ClearBridge portfolios.

By Robert Feitler & Dmitry Khaykin

Leaning into Quality Stocks As Risks Mount

Market Overview

U.S. equities pulled back from highs reached in the first half of the year due to signs of economic strain, including fears of slowing consumer spending and the prospect of a sustained period of higher interest rates. The benchmark Russell 1000 Value Index receded 3.17%, roughly in line with the broader market.

Supply cuts from OPEC+ combined with lower U.S. inventories pushed oil prices higher, fueling further inflation and interest rate concerns. While this dynamic was positive for the energy sector, it led every other sector to generate negative returns in the quarter. The consumer discretionary sector was the worst performer, as consumer spending showed some cracks across retail and food services. We have been concerned about the economic impact as the massive fiscal stimulus delivered by the U.S. government during the height of COVID gradually lapses, and there are increasingly worrying signs of a pullback in spending, particularly among lower-income cohorts that have fully depleted their excess savings. Alongside the weakening consumer environment, the 10-year U.S. Treasury yield climbed from 3.9% to 4.6% in the quarter, which negatively impacted rate-sensitive sectors such as utilities and real estate.

The Strategy held up well in this environment, outperforming the Russell 1000 Value Index primarily due to stock picking in the communication services, health care, and industrials sectors. Long-term holdings Charter ( CHTR ) and Comcast ( CMCSA ) delivered strong second-quarter results relative to expectations; their stable recurring revenue streams and undemanding valuations were rewarded in the current environment. Cable multiples compressed over the past 24 months on fears of heightened competition in their core broadband business from fixed wireless and fiber providers. While fiber remains a competitive alternative to cable broadband over the long term, high upfront investments and a materially higher cost of capital are resulting in slower buildouts than previously expected. Fixed wireless also continues to gain traction, particularly in rural markets, but share gains also appear to be moderating. At the same time, both Comcast and Charter are expanding their footprints into rural and adjacent markets while gaining wireless market share, leveraging their mobile virtual network operator agreements with Verizon. We think both cable companies are well-positioned to continue to grow while generating substantial free cash flows. We added to Comcast during the quarter.

Our healthcare positioning also fared well, led by managed care company UnitedHealth Group ( UNH ), which beat expectations and raised full-year guidance, supporting our thesis that it can successfully navigate the recent uptick in utilization among its Medicare patients. We continue to maintain an overweight position to managed care companies via long-term holdings in UnitedHealth and Elevance Health ( ELV ), as we believe the short cycle nature of their insurance franchises allows them to reprice their book of business in a relatively short time frame, even if health care costs come in higher than previously anticipated.

We took some money off the table in the areas that benefited from 2023's AI-related rally."

The healthcare space provided some opportunities in the quarter, as we increased our exposure to the medical device company Becton, Dickinson ( BDX ). The company recently received FDA approval for its Alaris infusion pump, which should accelerate revenue growth regardless of economic conditions. Though only a marginal contributor for the quarter, our other recent portfolio addition McKesson continues to execute well, leveraging its strong competitive position, rising usage of specialty pharmaceuticals, and rational industry structure to continue to deliver strong profitable growth.

At the same time, we took some money off the table in the areas that benefited from 2023's AI-related rally, including data center infrastructure company Vertiv ( VRT ) in the industrials sector, and social media platform Meta Platforms ( META ) in the communication services sector. Both stocks have performed exceptionally well and were meaningful contributors to performance.

A higher-for-longer rate mentality taking hold was a headwind for economically sensitive stocks. Rising wages have been one of the main drivers of inflation, and this has proved to be a sticky area, keeping the Fed's attention and weighing on share prices. For example, United Parcel Service ( UPS ) renegotiated a wage increase for its union-backed workforce this summer, which weighed on margins that were already being constricted by slowing volumes. While the new union deal will dampen profits over the next 12 months due to the front-end-loaded nature of the new five-year contract, management gained increased flexibility to deploy automation, which we think should further enhance UPS's strong competitive position and provide a long-term tailwind to profitability.

The current labor negotiations between the United Auto Workers and Detroit's big three auto manufacturers likewise put pressure on OEMs and the auto supply chain broadly. Our long-term holding TE Connectivity ( TEL ) generates about half of its revenue by selling highly differentiated connectors to the automotive and off-road transportation industries. While it is not immune to potentially lower production volumes as a result of the strike, we believe the company is fairly insulated due to the higher per-vehicle content of EVs, which are growing at the expense of legacy ICE vehicles. We trimmed our position given the cyclical nature of the business. We continue to like TE Connectivity's strong position with customers and its opportunities for content growth in automotive and data center customers over the next few years, and it remains a sizable active bet.

Other detractors included American Express ( AXP ), which fell on concerns over slower consumer spending and rising charge-offs, as well as wireless tower REIT American Tower ( AMT ), which was pressured by the increase in rates along with the broader real estate sector. Our two utilities Sempra ( SRE ) and Edison International ( EIX ) were also negatively impacted by rising rates, although both outperformed the utility benchmark. We maintain a large active overweight to Sempra and added opportunistically to Edison to reflect its strong fundamentals.

We also added to our position in Intel ( INTC ) to take advantage of signs that it continues to make progress on its goal of regaining technology leadership. Intel appears to be executing its technology/product roadmap; the company is on track to ramp up PC and server products over the next 12 months on advanced manufacturing nodes that we believe will be more competitive with chief rival Advanced Micro Devices ( AMD ). We also see green shoots in the PC and server markets, with an increasing possibility of a cyclical recovery in both end markets in 2024.

Outlook

Higher interest rates, a growing fiscal deficit, weakening consumer spending, and rising geopolitical risks - these are just a few of the headwinds and uncertainties facing the market. While we never position the portfolio toward any given macroeconomic outcome, risk management is in our DNA and reflected in every decision we make at both the individual stock and portfolio levels. We believe risk mitigation is equally important to upside participation, and we manage the Strategy accordingly, regardless of the environment. We remain convinced that high-quality, high-return, cash-flow-generative businesses should outperform in most environments, and the strengths of these businesses should continue to shine, especially in more challenging times.

Portfolio Highlights

The ClearBridge Large Cap Value ESG Strategy outperformed its Russell 1000 Value Index benchmark during the third quarter. On an absolute basis, the Strategy had positive contributions from three of the 11 sectors in which it was invested for the quarter. The communication services sector made the strongest contribution, while the information technology ((IT)), financials, and materials sectors were the main detractors.

On a relative basis, overall stock selection contributed to performance. In particular, stock selection in the industrials, communication services, and health care sectors added to relative returns. An underweight to the consumer discretionary sector was also beneficial. Conversely, stock selection in energy, financials, and IT sectors and an underweight to energy detracted.

On an individual stock basis, the largest contributors were Vertiv, Charter, Eaton ( ETN ), Progressive ( PGR ), and Intel. Positions in American Express, TE Connectivity, TC Energy ( TRP ), United Parcel Service, and American Tower were the main detractors.

In addition to the portfolio activity noted above, during the quarter, we exited our position in Bank of New York Mellon ( BK ) in the financials sector.

ESG Highlights

The Company's Role as Steward of Biodiversity

The push to halt biodiversity loss is increasingly demanding attention alongside climate change as a major environmental concern for investors. As we explore elsewhere in a recent ClearBridge introduction and discussion of the topic, the term biodiversity, meaning the variety of life on the planet or in a given ecosystem, is emerging as an umbrella concept for several related environmental concerns. These include issues tied to changes in land usage (such as deforestation), natural resource overexploitation, pollution, and the effects of climate change.

On the international stage, in an agreement recalling the 2015 Paris Agreement, attendees of the 2022 United Nations Biodiversity Conference adopted the Kunming-Montreal Global Biodiversity Framework ((GBF)), a plan for member countries to take urgent action to halt and reverse biodiversity loss and to conserve and sustainably use biodiversity.

As a result, regulation is stepping up. In May, an EU regulation on deforestation-free supply chains, for example, began requiring companies to confirm imported products have not been produced on land subject to deforestation or forest degradation, with fines of at least 4% of the company's annual income in the EU at stake.

Improving biodiversity is already an economic concern for many companies."

In September, the Taskforce on Nature-Related Financial Disclosures (TNFD), which was launched in 2021, published recommendations on the types of biodiversity disclosures companies can and should be making. These generally involve companies disclosing how their businesses both impact and depend on nature, what related material risks and opportunities they are assessing, and what metrics and targets they are using to measure and improve. As the TNFD points out, "Present and future cash flows depend on the flow of nature's inputs to business, and accelerating nature loss poses a growing risk to businesses and capital providers."

The materiality of biodiversity issues for public equities helps explain why ClearBridge has, over 35+ years of our ESG integration approach, assessed evolving nature-related dependencies, impacts, risks, and opportunities with holdings across sectors. To support our fundamental research and steer capital in a nature-positive way, ClearBridge encourages, among other things, assessment and disclosure of nature-related impacts and dependencies within the value chain, development of biodiversity and deforestation policies, responsible waste and water management, transparency into lending practices, and consideration of local affected communities.

Nature-positive revenue opportunities tend to be tied to companies with products that either substitute for a high-impact product (ClearBridge holding Ball's aluminum containers reduce the need for mining ore and extracting oil and are a substitute for single-use plastic, a major polluter) or reduce impact (ClearBridge holding Deere's precision agriculture technologies limit pollution in the form of chemical pesticides and herbicides). Both types are found across ClearBridge portfolios, as well as companies providing key financing for nature-positive solutions.

Reducing Impact: Untroubling Waters

Water looms large as a high-impact natural resource, both in its use in business and its importance to virtually every ecosystem. Of companies disclosing on water via CDP, formerly the Carbon Disclosure Project, that are exposed to substantive impacts on their business from water, most anticipate that water issues could limit the growth of their business through reducing/disrupting production capacity, closure of operations or constraints to growth (Exhibit 1).

Exhibit 1: Potential Impacts of Water Risk in Direct Operations and Supply Chain

Source: High and Dry: How Water Issues Are Stranding Assets, A report commissioned by the Swiss Federal Office for the Environment (FOEN). May 2022.

Long-time ClearBridge holding Ecolab stands out as a responsible steward of water resources and a company able to reduce the impact of the use of water across the economy. Ecolab offers water-saving solutions for laundries used by health care, hospitality, and food and beverage industries. Products and services include industrial water pre-treatment systems, industrial water reuse, water-efficient conveyor lubrication systems, and wastewater treatment. For a major hotel chain, Ecolab's chemical product delivery service replaces single-use drums of cleaning chemicals, reducing waste and improving work safety, while its ware washing and housekeeping solutions reduce wash time, water usage, and water temperature for food prep wares as well as plastic packaging used in housekeeping services. Ecolab estimates 57 million gallons of water savings as well as 1,400 metric tons of GHG emissions annually for the hotel chain as a result.

Ecolab has committed to helping its customers conserve 300 billion gallons of water a year, equivalent to the annual drinking water needs of 1 billion people by 2030, through reducing water withdrawal needs in customers' operations. Separately, Ecolab also has a target to restore >50% of its absolute water withdrawal at high-risk sites through collaboration with NGOs and local communities. Ecolab is also a co-founder of the Water Resilience Coalition, a CEO-led movement and part of the United Nations Global Compact aiming to preserve the world's freshwater resources through action in water-stressed basins.

Reducing Impact: Sustainable Forestry

There are also benefits for companies that recognize and mitigate deforestation risks (Exhibit 2). Broadly, these may include, increased brand value, demand for certified or deforestation-free materials, availability of products with reduced environmental impact, supply chain transparency, and resilience. ¹

Exhibit 2: Potential Financial Impact of Reported Forest-Related Opportunities (Billions)

Source: "The Forest Transition: From Risk to Resilience," Global Forests Report 2023, CDP. July 2023. Shows forest-related opportunities identified by 231 companies reporting. Markets include increased demand for certified materials or products with reduced environmental impact; resilience includes greater supply chain resilience and climate change adaptation; products and services includes increased brand value and R&D and innovation opportunities; efficiency includes increased efficiency of manufacturing and distribution processes and cost savings; financial incentives include issuing green bonds and earning a price premium for deforestation-free materials.

Home Depot ( HD ) has long been a leader in advancing sustainable forestry, and its wood products can have a significant impact, as timber rates are at the top of high-risk commodities responsible for most agriculture-related deforestation (Exhibit 3). The home improvement retailer adopted its first wood purchasing policy in 1999, pledging to give preference to sustainably sourced wood and to eliminate wood purchases from endangered regions around the world.

Biodiversity-boosting efforts at Home Depot have included tracing the origin of all the wood products it sells. This forms part of the process of verifying sustainable production, which it does using the certification standards of the Forest Stewardship Council (FSC). Since 2000 Home Depot has developed programs to purchase FSC wood products, such as doors, boards, and patio furniture, from over 60 global suppliers. It has also moved more than 90% of its cedar purchases to second- and third-growth forests, with the rest coming from areas with local community stakeholder review.

Exhibit 3: High-Risk Commodities for Agriculture-Related Deforestation

Source: "The Forest Transition: From Risk to Resilience," Global Forests Report 2023, CDP. July 2023. Of 810 companies disclosing at least one of the seven high-risk commodities, equaling 1,375 commodity-level disclosures.

Suppliers preferred by Home Depot such as Mendocino Redwood Company also help maintain sustainable forests through building forests' wildfire resilience. For example, Mendocino practices fuel reduction by removing excess burnable materials that help wildfires stay closer to the ground where they can be more safely controlled by firefighters before they reach the forest canopy.

Substituting Impact: Preventing Deforestation

ClearBridge holding Trex ( TREX ) has redefined the decking industry with a business model that addresses two key drivers of biodiversity loss, deforestation, and pollution, by substituting high-impact products. Instead of relying on virgin wood, Trex makes composite decking for residential and commercial customers using 95% recycled wood fibers and plastic waste. In 2022, Trex recycled 337 million pounds of waste polyethylene, a plastic commonly used for plastic bags and bottles, as it produced its high-end decking. Wood decks stopped using arsenic treatments in 2004, which has shortened their life span, dramatically increasing the number of decks that need to be replaced. Trex's products help fill this need in a way that preserves forests, reduces a major source of pollution in oceans, and lowers customers' total costs of ownership since Trex's decks have much longer lifespans relative to natural lumber decks.

Financing Biodiversity

In addition to business models that support biodiversity, it is also important to provide financing for efforts to improve biodiversity. Large financial firms such as ClearBridge holding JPMorgan Chase ( JPM ) have a key role here through green bond underwritings that support natural capital protection. In 2021 JPM announced a target to finance and facilitate $1 trillion toward green initiatives by 2030 as part of its broader $2.5 billion sustainable development target. The green initiatives include biodiversity-linked areas such as water management, circular economy, and waste management, in addition to conservation and biodiversity, which focuses on improving terrestrial and aquatic biodiversity ecosystems or forests.

As part of this target, in 2022 JPM served as the lead underwriter for a $350 million green bond issued by The Nature Conservancy, the largest green bond issuance by a conservation nonprofit ever. The issuance is expected to help The Nature Conservancy avoid or sequester 3 billion metric tons of carbon dioxide equivalent (CO2e) and conserve 650 million hectares of healthy land, 30 million hectares of freshwater, and 4 billion hectares of oceans.

Nature-Based Carbon Credits: Early Stages

JPM also highlights the value of nature-based carbon credits: these are credits a company can purchase to fund nature-based solutions to climate change to help offset its own emissions. For JPM, in addition to sourcing renewable energy to reduce its carbon footprint, it also purchases high-quality nature-based carbon credits that help restore the natural world, helping to offset the remainder of its emissions. One purchase in 2022 was from the Indus Delta Blue Carbon Project in southeastern Pakistan, one of the largest mangrove forest restoration projects in the world. Mangroves are among the world's most diverse and vulnerable ecosystems and are effective carbon sinks; in this case, they are also important habitats for endangered and threatened species and serve as a protective barrier, mitigating potential damage from hurricanes and tsunamis.

Conclusion

Improving biodiversity is already an economic concern for many companies. While developing standardized measurements of biodiversity remains an industry challenge, international agreements are spurring policy action, and the materiality of biodiversity for companies is poised to increase. As it does, ClearBridge will continue to analyze and engage companies on nature-related risks and opportunities, seeking to build more resilient businesses in a more resilient world.

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 "The Forest Transition: From Risk to Resilience," Global Forests Report 2023, CDP. July 2023. Page 36.

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