VRT - ClearBridge Large Cap Value Strategy Q2 2023 Portfolio Manager Commentary

2023-07-14 04:59:00 ET

Summary

• 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.
• We were active during the quarter, opportunistically capitalizing on market dislocations, with activity focused on further upgrading quality and seeking companies with greater pricing power, higher returns and mispriced growth expectations.
• 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.

By Robert Feitler, Dmitry Khaykin

Upgrading Quality and Upside Potential

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 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 is 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, 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 downside, stock selection in the industrials sector was a headwind, with United Parcel Service ( UPS ) trading 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 ( SRE ), 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 out of 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 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 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 communication services, financials and IT sectors made the strongest contributions, while the utilities and real estate sectors were detractors.

On a relative basis, overall stock selection contributed to performance. In particular, stock selection in the materials, IT, health care, energy and communication services sectors added to relative returns. Conversely, stock selection in the industrials sectors detracted.

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

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.

Robert Feitler, Managing Director, Portfolio Manager

Dmitry Khaykin, Managing Director, Portfolio Manager

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