WSC - ClearBridge Select Strategy Q1 2023 Portfolio Manager Commentary

2023-04-21 05:30:00 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 outperformed in the first quarter as standout results from several disruptors offset the headwinds of a rotation into mega cap growth stocks.
• Recent results reflect the active repositioning we executed in 2022 to prepare for a higher interest rate environment with elevated volatility. These moves have improved the balance of the portfolio, enabling consistency through both growth and value led markets.
• After focusing on risk management through a turbulent 2022, we have returned to an offensive stance in the alternatives side of the portfolio and have established several new option positions to gain equity exposure.

By Aram Green

Market Overview

Optimism about a soft landing to start the year followed by a March banking crisis spurred a rotation into mega cap equities in the first quarter, obscuring weakness down the market cap scale due to further monetary tightening by the Federal Reserve. The S&P 500 Index ( SP500 ) rose 7.50%, the benchmark Russell 3000 Index advanced 7.18% while the small cap Russell 2000 Index gained 2.74% as investors gravitated to larger companies deemed more resilient as the removal of liquidity accelerated. Growth stocks dominated performance, with the Russell 3000 Growth Index surging 13.85%, reversing the leadership trend of the last year and outperforming the Russell 3000 Value Index by nearly 1,300 basis points.

Reminiscent of the FAANG period of market leadership in recent years, performance was concentrated in a handful of the largest growth stocks in the benchmark. For example, Apple ( AAPL ), Microsoft ( MSFT ) and Nvidia ( NVDA ) were responsible for more than 40% of its total return (3.14%). Adding the contributions of Tesla ( TSLA ), Amazon.com ( AMZN ), Alphabet ( GOOG , GOOGL ) and Meta Platforms ( META ), that total rises to over 70% (5.17%). Meanwhile, a tighter financing environment created by the Fed’s aggressive rate hike campaign, and exacerbated by the failures of Silicon Valley Bank and Signature Bank, hurt small cap companies (Exhibit 1).

Exhibit 1: Mega Caps Dominated First Quarter Performance

This environment proved challenging for the ClearBridge Select Strategy, which generally targets companies in a lower market cap range. However, several of our disruptors behaved like the FAANGs during the quarter, drawing investor interest due to their growth visibility and profitable business models. Long-time holdings MercadoLibre ( MELI ), HubSpot ( HUBS ) and Fortinet ( FTNT ) were all up strongly, and graphics chipmaker Nvidia saw its share price nearly double in the quarter. Already the leader in the market for chips to power advanced computing, the positive sentiment around generative AI further highlighted Nvidia’s opportunities among data center and hyperscale cloud providers reliant on the company’s GPUs to empower digital transformation and new AI applications. Taken together, these contributions enabled the Strategy to outperform for the quarter.

The strong showing for disruptors was offset by weakness in some of the Strategy’s energy, financials and real estate holdings. Nothing fundamentally changed for exploration and production companies Pioneer Natural Resources ( PXD ) and Chesapeake Energy ( CHK ), cell phone tower operator SBA Communications ( SBAC ) and annuity provider American Equity Investment Life ( AEL ). After being strong performers in a more value-driven environment that characterized most of the last year, they were simply caught up in the rotation out of cyclical and interest-rate sensitive areas of the market.

Portfolio Positioning

We believe recent results reflect the active repositioning we executed in 2022 to prepare for a higher interest rate environment with elevated volatility. These efforts were meant to improve the balance of the portfolio through the sale of several cash flow negative companies leaning into investment and that catered to consumer end markets. Better balance has led to better relative performance, enabling the Strategy to outperform the benchmark over the last three quarters.

New additions during the quarter included Kering ( PPRUF ), a luxury goods conglomerate best known for its Gucci brand. Gucci, which represents the majority of the business, has struggled over the last couple of years as the fashion has gone out of favor. Kering’s founder and controlling shareholder has made several key changes in the organization, bringing in and elevating new talent that we believe will produce better results into 2024. The company is one of those evolving opportunities where we do not see a lot of downside, as the stock is trading at a substantial discount to peers like LVMHF , but which could see substantial upside should management execute and improve results.

The shift to renewable energy is a secular growth trend where we increased exposure with the addition of two solar energy companies, Nextracker ( NXT ) and the repurchase of SolarEdge Technologies ( SEDG ). Nextracker was the first IPO we have participated in for some time. The company, which was spun out of contract manufacturer Flextronics, produces solar tracker and control systems for utility scale solar fields and is already profitable. We believe the company is well-positioned to take a market share lead with the increasing adoption of large-scale solar projects, as well as pent up demand after supply chain issues in China. We gained shares of SolarEdge by exercising options we established in 2022. The stock was trading at a discount to peers and features very attractive margins, good cash flow growth and easing costs as supply chains normalize.

We also added to HealthEquity ( HQY ), a position we established late last year. The company is the market share leader in providing health savings accounts, commuter benefits and other employee directed savings accounts. We see a number of tailwinds to those businesses in a higher interest rate environment, such as earning more money in investing their float. Health Equity has also made several acquisitions over the last couple of years that they're integrating, including commuter benefits provider WageWorks, that should produce synergies both on the sales and cost sides.

After focusing on risk management through a turbulent 2022, we have returned to an offensive stance in the alternatives side of the portfolio and have been more active in establishing several new option positions. Some are meant to gain outright exposure to companies that had sold off and had not been participating in the rally such as call options on Palo Alto Networks ( PANW ) and Goldman Sachs ( GS ). Others were to take off some exposure or hedge positions that had grown with a valuation we thought was starting to get stretched, such as Nvidia and ON Semiconductor ( ON ). We also bought a new convertible position in concert promoter and Ticketmaster owner Live Nation ( LYV ), which is a company that we've known very well for some time. The common stock has come under pressure due to regulatory concerns, and we viewed the convertibles as an attractive way to gain equity-like exposure to the upside while providing a measure of protection to the downside. We also purchased common stock in Live Nation when the price fell to a more attractive level.

While the Strategy did not own SIVB or Signature Bank ( SBNY ), we did have exposure to First Republic Bank ( FRC ), a lender that was caught up in the bank crisis due to a high level of uninsured deposits. Focused on providing best-in-class service to high-net-worth clientele, FRC had a strong loan portfolio with a history of minimal credit write-offs but fell victim to the deposit flight to larger, more regulated banks. We quickly exited the position as contagion fears increased.

Outlook

While we do our analysis from the bottom up, four emerging themes permeate our portfolio and are guiding current positioning and future investment opportunities. The first is data and analytics, where we see a lot of growth runway in companies like data warehouse operator Snowflake ( SNOW ), Nvidia, workflow software maker ServiceNow ( NOW ) and marketing automation software developer HubSpot. The second theme is onshoring or reshoring, where we are targeting the potential for new domestic production and development. This includes companies like WillScot ( WSC ), nVent Electric ( NVT ) and MSC Industrial ( MSM ) and our solar companies including Shoals Technologies ( SHLS ), which we believe can benefit over the next couple of years even in a choppier economic environment. The third area of focus is information security, where companies like Fortinet and Varonis ( VRNS ) have been major contributors to long-term performance. The fourth theme is e-commerce, where we see that companies like merchant enablement provider Shopify ( SHOP ) and cross-border commerce provider Global-E Online ( GLBE ) stand to take a lot of market share in a growing pie.

Portfolio Highlights

The ClearBridge Select Strategy outperformed its benchmark during the first quarter. On an absolute basis, the Strategy posted gains across seven of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors were the IT and consumer discretionary sectors, while the energy sector was the main detractor.

Relative to the benchmark, overall stock selection and sector allocation contributed to performance. In particular, stock selection in the health care, consumer discretionary, industrials and consumer staples sectors and an underweight to the financials sector were the primary drivers of results. Conversely, stock selection in the communication services and energy sectors and an underweight to communication services detracted from performance.

On an individual stock basis, the leading contributors were positions in MercadoLibre, Nvidia, Apple, Fortinet and ServiceNow. The primary detractors were First Republic Bank, American Equity Investment Life, Gitlab ( GTLB ), Pioneer Natural Resources and Chesapeake Energy.

In addition to the transactions mentioned above, we initiated a position in Atkore in the industrials sector and closed positions in Confluent in the IT sector and RXO in the industrials sector.

Aram Green, Managing Director, Portfolio Manager

Original Post

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

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