ASMLF - ClearBridge Sustainability Leaders Strategy Q1 2023 Portfolio Manager Commentary

2023-04-22 02:15:00 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.
• Equities made healthy gains in the first quarter as growing expectations of a Fed pivot enabling a soft landing in 2023 overcame a banking crisis and worries of downside risk to earnings as margins revert from peaks.
• A volatile quarter made conditions ripe for portfolio adjustments in which we favored defensive players in part to account for the likelihood of a macro slowdown later in the year.
• 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 Derek Deutsch & Mary Jane McQuillen

Market Overview

Equities made healthy gains in the first quarter as growing expectations of a Fed pivot enabling a soft landing in 2023 overcame a banking crisis and worries of downside risk to earnings as margins revert from peaks. Smaller rate hikes in February and March and a flight to safety kept yields contained, helping growth stocks in the information technology (IT; +23%) and communication services (+20%) sectors rebound from oversold levels and lead the benchmark Russell 3000 Index to a 7.18% gain. Cyclical areas such as energy (-5%) and financials (-3%) and the defensive health care (-4%) and utilities (-3%) sectors saw negative returns.

The Strategy participated nicely in the rally for much of the quarter, with our IT holdings dominating top contributors, led by strong quarters for software leaders Microsoft ( MSFT ) and Salesforce ( CRM ) as well as semiconductor companies ON Semiconductor ( ON ) and ASML . Countervailing this, however, relative to the benchmark, was our stock selection in IT and financials: Nvidia ( NVDA ), not in the Strategy, led the tech rebound by rising 90% from oversold levels, while in financials our regional bank exposure was a liability.

The failures of Silicon Valley Bank and Signature Bank ( SBNY , not owned in the Strategy) led to punishing market scrutiny of banks with large amounts of uninsured deposits (those above the $250k FDIC-insured limit) and securities portfolios that carry significant imbedded losses. As concerns grew in the banking industry, we took a number of actions in the portfolio to protect client capital, exiting First Republic Bank ( FRC ), trimming Charles Schwab ( SCHW ), and exiting Bank of America ( BAC ) to initiate a new position in JPMorgan Chase ( JPM ).

In the case of First Republic, the main detractor for the quarter, while we consider it to be a high-quality regional bank with real franchise value and excellent credit metrics, it carries a large amount of uninsured deposits due to its high-net-worth client base. It also has securities that are being carried at losses on the balance sheet. Amid the Silicon Valley Bank and Signature Bank failures, we grew concerned depositors could leave First Republic en masse, making the bank vulnerable to collapse. Should First Republic survive, we think it will experience significant earnings pressure as the cost of funding has risen significantly.

We decided to reduce our weighting in Charles Schwab, also a detractor for the quarter, but maintain a position, because we believe while it has some risk of deposit flight, that risk is much less relative to First Republic’s, as Schwab has a much smaller amount of uninsured deposits. We consider it to be a high-quality, diversified financial services company that has ample financial strength to withstand most scenarios of financial shock.

"AI has potential in cloud offerings and productivity software, for which companies can earn a premium for higher AI service levels."

In the case of Bank of America, we decided to swap it for a new position in JPMorgan Chase, which, in this environment, is in a stronger financial position, with higher capital ratios, less interest rate risk, less unrealized losses in its investment portfolio and higher returns on equity. Like Bank of America, JPMorgan Chase has a strong commitment to community investment and employee diversity and development. It joined the Net Zero Banking Alliance and has committed $2.5 trillion through 2030 to address climate change and contribute to sustainable development.

Technology holdings drove strong absolute returns for the Strategy in the first quarter, with top contributor Apple ( AAPL ) still showing strong iPhone demand (its active installed base climbed to over 1.1 billion units), enjoying better than expected engagement in its services businesses and executing $19 billion of share buybacks in the fourth quarter of 2022.

Software stalwarts Microsoft and Salesforce also made strong gains. Microsoft is well-positioned to benefit from its relationship with OpenAI, the creator of the natural language processing tool ChatGPT. Microsoft began integrating ChatGPT into its Bing search engine during the quarter but sees even greater potential for generative AI in its Azure cloud offerings and across its productivity software products. We believe AI will allow the company to monetize its applications more effectively and charge a premium for higher AI service levels. Shares of cloud software maker Salesforce rose as management followed through on a leaner operating strategy that places greater focus on shareholder returns and expense management while de-emphasizing its previous growth by acquisition approach.

Portfolio Positioning

In addition to our financials repositioning, a volatile quarter made conditions ripe for portfolio adjustments in which we favored defensive players in part to account for the likelihood of a macro slowdown later in the year.

We exited Amazon.com ( AMZN ), where we see greater downside risk in a recessionary scenario and are concerned about share loss at AWS. We opened a new position in ETSY , the leading e-commerce marketplace for handmade artisan items in categories such as home, apparel, health and beauty, and arts and crafts. With over seven million sellers and 90 million buyers, Etsy has an established competitive position that should prove resilient well into the future. Its asset-light business model has strong incremental margins as growth is increasingly driven by repeat buyers. We believe growth will also benefit from market share gains, higher take rates and geographic expansion. Etsy is a sustainability leader and exhibits best practices around ESG initiatives. It has committed to building a diverse and inclusive workforce and supplier base, and its marketplace drives economic empowerment for its over seven million sellers. Etsy offsets 100% of its carbon emissions from shipping and packaging of every delivery and has committed to reaching net-zero emissions by 2030.

"The banking turmoil will clearly cause some tightening of financial conditions as banks and lenders take a more conservative approach."

Staples company Colgate-Palmolive ( CL ), another addition, is a manufacturer and marketer of oral care, personal care, home care and pet food products. The business is globally diversified, with particularly strong positions in Latin America, Africa and North America. Colgate has underperformed over the past few years, most recently due to gross margin pressure. With multiple drivers, including a fast-growing premium pet food division, and margin improvement from easing input and moderating FX headwinds, Colgate earnings should improve measurably in the period ahead. We consider Colgate a sustainability leader with products that promote health and hygiene, and the company has strong environmental commitments with industry leading disclosure.

We also established a position in Ormat Technologies ( ORA ), a geothermal power producer in the utilities sector. Ormat provides unique exposure to geothermal, a niche zero-carbon baseload power generation technology in which the company is the leading player. Geothermal has the potential to play a bigger role in decarbonizing the grid and should become increasingly valued as intermittent wind/solar penetration increases. Ormat also has a battery storage business that is growing quickly and providing grid services that are becoming increasingly valuable with higher rates of renewables penetration. Its storage business is benefiting from tax incentives in the Inflation Reduction Act (IRA), which should improve the returns on new projects, reduce capital spending needs per project and allow for faster growth.

Outlook

With first-quarter gains concentrated in a narrow part of the market and overall valuations fairly full, we are cautious in our outlook for the rest of 2023. Positives include expectations for a Fed pivot and balance sheet re-expansion and the consumer, who remains resilient thus far. Companies are also benefiting from cost-cutting actions to cushion profit margins — although much of this may be priced in now — dampened supply chain pressures and banking sector stabilization following the recent failures.

Against this we may see the Fed hold interest rates higher for longer in response to sticky services inflation and a tight labor market and downside risk to earnings as margins revert from peaks. The banking turmoil will clearly cause some tightening of financial conditions as banks and other lenders take a more conservative approach. Lower liquidity will likely put a premium on profitable companies generating cash today.

Portfolio Highlights

The ClearBridge Sustainability Leaders Strategy underperformed its Russell 3000 Index benchmark during the first quarter. On an absolute basis, the Strategy had gains in eight of 10 sectors in which it was invested (out of 11 sectors total). The main contributors were the IT, consumer discretionary, industrials and communication services sectors, while the financials and health care sectors were the detractors.

On a relative basis, overall stock selection detracted while sector allocation was positive for results. Stock selection in the financials, IT and consumer discretionary sectors were the main detractors; a health care overweight and an underweight to the communication services sector also weighed on performance. Conversely, stock selection in the real estate, industrials, utilities and consumer staples was positive, as were a lack of energy holdings and an overweight to the IT sector.

On an individual stock basis, Apple, Microsoft, Salesforce, Booking ( BKNG ) and ON Semiconductor were the largest contributors to absolute performance in the quarter. The main detractors from absolute returns were positions in First Republic Bank, Charles Schwab, CVS Health ( CVS ), UnitedHealth Group ( UNH ) and Johnson & Johnson ( JNJ ).

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 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.

Derek Deutsch, CFA, Managing Director, Portfolio Manager

Mary Jane McQuillen. Head of ESG, Portfolio Manager

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