ASMLF - ClearBridge Large Cap Value Strategy Q1 2023 Portfolio Manager Commentary

2023-04-22 03:30:00 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.
• The Strategy’s bias toward larger banks with strong and diverse deposit bases provided a measure of defense during the bank selloff, with our financials holdings performing well on a relative basis.
• The selloff in the health care space provided an opportunity to add to our position in a medical device company and initiate a new position in a company distributing pharmaceuticals to retail drug stores, physicians’ offices and hospitals.
• Recent net-zero engagements across ClearBridge help us get under the hood with company-specific nuances to setting or meeting science-based emissions reduction targets and highlight the value of lesser-known enablers of the energy transition.

By Robert Feitler & Dmitry Khaykin

Market Overview

U.S. equities rose in the first quarter, driven by hopes the Fed is nearing the end of its hiking cycle and by optimism for a soft landing later in 2023. The prospect of a dovish pivot from the Fed helped longer-duration technology stocks outperform and made for a strong quarter for growth stocks, with the Russell 1000 Value Index’s 1.01% return far behind its growth counterpart’s 14.37% gain — a near mirror reversal from the previous quarter.

In March, markets focused on the U.S. banking system after significant market losses in Silicon Valley Bank’s securities portfolio spurred a run on the bank’s deposits and resulted in the second-largest bank failure in U.S. history. This sparked a crisis of confidence across small and midsize regional banks, as consumers shifted their deposits to larger banks perceived to be more stable. Although contagion concerns had eased by the end of the month, the crisis intensified concern over the probability and severity of a recession as banks are likely to tighten lending standards.

The Strategy’s lack of exposure to less diversified banks with more concentrated deposit bases acted defensively during the bank selloff, with our financials holdings performing well on a relative basis versus the benchmark. Our concerns over financials with asset/liability mismatches and those making very long-duration bets led us to reduce our bank exposure in 2022 for example, with trims to Charles Schwab ( SCHW ). We trimmed Schwab further in the quarter due to the potential for more regulatory scrutiny and heightened risk of “cash sorting” as customers shift low-yielding deposits into higher-yielding options such as money market funds and U.S. Treasurys. While this impacts the company’s earnings in the near term, roughly 80% of its deposits are FDIC insured and we believe the vast majority of the deposits are likely to stay inside of the Schwab ecosystem where the company can still collect fee and spread income over time.

Our quality bias has always led us to gravitate toward banks with strong and diverse deposit bases; those we own tend to be the larger players, which we also expect to be the biggest beneficiaries from a flight to safety in terms of deposits. JPMorgan Chase ( JPM ) comes to mind especially here, but so does Bank of America ( BAC ) despite its weakness in March, as well as U.S. Bancorp ( USB ), to which we added opportunistically in the quarter.

"The Strategy’s lack of exposure to less diversified banks with more concentrated deposit bases acted defensively during the bank selloff."

Other financial holdings were among the top contributors, such as American Express ( AXP ), whose business is less sensitive to changes in the yield curve than most financials. Progressive ( PGR ), which has minimal interest rate mismatch exposure, continues to demonstrate superior underwriting practices with consistent share gains in the personal auto insurance market while maintaining strong profitability. The company pioneered the use of in-vehicle telematics, providing it with a substantial amount of differentiated user data that it uses to reward better drivers while also reducing its risk of losses. These data-driven insights enabled Progressive to lead the industry in raising prices to offset higher losses. Subsequently, as competitors have been forced to sharply raise prices in order to restore profitability, customers have shopped for better rates and Progressive has been able to accelerate its market share gains. The company has a conservative investment portfolio, which we believe is likely to prove defensive in a softer macro environment.

The standout contributor for the quarter, meanwhile, was Meta Platforms ( META ), which we bought in the fourth quarter of 2022. We still feel good about Meta shares after the rally, with positive drivers that we found attractive in late 2022 — large scale advantages in driving user engagement, the ability to invest in tools to monetize its audience, cost discipline and a strong balance sheet — still in play. While Alphabet ( GOOG , GOOGL ) was another positive contributor in the quarter, we trimmed the position given the launch of Microsoft’s ( MSFT ) new generative AI product (“Bing AI”) which is targeted directly at Alphabet’s core search business. While we believe Alphabet’s business model is likely to remain resilient given the breadth of its user data as well as its internal innovations around AI, we continue to monitor the area closely given the rapid adoption of ChatGPT and other generative AI products.

Elsewhere in the market rotation to tech, a broad recovery in cyclicals such as industrials and the semiconductor supply chain helped long-time holding TE Connectivity ( TEL ). While automotive sales are likely to be pressured as higher financing costs reduce the affordability of new vehicles, we believe TE Connectivity is positioned to benefit from secular trends around automotive electrification and remain believers in the company’s strong competitive position.

The tech-dominated quarter was a headwind for both defensive and cyclical sectors, with shares of health care holdings such as UnitedHealth Group ( UNH ) and Elevance ( ELV ) declining after a strong 2022. The selloff in the health care space provided an opportunity to add to our position in medical device company Becton Dickinson ( BDX ). We believe the company maintains a strong position at hospital customers, where it is able to drive pricing given its differentiated consumable offerings and regulatory hurdles to replace existing solutions. While the company has struggled procuring components due to COVID-induced supply chain challenges, easing constraints should lead to revenue growth in the coming quarters combined with margin expansion as the company focuses on better integrating previous acquisitions, improving operations and reducing product SKUs.

We also initiated a new position in McKesson ( MCK ), the leading distributor of pharmaceuticals to retail drug stores, physicians’ offices and hospitals in the U.S. McKesson also has the largest specialty drug and oncology business in the U.S., which is the fastest-growing, highest-margin segment of drug distribution. A stable, cash-flow generative business, the company competes in a stable oligopoly with two other major distributors and, in addition to drug distribution, it is a significant provider of technology and transaction processing to drug stores, commercialization services to drug manufacturers, and basic supplies to physician offices. We expect at least low double-digit earnings growth from a combination of operating earnings, accretive acquisitions and share repurchases.

Dish Network ( DISH ) was lower for more idiosyncratic reasons. The pay-TV provider, with unique potential to become a viable fourth wireless carrier, continues to face challenges executing its wireless buildout in a higher rate environment where a leveraged balance sheet is a liability. We believe there is still value to be captured for Dish, but it is clearly taking longer to realize, and we are monitoring the stock closely.

Outlook

The quarter’s market optimism notwithstanding, we remain guarded in our outlook given macro uncertainties, the Fed’s ongoing inflation fight and the real possibility of a hard landing. In this environment, it is doubly important to stick to our philosophy of disciplined valuation with a focus on high-quality businesses whose sustainable competitive advantages we believe will drive strong portfolio performance over time.

While consumer spending has remained resilient, the recent bank crisis is likely to drive even tighter financial conditions in the coming months. On the flip side, consumer balance sheets remain healthy and the prospect of elevated growth from China as it relaxes COVID-related lockdowns are likely to somewhat counterbalance tightening lending standards. These crosswinds are likely to make the Fed’s mission of fighting inflation more difficult as it introduces more variability into the optimal state of monetary policy, increasing the risk of policy mistakes.

"The selloff in the health care space provided an opportunity to add to quality companies at attractive prices."

From a portfolio perspective, we continue to focus on high-quality companies and look for opportunities to take advantage of dislocations, preferring businesses that would hold up well in a challenging environment. A potential recession in 2023 would not change this approach.

Portfolio Highlights

The ClearBridge Large Cap Value ESG Strategy outperformed its Russell 1000 Value Index benchmark during the first quarter.

On an absolute basis, the Strategy had gains in six of 11 sectors in which it was invested for the quarter, with the information technology ( IT ) and communication services sectors the most positive contributors. The financials and health care sectors were the main detractors.

On a relative basis, stock selection and sector allocation contributed positively. In particular, stock selection in the financials, utilities and industrials sectors, an overweight to the IT sector and underweights to the energy and health care sectors contributed to relative returns. Conversely, stock selection in the materials, health care and consumer discretionary sectors, and a financials overweight detracted.

On an individual stock basis, the largest contributors were Meta Platforms, TE Connectivity, Motorola Solutions ( MSI ), Eaton ( ETN ) and United Parcel Service. Positions in Charles Schwab, Bank of America, Dish Network, UnitedHealth Group and Elevance were the biggest detractors.

In addition to the transactions mentioned above, the Strategy exited its position in Apple in the IT sector.

ESG Highlights

ClearBridge Engagements Zero In on Net Zero

Climate change, and its associated investment opportunities and risks, remains a priority for ClearBridge, both in our active stock selection across portfolios and in our engagements with C-suite leaders of the companies we invest in. Our interest in the topic across sectors and portfolios coincides with growing interest in climate mitigation across the country: as of December 2022, 33 U.S. states had released a climate action plan or were in the process of revising or developing one, according to the Center for Climate and Energy Solutions.

In 2021 we joined the Net Zero Asset Managers (NZAM) initiative — a group of more than 300 asset managers with nearly $60 trillion in assets under management committed to getting the world to net-zero carbon emissions by 2050 — and we have designed our net-zero approach around high-touch engagement with portfolio companies on their decarbonization strategies.

We are making progress on our goal of assessing each portfolio company’s emissions trajectory and determining its alignment with the pathway required to achieve global net-zero emissions by 2050 (Exhibit 1). We are ahead of schedule in confirming the net-zero alignment of our initial in-scope assets (43% we deem to be net-zero aligned versus a goal of 39% as of December 2022), and are conducting either in-depth or exploratory engagements with unaligned portfolio companies across the firm.

Exhibit 1: Tracking Progress Toward Targets for In-Scope Assets

Recent net-zero engagements across ClearBridge portfolio companies reveal how company- and sector-specific conditions shape decarbonization efforts, help us get under the hood with challenges to setting and meeting science-based emissions reduction targets and highlight the value of lesser-known enablers of the energy transition.

Semiconductor Growth Sets High Bar for Renewable Energy Capacity

ASML makes semiconductor manufacturing equipment and is a leading supplier of lithography systems to the semiconductor industry. It has set science-based targets to achieve net-zero Scope 1 (direct from sources controlled or owned by a company) and Scope 2 (indirect, through the purchase of power, heat, cooling, etc.) emissions by 2025, and zero emissions in the supply chain or Scope 3, by 2030. We consider ASML’s emissions reduction pathway to be net zero aligned.

While ASML seems on track to meet its net-zero goals, in January 2023 we met with its CEO to discuss, among other topics, potential hurdles it might encounter along the way. Among these might include ASML’s own success as it works to build a renewable energy grid for its Veldhoven headquarters in the Netherlands fast enough to keep up with its own growth. ASML is investing in solar and wind and working with energy generation companies to build its own renewable energy capacity in order to support its fast-growing production capacity. The company also cited a goal of 75% reduction in gas use as another key lever in meeting its Scope 1 and 2 goals, which we find credible.

While ASML works to lower its own emissions, it is also enabling its customers to lower theirs. As a semiconductor capital equipment provider, ASML directly improves the energy efficiency of semiconductor chip manufacturing. Its extreme ultraviolet (EUV) lithography systems, which took ASML more than two decades to develop, enable semiconductor manufacturers to make chips that use less energy and/or have higher performance. More power-efficient chips have an emissions reduction multiplier effect down the semiconductor supply chain. ASML directly enables chip manufacturers serving rapidly growing data center and AI businesses, as well as auto and industrial markets, and even smart phones to make more powerful chips using less energy.

Navigating Spotty EV Penetration

Casey’s General Stores ( CASY ) is one of the largest gas station and convenience store owners and operators in the U.S., with over 2,400 stores predominately in the Midwest. Most of Casey’s sales and profits come from the sale of gasoline, prepared foods (pizza, sandwiches and breakfast items) and grocery and other convenience items. Its stores are well-located and have significant brand recognition. Casey’s tends to have dominant market share in the states and the markets in which it operates. As such, its business is stable and cash generative. Also, its small market presence gives Casey’s pricing power and provides for a wide moat against would-be competitors.

One of the risks to Casey’s is the slow but accelerating shift from internal combustion engine cars to electric vehicles (EVs). This will slowly eat into the company’s sales of gasoline and some traffic into the stores. We have encouraged Casey’s to be a leader in the rollout of EV charging stations at its stores. To this end, currently Casey’s has installed EV charging stations at 29 of its 2,400+ gas station and convenience stores. Management has shared with us that the stores with EV chargers average roughly 390 fuel transactions per day but average only 12 EV charges per day. That equates to a 3% penetration rate for EV demand. That data may actually overstate demand somewhat because the stores with the EV charging stations were handpicked by their charging station vendor/partner as being the stores most likely to see charging demand. EV adoption across the U.S. remains concentrated in mostly coastal states (Exhibit 2); across Casey’s entire 16-state portfolio, we think EV charging demand is roughly 0.6%. We, and the company, recognize that EV acceptance is lower in Casey’s market than in other more urban and coastal markets.

Exhibit 2: EV Penetration Across the U.S. Is Uneven

Casey’s remains committed to offering EV charging as a service, just as it offers gasoline today, but will do so at a rate that more closely aligns with the rate of EV acceptance and demand for EV charging. As EV penetration continues to rise, Casey’s will install more charging stations. We also believe that the level of service and range of goods and prepared foods offered inside Casey’s stores will make Casey’s an attractive place to pass the time required to recharge electric vehicles.

Capital-Intensive Industries Going Digital

Part of our net-zero strategy entails recognizing climate solution enablers such as Aspen Technology ( AZPN ), a pure-play industrial software leader supporting complex operations across a wide range of industry verticals, including operations, maintenance and asset optimization. The company has limited carbon emissions itself, and our engagements with it focus on how it is benefiting from the growth in renewables and sustainability investments as Aspen helps the digitalization of capital-intensive industries. Broadly, Aspen’s products help organizations streamline engineering and maintenance processes to reduce downtime and increase operational efficiency, in part helping industry to limit emissions and pollution.

Recent engagements with the company’s CEO and CFO have focused on markets opened up by Aspen’s recent transaction with Emerson Electric ( EMR ) to acquire Emerson’s Open Systems International ((OSI)) and Subsurface Science and Engineering ((SSE)) businesses in exchange for a majority share in the combined company. OSI helps global electrification through digitalizing and optimizing transmission and distribution systems for utility companies in the power industry. In particular OSI supports smart grid initiatives, processing and analyzing millions of data points in real time from all levels of the electrical power supply chain, helping to manage the complexity of integrating renewable energy into the grid.

Aspens’ SSE business supports efficiency in the oil and gas industries and aids the development of carbon sequestration, geothermal and hydro energy.

Sustainability investments and decarbonization spending across the product suite should act as strong growth drivers for Aspen. Its technologies are also being used by Google and Meta to model emissions and heat flows at data centers, and Tesla and Rivian are now customers on battery energy flow modeling. Biofuel and hydrogen investments are expected to be modeling intensive, too, providing Aspen several avenues to deliver for shareholders and help decarbonize the operations of equities across many sectors.

Climate Initiatives Raise Awareness and Improve Disclosures

ClearBridge’s involvement with several climate initiatives — such as the Task-Force for Climate-related Financial Disclosures (TCFD), which develops consistent metrics for companies to use in disclosing financial risks associated with climate change; Climate Action 100+, an investor-led initiative to engage high emitters on lowering emissions and better disclosure; and the CDP, or Carbon Disclosure Project, which collects climate and water data from companies worldwide — further supports more acute awareness of climate risk and attests to our commitment to moving the energy transition forward.

In the interest of transparency, we provide more information on our climate-focused investing in our 2022 Climate Report and outline our approach to meeting our NZAM commitment, both on our website and via the Principles for Responsible Investment .

Robert Feitler, Managing Director, Portfolio Manager

Dmitry Khaykin, Managing Director, Portfolio Manager

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