BKNG - ClearBridge Large Cap Value Strategy Q3 2022 Portfolio Manager Commentary

Summary

• Markets beginning to price in a reasonable chance of recession, both domestically and abroad, led to dramatic moves across various often uncorrelated asset classes, with wide ranging implications across global economies.
• The Strategy held up well relative to the Russell 1000 Value Index, led by holdings in the energy and materials sectors, which benefited from natural gas exposure as well as the falling price of raw materials.
• Overall, for the past year, we have taken steps to reduce cyclicality in the portfolio, while emphasizing characteristics such as differentiated business models and strong execution that we believe help position the portfolio for more volatile market conditions.

By Robert Feitler | Dmitry Khaykin

Fear Unfairly Punishes Quality Stocks

Market Overview

Global economies continued to face multiple headwinds in the third quarter led by a combination of stubbornly high inflation, rising geopolitical uncertainty and lingering supply chain and policy impacts from the COVID-19 pandemic. In the U.S., the Fed’s attempt to constrain inflation led to two more 75 basis point rate hikes in the quarter, following the one in June, with an indication that more hikes are likely in coming quarters.

At the same time, Russia’s invasion of Ukraine has helped create a spiraling energy crisis in Europe as some of its natural gas supplies have been cut off heading into the winter. Finally, China has experienced slowing growth as the country continues to enact strict measures to reduce the spread of COVID-19 among the country’s older, more immunocompromised communities.

Consequently, markets have begun pricing in a reasonable chance of recession, both domestically and abroad. A nearly 5% selloff in the S&P 500 Index was accompanied by commodities rolling over as well, with oil declining about 25% and copper down about 8%. Higher U.S. interest rates and the relative safe haven status of the U.S. dollar have led to the dollar’s appreciation of ˜17% against major currencies year to date (per the WSJ Dollar Index) and its reaching parity versus the euro for the first time in 20 years.

Long-term bond yields rose sharply as bonds sold off; the 10-year U.S. Treasury yield jumped 82 basis points in the third quarter, breaching 4.00% at one point and ending September at 3.83%. These are dramatic moves across various often uncorrelated asset classes with wide-ranging implications across global economies.

"We have positioned the portfolio to take advantage of the current commodity environment."

While growth stocks lagged in the beginning of the year as high-flying technology stocks de-rated, in the third quarter it was value’s turn to lag, with the Russell 1000 Value Index falling -5.62%, about 200 basis points below the Russell 1000 Growth Index. Value’s year-to-date and one-year edge on growth stocks, though, remains substantial.

In this environment, the Strategy held up well relative to the benchmark Russell 1000 Value Index. Positive contributors were led by our holdings in the energy and materials sectors, where we have positioned the portfolio to take advantage of the current commodity environment.

ConocoPhillips ( COP ) handily outperformed the energy sector, which led the value benchmark. Its exposure to natural gas helped the stock perform more in line with natural gas E&Ps, which led the sector due to the European energy crisis and U.S. shale gas being considered a secure long-term source of liquid natural gas. In addition to COP’s low-cost resource base, conservative balance sheet and experienced management team, we appreciate its strong focus on ESG measures, which we believe is a good indicator of the quality of a company’s business model and management team.

Specifically, we appreciate solid governance practices with compensation metrics emphasizing ROCE and relative total shareholder return, the board’s effective oversight of management as well as the company’s methane flaring leadership. COP is investing in field electrification and carbon capture across its portfolio, with ambitions to deliver oil production with a CO2 intensity of sub-5 kg/BOE, which would be one of the lowest emission sources of supply in the world.

Our materials holdings, which tend to have commodities as inputs, were a slight drag on performance earlier in the year as prices for commodities soared; this focus made them strong contributors in the third quarter as commodity prices softened. Within the sector, we are positioned away from pure commodity plays and toward value-added, differentiated businesses such as Martin Marietta Materials ( MLM ), a leading producer of aggregates for construction and road paving that is well-positioned to benefit from robust infrastructure investments.

An oligopolistic industry structure enables MLM and its peers to demonstrate strong pricing power through the cycle.

Within communication services, cable and satellite companies were detractors during the quarter, as they have weighed on performance year to date, despite the industry’s relative fundamental stability. Companies like Charter ( CHTR ) and Comcast ( CMCSA ) were major beneficiaries during the pandemic from the shift to work-from-home and enjoyed a massive pull-forward in demand for broadband access.

Coming off this high, a material slowdown in broadband subscriber growth starting in the second half of 2021 and aggressive fixed wireless competition from T-Mobile ( TMUS ) and Verizon ( VZ ) have led to a derating in cable stocks. Broadly, companies with higher leverage, even if well supported by stable and recurring cash flows, are being penalized as the Fed raises rates and reduces liquidity, with Charter ( CHTR ) being a prime example.

Also on the detractor side, Intel ( INTC ) delivered a disappointing revenue miss and lowered full-year revenue and earnings guidance as COVID-19-driven demand for PCs abated (where Intel enjoys half its sales) and a delay in its flagship Sapphire Rapids CPU hurt its data center business. Despite these issues, we still believe Intel is an economically sensitive turnaround story with substantial upside.

There were a few green shoots in the quarter: Intel’s process technology roadmap is on track (which should allow it to catch up to Taiwan Semiconductor ( TSM ) in coming years) and the CHIPS and Science Act passed in August should provide billions of dollars to the company as it solidifies its position as the lone domestic provider of leading-edge semiconductor manufacturing.

Portfolio Positioning

As we have highlighted, over the past year we have taken steps to reduce cyclicality in the portfolio, while at the same time emphasizing characteristics that we believe help position the portfolio for more volatile market conditions.

On that basis, we exited online travel agency Booking Holdings ( BKNG ) in the quarter and trimmed our position in American Express ( AXP ) as both companies are exposed to weakening consumer spending trends. We also initiated a new position in Haleon ( HLN ), which has market leadership in several consumer health care brands (an area which we believe will be resilient in a challenging macroeconomic environment) and an attractive valuation given unique spinoff dynamics and a legal overhang related to legacy OTC products.

While we remain overweight the industrials sector, which is generally perceived to be more economically sensitive, much of that is driven by large positions in defense companies (which tend to be less economically sensitive) as well as franchises with unique competitive advantages.

For example, we believe that farm equipment manufacturer Deere ( DE ) continues to benefit from both a strong farm economy and product innovations that directly benefit farmers’ productivity while also reducing their environmental footprint. The company has also demonstrated excellent execution, highlighted by capturing market share and maintaining margins despite dealing with a labor strike and elevated supply chain costs.

We believe quality of management and quality of assets also distinguishes industrials holding United Parcel Service ( UPS ), which significantly outperformed competitor FedEx ( FDX ) in the quarter. While UPS is also economically sensitive to the consumer and macro environments, superior execution under CEO Carol Tome gives us greater confidence in the company, whose asset-light structure in its international business is reflected in its substantially higher margins versus FedEx. Given its lower fixed costs, UPS should be less impacted by a slowing economic environment.

Outlook

While we can’t predict macroeconomic conditions, we believe that a portfolio of high-quality, competitively advantaged companies should prove to be relatively resilient during difficult markets. Our long-standing focus on balance sheet strength should also benefit the portfolio, as rising interest rates and slowing economic growth stress weaker business models with excessive leverage.

We also continue to search for opportunities to deploy capital, as high-quality franchises are likely to be unfairly punished in periods of excessive fear. While macroeconomic challenges appear to be with us for the foreseeable future, we believe that periods like these have historically provided good opportunities for investors with a long-term focus, and we continue to believe our approach should allow us to weather these periods effectively.

Portfolio Highlights

The ClearBridge Large Cap Value Strategy outperformed its Russell 1000 Value Index benchmark during the third quarter. On an absolute basis, the Strategy had positive contributions from two of the 11 sectors in which it was invested for the quarter: the energy and consumer discretionary sectors. The communication services and information technology ((IT)) sectors were the main detractors.

On a relative basis, overall stock selection and sector allocation contributed positively to performance. In particular, stock selection in the materials, energy, industrials, utilities and IT sectors were positive for relative returns. Conversely, stock selection in the communication services sector detracted.

On an individual stock basis, the largest contributors were ConocoPhillips ( COP ), Deere, Charles Schwab ( SCHW ), Motorola Solutions ( MSI ) and Martin Marietta Materials ( MLM ). Positions in Charter Communications, Raytheon Technologies ( RTX ), Comcast, Intel and American Tower ( AMT ) were the main detractors.

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

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