TSLA - ClearBridge Large Cap Value Strategy Q4 2023 Portfolio Manager Commentary

2024-01-19 22:20:00 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 ClearBridge Large Cap Value Strategy outperformed its benchmark Russell 1000 Value Index in the fourth quarter, capping a strong year overall for relative performance.
• U.S. equities made solid gains in the fourth quarter as falling inflation, a dovish pivot for the Federal Reserve and a still healthy job market raised hopes of an economic “soft landing” along with interest rate cuts in 2024.
• After being roiled during a regional bank crisis earlier in the year, financials benefited from the Fed’s pivot, which relieved pressure on deposit outflows, reduced unrealized losses of mortgage-backed securities and benefited companies exposed to credit risk.
• We continue to recycle capital out of areas that have done well over time and where fundamentals look to be at risk and redeploy it into areas where valuations have been reset or where fundamentals look to be improving.

By Dmitry Khaykin, Portfolio Manager | Deepon Nag, Portfolio Manager

Staying Active as Case for Value Stocks Strengthens

Market Overview

U.S. equities made solid gains in the fourth quarter of 2023 as falling inflation, a dovish pivot for the Federal Reserve and a still healthy job market raised hopes of an economic “soft landing” along with interest rate cuts in 2024. While the quarter began with indexes retreating amid worries of higher-for-longer interest rates and an imminent recession, stocks reversed halfway through November after a favorable headline inflation reading drove a risk-on mentality for market participants. The broad market S&P 500 Index finished the quarter up 11.69%, while the Russell 1000 Value Index advanced 9.50%.

Following the inflation print, the market rotated toward cyclical sectors that are more sensitive to interest rates and economic activity, along with stocks that were out of favor. Real estate, industrials and financials sectors rebounded as 10-year Treasury yields fell from over 5% in October to 3.8% to finish the quarter and expectations rose for three interest rate cuts in 2024. At the same time, oil prices dropped from $88 per barrel of WTI crude to $72 amid surging Russia exports, high U.S. production and slower growth from China, leaving energy the sole sector in the S&P 500 with a negative return.

Against this backdrop the ClearBridge Large Cap Value Strategy outperformed its benchmark Russell 1000 Value Index in the fourth quarter, capping a strong year overall for relative performance.

Solidly positive stock selection more than offset modestly negative sector allocation during the quarter, in particular in the IT and financials verticals. Our largest portfolio position, Intel, was a strong contributor as the company’s margins surprised to the upside, and it gave positive comments about its technology and product roadmap. The company should also benefit from a strong PC upgrade cycle over the next two years as Microsoft ( MSFT ) releases a new version of its Windows operating system with AI capabilities, while also ending support for its Windows 10 operating system. Ongoing geopolitical uncertainty supporting a U.S. domestic focus on semiconductor capabilities is also supportive for the stock, which remains attractively valued in our view.

Semiconductor capital equipment company Lam Research (LRCX) also advanced strongly in the quarter as the memory semiconductor capex cycle looks to be troughing, setting up for a period of growth. Memory pricing is improving, usually a good indicator, while data center and AI growth are also supporting fundamentals.

After being roiled during a regional bank crisis earlier in the year, financials benefited from the Fed’s dovish pivot in the fourth quarter. Ten-year Treasury yields fell, which relieved pressure on deposit outflows at Charles Schwab ( SCHW ) and reduced unrealized losses on Bank of America’s ( BAC ) portfolio of longer-duration mortgage-backed securities. The market’s more positive view of the economy’s ability to narrowly dodge a recession (“the soft landing” scenario) also benefited companies exposed to credit risk such as American Express ( AXP ) and U.S. Bancorp ( USB ).

Detractors were largely idiosyncratic, with Charter Communications ( CHTR ) reporting a softer quarter for broadband subscriptions and guiding to a slightly more negative fourth quarter. Cable peer Comcast ( CMCSA ) also trailed the market. As we have highlighted before, cable multiples have compressed on fears of heightened competition in their core broadband business from fixed wireless and fiber providers. While these competitors are making inroads, we believe that Comcast and Charter can continue to deliver modest growth as they expand their broadband footprints into rural and adjacent markets as well as gain market share in the wireless market. The companies continue to generate substantial free cash flow, and their stable recurring revenue streams and undemanding valuations look valuable in a potentially volatile 2024.

Energy holdings Chevron ( CVX ), ConocoPhillips ( COP ) and Enterprise Products Partners LP ( EPD ) were also detractors, mainly due to a sharp decline in oil prices in the quarter. Chevron particularly struggled due to additional cost overruns and delays in its Tengiz expansion in western Kazakhstan, while its $59 billion purchase of Hess also weighed on sentiment.

Portfolio Positioning

During the quarter, we continued executing our fundamentally based bottom-up investment process of identifying mispriced high-quality franchises operating in attractively structured end markets. We continue to recycle capital out of areas that have done well over time and where fundamentals look to be at risk and redeploy it into areas where valuations have been reset or where fundamentals look to be improving. With that in mind we exited Vertiv (VRT) as its valuation became full, and trimmed Meta Platforms ( META ) and Progressive ( PGR ) after strong reratings. Softer agricultural market fundamentals led us to trim Deere ( DE ), while slowing electric vehicle adoption and concerns around the affordability of new automotive purchases resulted in us paring back our TE Connectivity ( TEL ) position.

"Several deflationary forces that drove the zero-interest-rate environment of the past decade are reversing or coming to an end."

On the flip side, we were able to find several new attractive opportunities that we believe will offer superior returns over the next three to five years on a risk-adjusted basis. For example, within the health care space, we initiated positions in CVS Health ( CVS ) and Thermo Fisher Scientific ( TMO ).

CVS is one of the largest providers of health care benefits in the industry but it has struggled in recent years due to reimbursement pressures at its retail pharmacies and execution missteps in its Medicare Advantage business. However, we see some evidence of improvement on both fronts, as it recently announced a bold plan to stabilize margins in its pharmacy business as it moves to a “cost plus” model on scripts fulfilled. While the plan isn’t without risk, we would note that CVS’s largest competitor Walgreens has endorsed the approach and given the combined market share of the two companies (~40% of the U.S. pharmacy market), increased regulatory scrutiny around price transparency and continued shortage of pharmacists in the U.S., we believe plan sponsors will be amenable. Similarly, we see evidence that the company has improved the quality of its Medicare Advantage service, as demonstrated by improved “Star Ratings,” something we believe will be reflected in a growing margin profile of the business through 2025. Steady free cash flows also give CVS valuable defensive characteristics. We funded the purchase partially with trims to UnitedHealth Group ( UNH ) and Elevance Health ( ELV ), wishing to lower our managed care exposure while taking advantage of a valuation discrepancy and a hopefully derisked CVS investment profile.

Thermo Fischer Scientific is a well-run, high-quality health care tools business whose valuation became attractive due to a cyclical correction in its channel. It should also offer defensive characteristics with less economic sensitivity than many other businesses.

We also initiated a position in Veralto ( VLTO ), which was recently spun out of Danaher ( DHR ), a company somewhat similar to Thermo Fischer Scientific. Veralto operates in the industrials sector and is a leader in the stable and growing global water treatment and filtration markets. It also holds a strong position in packaging printing solutions that include traceability applications for food and beverage, consumer packaged goods and pharmaceutical products. Veralto trades at a reasonable valuation, in our view, and should enjoy mid-single-digit organic growth to be augmented by tuck-in acquisitions while also offering margin expansion opportunities.

Outlook

The equity market in 2023 was dominated by the “Magnificent Seven” stocks (Alphabet (GOOG) ( GOOGL ), Amazon.com ( AMZN ), Apple ( AAPL ), Meta Platforms ( META ), Microsoft ( MSFT ), Nvidia ( NVDA ) and Tesla ( TSLA )), which accounted for ~60% of the S&P 500’s return for the year. This allowed growth stocks to handily outperform value stocks for the year, after a period of underperformance in 2022. Going forward, we see several reasons that the historic outperformance of value could resume in the coming years. First, we would note that several of the deflationary forces that drove much of the zero-interest-rate environment of the past decade (particularly globalization and global austerity) are reversing or coming to an end. Second, growth stocks continue to be priced near record levels when compared to value stocks, which we view as unsustainable. Finally, we believe the outsize earnings growth experienced by the Magnificent Seven in 2023 (~35%) is unlikely to persist into 2024.

Going forward, the market appears to be anticipating a “soft landing” scenario, with the market action exiting the year resembling more of an early cycle, risk-on environment. However, we would caution that this is certainly not a foregone conclusion. In addition to being human tragedies of enormous scale, geopolitics of the Middle East conflict combined with a protracted war in Ukraine, now approaching its third year, are adding yet another layer of uncertainty.

In our experience it hasn’t been a fruitful or profitable endeavor to make a bet on an economic scenario (particularly given the market’s recent waffling on the topic). Instead, we continue to consistently execute our longer-term investment philosophy of identifying durable and defensible franchises operating in structurally sound industries and trading at discounts to their intrinsic values. We believe this balanced approach will provide attractive long-term returns combined with healthy downside risk management, regardless of the macroeconomic environment.

Portfolio Highlights

The ClearBridge Large Cap Value Strategy outperformed its Russell 1000 Value Index benchmark during the fourth 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 financials and IT sectors made the main positive contributions, while the energy sector was the main detractor.

On a relative basis, overall stock selection contributed to performance. In particular, stock selection in the IT, financials and energy sectors and an underweight to the consumer staples sector added to relative returns. Conversely, stock selection in the communication services and industrials sectors and a real estate underweight detracted.

On an individual stock basis, the largest contributors were Intel ( INTC ), American Express, Charles Schwab, JPMorgan Chase ( JPM ) and Bank of America. Positions in Chevron, Charter, ConocoPhillips, Becton Dickinson ( BDX ) and Air Products and Chemicals ( APD ) were the main detractors.

In addition to portfolio activity noted above, during the quarter we initiated a new position in WEC Energy Group ( WEC ) in the utilities sector.

Dmitry Khaykin, Portfolio Manager | Deepon Nag, 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.

Performance source: Internal. Benchmark source: Standard & Poor's.

Original Post

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

For further details see: