BNTX - ClearBridge Value Equity Strategy Q1 2023 Portfolio Manager Commentary

2023-04-22 04:45:00 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 during the first quarter, as strong stock selection in the communication services and industrials sectors overcame weakness in the financials sector.
• The collision of aggressive monetary tightening and massive fiscal expansion has resulted in elevated market turbulence, of which the banking crisis was merely the most recent result.
• We must prepare for the possibility of a harder economic landing in the near term, but also for a return to higher nominal growth and inflation in the longer term as the realities of ongoing fiscal policy, the global energy transition and shifts in geopolitics set in.

By Sam Peters & Jean Yu

Economic Storms on the Horizon

Market Overview

Spring weather is typically the most violent and volatile of any season. Warm air from the south collides with cold air from the north, often resulting in intense storms. A similar collision is occurring now between monetary and fiscal policy, creating turbulence for financial markets, and the recent banking crisis will not be the last storm. This portfolio management team is experienced, and it includes a long-time pilot; we know that storms, both meteorological and financial, are not conducive to soft landings. However, that is the benign outcome the market is priced for.

The current financial storm is being driven by the collision of aggressive tightening in monetary policy as the Fed tries to cool the heat from the biggest fiscal expansion since World War II (Exhibit 1). In essence, it is a mix of 1970s monetary policy battling 1940s fiscal policy, resulting in a stubbornly strong economy in key areas like the labor market, and requiring the Fed to keep draining liquidity. Monetary growth, as measured by M2, has never gone this negative on a year-over-year basis (Exhibit 2). Our concern has been that the liquidity drain would result in gradual and linear economic cooling, until things started to break.

Exhibit 1: Fiscal Expansion Matches Wartime Levels

Exhibit 2: M2 Shows Sign of Decline

We are already seeing signs of this, such as record volatility in the U.K. Gilt market last fall, the implosion of FTX in December and the recent rapid failures of select U.S. banks. We expect more things will break until the economy and inflation show real signs of cooling. Even if the process stopped here, we expect U.S. bank loans to contract and put intense pressure on vulnerable areas like the commercial real estate sector, which was already facing pressure from lower occupancy rates and hybrid work models. As credit gets withdrawn, dropping asset levels will put pressure on lending, which will put further pressure on assets in a vicious cycle. Contracting credit is not conducive of soft landings and will feed on itself until the Fed reverses course by lowering rates and flooding the system with liquidity. The market is now expecting the Fed to lower rates later in 2023 thanks to the recent turmoil, but the Fed’s traditional playbook has been complicated by sticky inflation.

What we can expect is a much more volatile economic and financial environment than the placid, post-Global Financial Crisis ((GFC)) market cycle. Economic growth was much more volatile when inflation was elevated during the 1980s (Exhibit 3) but, as inflation cooled into the 1990s, so did the economy’s volatility. We think structurally lower inflation allowed the Fed to flood the economy and markets with liquidity when it needed to be relatively costless. This proved particularly true during the last cycle, as the private sector deleveraged in the wake of the GFC, and the advent of shale oil and gas in the U.S. effectively brought online the equivalent of two Saudi Arabias worth of energy within 10 years. These were remarkable deflationary currents that allowed for tremendous degrees of freedom in monetary policy.

Exhibit 3: Inflation Induces Economic Volatility

COVID-19 changed things dramatically. Fiscal policy swung into action in a big way as monetary growth exploded, and the shale energy era gave way to capital discipline and underinvestment in energy and other commodities. We think fiscal policy will remain a key economic driver as highlighted by the Inflation Reduction Act, the CHIPs Act, and major geopolitical uncertainty surrounding the conflict in Ukraine and U.S.-Chinese relations. In addition, the underinvestment in energy will need to be addressed by both higher investment and demand destruction from higher prices. None of these is supportive of a low-cost Fed put.

The economist Hyman Minsky argued that periods of economic stability lead to periods of instability, as excess investment and leverage build up during the easy times and sow the seeds for their reversal. The post-GFC era was arguably the most stable period of economic growth ever, allowing for an extended period of low interest rates and elevated liquidity. If the ongoing reversal from historically low economic volatility only requires a soft landing, we will be amazed.

"If the ongoing reversal from historically low economic volatility only requires a soft landing, we will be amazed."

When the Fed does indeed ease, we do not expect it to be a magical time machine back to 2019 and the extreme low-volatility regime of the previous market cycle. We must prepare for the possibility of a harder economic landing in the near term, but also for a return to higher nominal growth and inflation in the longer term as the realities of ongoing fiscal policy, the global energy transition and shifts in geopolitics set in. This wide range of potential outcomes requires an active valuation-disciplined approach like ours.

Adapting to Surprise Events

As Bayesian decision makers, we move quickly to adjust the portfolio when surprise events require a dramatic update in our probabilities. The latest surprise was the digitally-enabled bank runs on technically solvent banks, where online banking allowed for almost instantaneous withdrawals of deposits and panic spread rapidly on social media platforms like Twitter. The challenge for banks is that, while confidence is their most important asset, they have little control over it; if depositors think you have a problem, then you have a problem. This creates a feedback-driven doom loop as deposits vanish, the stock drops, further eroding confidence, and more deposits leave. Fortunately, only a few banks had the toxic combination of large, uninsured deposit bases and large, unrealized losses in securities portfolios. The real measure of any regional bank is its core deposit franchise and how sticky deposits will be even as rates rise, especially in an environment where money market yields are at a record gap to deposit rates, and a higher yield is simply a smartphone click away. With new regulations certain to follow, the earnings power and franchise values of regional banks are materially lower.

We quickly adapted to the crisis by significantly trimming our bank exposure and no longer own any regional banks. We also raised our probability of a hard landing and shifted more to cash and value defense by adding to health care. With our cash balances earning almost 5%, as well as earning a positive carry on an asset with no beta and zero correlation to the portfolio, we consider this a valuable tactic with which to take advantage of future opportunities.

Despite the recent signs of an emerging liquidity crisis, the market is still not paying up for taking risk. Equity risk premiums, credit spreads, valuation multiples in general and valuation spreads are all at or below historic levels and show no real distress, an argument that the market is still pricing in a soft landing. We also see this in earnings estimates for the overall market, where bottom-up consensus expects flattish earnings growth this year, followed by a rebound to double-digit earnings growth in 2024. Given that a soft landing is contingent on slowing inflation and nominal growth, this level of earnings growth supposes a major increase in profit margins back to historically high levels. We are skeptical of this logic.

Exhibit 4: EPS Expectations May Be Too High

The big advantage of being valuation-disciplined, active managers is that we can wait. The portfolio has absolute upside to our estimate of fair value that is in line with historic averages, and still supports the potential for the long-term double-digit absolute returns that we look for. Despite elevated index valuations, the earnings valuation multiple of our portfolio is still well below our value index, with better expected earnings and free cash flow growth.

Looking For Free Options

One of the biggest tools that allows uncertainty to work for rather than against us, and which benefits from higher volatility, is optionality. Our process is driven by finding stocks that have healthy current free cash flows, which enable shareholder returns from share buybacks and dividends and offer future growth opportunities. In many cases, we believe these growth opportunities are not incorporated into the market price, and we describe these as getting options for free. We think these are especially valuable right now, and value will be realized if future scenarios are as wide as we expect, or where the option provides great portfolio diversification.

For example, commodity stocks can be framed as buying an option on the underlying commodity. In the case of energy stocks, we are buying an option on an oil price that we estimate is between $60 and $70. While there could be downside to energy equities if oil dips below these levels, energy companies have used the last two years of gushing free cash flow to pay down debt and cement fortress balance sheets, dramatically cutting this downside risk. There has also been enough free cash flow to pay out the highest cash dividend yields in the market while simultaneously engaging in share buybacks. The free option here is that the world is not investing enough to keep oil at these levels over the long term. Inventory levels are well below historic averages and, despite reflecting the hit to demand from electrification and electric vehicle adoption, are still well below future supply. We expect volatility to swing the other way as demand rebounds and climbs a very steep supply curve. The result should be price spikes that make the underlying option extremely valuable for any portfolio’s resilience in a volatile and potentially inflationary environment.

In another example, one of the lowest correlating stocks in the portfolio is new holding BioNTech ( BNTX ), a biotechnology company developing immunotherapies for cancer and other infectious diseases. A very attractive element of any drug stock is that it has idiosyncratic drivers that protect the portfolio from macro shocks and that lower portfolio correlation. In the case of BioNTech, the stock is undervalued due to material drops in its COVID-19 revenues. However, the company has accumulated almost $20 billion in cash and is using its research platform in mRNA and immunology to pursue lucrative opportunities in immuno-oncology and other major disease areas. This massive cash balance curtails our downside, while offering incredibly attractive optionality on the upside.

Portfolio Positioning

As active managers, we use these market observations to frame our decisions on construction and positioning but rely on our rigorous fundamental analysis to determine the strongest and most attractive investments for inclusion in the portfolio. We are constantly searching for new opportunities to enhance the characteristics of our portfolio and have carefully cultivated a watchlist of companies that we feel may merit inclusion under the right conditions. As a result, we made a number of adjustments to the portfolio during the period.

We added aerospace company Airbus ( EADSF ). Aerospace manufacturing remains one of the few areas that is still operating under the pre-COVID levels. As China reopens and international travel recovers, Airbus stands to accelerate earnings growth. We believe that challenges at its competitors have allowed Airbus to gain additional market share in the industry, further extending its opportunities. Despite continued market concerns centering around supply chain disruptions and Airbus’s ability to deliver on its production schedule, continued improvements in global supply chains should yield strong stock performance through a better earnings outlook and a decline in operational risks. We believe the company has strong, long-term value creation potential and will be a significant compounder for the portfolio.

We also added Capital One ( COF ), a largely domestic diversified financial services company with a focus on credit cards that also operates a leading auto lending business. We believe recent regulatory changes such as the Current Expected Credit Losses ((CECL)) methodology of the U.S. Treasury and the ability of credit card companies to manage credit risks have improved the risk profile of leading credit card businesses but have been underappreciated by the market. With its substantial financial reserves, we believe that Capital One is well-positioned to navigate future economic uncertainty. Additionally, we believe this current market and credit cycle is fundamentally different than prior ones due to stronger consumer balance sheets, excess savings, strong wage growth and strong employment environment. As a result, we believe Capital One’s current price has already been overly discounted, and we expect it to offer compelling upside despite further risks of drawdown when a recession emerges.

At the same time, we exited health insurance company Cigna ( CI ), whose strong outperformance over the last year has resulted in shares trading at a significant premium relative to competitor CVS Health ( CVS ). Additionally, we view CVS Health’s underperformance as driven by temporary issues and believe it has a good likelihood of succeeding in its improvement initiatives following upgrades to the management team and its acquisition of Oak Street Health ( OSH ). As a result, we elected to swap our position in Cigna into CVS Health to capitalize on the valuation gap while maintaining similar exposure within the sector.

Outlook

Accepting that we cannot know the future is a fundamental component to our process, and we believe this humility keeps us focused on positioning the portfolio to do well across a multitude of scenarios and outcomes and on reacting accordingly when surprise events do happen. Additionally, our absolute valuation discipline gives us the patience to seize opportunities when they arise while benefiting from uncertainty through owning free growth options. We believe this combination will persevere through coming uncertainty and allow us to ride out the storm to the benefit of our investors.

Portfolio Highlights

The ClearBridge Value Equity Strategy outperformed its Russell 1000 Value Index during the first quarter. On an absolute basis, the Strategy had gains across seven of the 11 sectors in which it was invested during the quarter. The leading contributors were the communication services and industrials sectors, while the financials sector was the main detractor.

On a relative basis, overall stock selection contributed to performance while sector allocation effects detracted. Specifically, stock selection in the communication services, industrials, consumer discretionary, consumer staples and materials sectors benefited performance. Conversely, stock selection in the financials, IT and utilities sectors, an underweight to the communication services sector and an overweight allocation to the energy sector weighed on returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Meta Platforms ( META ), COTY , UBER Technologies, MGM Resorts International ( MGM ) and Oracle ( ORCL ). The largest detractors from absolute returns were American International Group ( AIG ), Bank of America ( BAC ), AES , APA and Western Alliance Bancorp ( WAL ).

In addition to the transactions listed above, we initiated new positions in Micron Technology ( MU ), Black Knight ( BKI ) and Taiwan Semiconductor Manufacturing ( TSM ) in the IT sector, Sensata Technologies ( ST ) and United Airlines ( UAL ) in the industrials sector and MGIC Investment ( MTG ) in the financials sector. We also exited positions in BioMarin Pharmaceutical ( BMRN ) and Pfizer ( PFE ) in the health care sector, M&T Bank ( MTB ), Intercontinental Exchange ( ICE ), Signature Bank ( SBNY ), Charles Schwab ( SCHW ), Corebridge ( CRBG ) and Synchrony Financial ( SYF ) in the financials sector, Pioneer Natural Resources ( PXD ) in the energy sector, Quanta Services ( PWR ) in the industrials sector, General Motors ( GM ) in the consumer discretionary sector, VMware ( VMW ) and Enphase Energy ( ENPH ) in the IT sector and Alcoa ( AA ) in the materials sector. During the period, we sold the Strategy's warrants in East Resources Acquisition ( ERESU ), a special-purpose acquisition company (SPAC), which we received after the company voted to extend its investment window.

Sam Peters, CFA, Managing Director, Portfolio Manager

Jean Yu, CFA, PhD, Managing Director, Portfolio Manager

Original Post

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

For further details see: