BSQKZ - ClearBridge Value Equity Strategy Q3 2023 Portfolio Manager Commentary

2023-10-17 07:00:00 ET

Summary

• ClearBridge Value Equity Strategy takes an active, opportunistic approach to finding and exploiting price-value gaps among stocks across market capitalizations.
• Our hypothesis is that 2023 is simply a pause in what will prove to be a long market cycle that favors value over growth, driven by higher rates, fiscal spending, and the energy transition.
• The Strategy outperformed its benchmark in the third quarter, as strong performance in the energy and utilities sectors helped overcome headwinds from our industrials holdings.
• Our thesis for this value market cycle should crystallize if concentrated U.S. indexes experience more downside volatility, which we expect due to a higher cost of capital.

By Sam Peters, CFA & Jean Yu, CFA

Despite Tests, Value Cycle Hypothesis Stays Strong

Market Overview

Markets tend to arc in a repeating cycle between fear and greed, creating extremes in fundamentals and valuation that ultimately must be corrected. The most vivid examples include the Internet bubble in 2000 and the Global Financial Crisis ((GFC)) in 2008. Our hypothesis is that we are in a new market cycle that will favor value over growth, particularly given the current extremes of what may prove to be a concentration bubble in mega-cap U.S. growth stocks (Exhibit 1). This hypothesis got off to a good start in 2022 but has been challenged in 2023. Year to date, growth has outperformed value by over 2,000 basis points, bringing the relative value of value back to historic extremes.

Exhibit 1: The Value of Value Returns to Historic Highs

As of Aug. 31, 2023, the latest available as of Sept. 30, 2023. Source: AQR, FactSet, ClearBridge Investments. AQR's U.S. Large Cap Universe is the union of the Russell 1000 Index, MSCI US Index, S&P 500 Index, and S&P 400 Index.

However, it is very normal for the previous style winner to have a big rebound year after an initial test. During the previous market cycle transition, value rebounded strongly in 2009 after completely collapsing in 2008. We think these rebounds reflect another key aspect of human nature: resistance to change. It is much more comforting to go with what has worked than to embrace the challenges and uncertainties that arise during major market transitions. The key is that we are undeniably observing two major transitions that should more fully unlock the current extremes in favor of value.

A Big Government Market Cycle

We think adapting to an era of big government spending will be critical during this new market cycle, something most investors are underreacting to. A massive increase in fiscal policy is driving record levels of fiscal deficits, especially as higher interest rates increasingly add to the deficits. This creates a feedback loop of higher rates leading to higher deficits leading to higher rates. We believe this is a key narrative in explaining the rise in interest rates and the bond bear market. In 2007, the last time interest rates were at this level, the federal debt equaled 35% of GDP versus almost 100% today. Servicing this elevated level of debt is expected to cost the government 2.5% of GDP this year, which is double the amount from 10 years ago (Exhibit 2). This, combined with continued fiscal expansion, results in a deficit exceeding 7% this year - a level typically associated with major wars and downturns.

Exhibit 2: Despite Fluctuations, Debt to GDP Continues to Grow

Data as of Sept. 15, 2023. Source: BEA, BLS, NBER, U.S. Treasury, Bloomberg.

We also do not see a shift to austerity given the extreme level of political dysfunction, and the record of both parties in driving massive fiscal expansion. These deficits have become even more politically charged given that increased spending will shift to untouchable entitlements for an aging and politically powerful baby boomer demographic.

Another driver of big government spending is the energy transition, arguably the largest global construction project ever attempted, requiring vast amounts of government and private capital investment. In 2023, global capital spending on energy was roughly $2.7 trillion, according to the International Energy Agency, with roughly $1 trillion spent on fossil fuels and over $1.7 trillion on clean energy. The estimates for additional spending are enormous and range from roughly $2 trillion to $8 trillion annually. If accurate, this will require an additional investment of at least 3% of global GDP.

The issue is that, despite the massive increase in clean energy investment, we are already underinvesting in all forms of energy. Certain analysts estimate that energy markets are likely 2.5% to 5% undersupplied through 2030. This means that just keeping the status quo will require energy investment to grow at well over 10% annually during this period, but likely much more, as most of the spending will be on projects with lower capital returns and less energy density.

During our investment tenure, we have been fortunate to experience structurally lower interest rates and energy prices, culminating in the free money market cycle following the GFC. However, our hypothesis is that the free money era is over, and investors must adjust to higher costs of capital for all investments. This should favor value over growth as an investment style. Value stocks tend to do much better in market cycles with higher nominal growth and positive real interest rates, both of which we are observing and which we expect to continue. We remain particularly focused on value stocks that will benefit from higher energy prices and higher interest rates.

Stock-Level Value Edge

The key hypotheses that drive our investment process occur at an individual stock level, where we test our investment cases to detail our expectations for a much higher business value than market price. We incorporate two important risk-management tools here:

• If the investment case becomes invalidated, we change our minds and sell the stock. This helps us avoid the value trap risk that comes with every valuation-driven process.
• We are focused on capturing a truly attractive risk-reward, with much greater upside potential than downside risk. We say truly because our valuation ranges try to capture two additional things: The bigger ("fatter") tails that are observed in market prices but not fully captured by a lognormal distribution, and the fact that downside risk reduces returns at a larger magnitude versus the equivalent upside return. We are after returns that are truly convex and can generate risk-adjusted alpha.

Just keeping the status quo will require energy investment to grow at well over 10% annually during this period, but likely much more."

These risk management tools are essential because value stocks often have more volatile stock prices, and we need to make sure they have a significant enough benefit to take the risk so that volatility works for us. In fact, we have arguably never seen such an abundance of attractive opportunities for such little fundamental risk, which further supports great risk reward.

From a risk-reward perspective, one of the keys to investing is taking risks you want, typically because other investors eschew them and will compensate you for taking risks they don't want, while also avoiding risks you don't want. In this environment, investors still hate volatile value stocks, while loving passive crowding risks in the most concentrated indexes ever. The stocks we like generate ample free cash flow, have strong balance sheets, and have stable to increasing returns on capital. In most cases, these stocks are also resilient to higher energy prices and higher interest rates and will likely benefit from this new environment. The risks we are trying to avoid are crowded indexes that are currently ignoring the increasing risks from higher rates and rising costs of capital.

The other advantage of volatile value stocks is that they can drive robust portfolio construction by combining mispriced stocks with low correlation. This is Portfolio Construction 101 in trying to maximize diversification, as low correlations can mute portfolio volatility, allowing the valuation signal to be captured. By aiming for this, we often end up with portfolios that are highly differentiated, and we think more robust to constantly changing market environments.

We have never seen such an abundance of attractive opportunities for such little fundamental risk."

One recent example of the stock and portfolio attributes we like is independent power producer, Vistra ( VST ). The stock has a free cash flow yield of over 20%, which management is using to pay down debt, buy back stock, and grow the dividend at the same rate as its shares outstanding shrink. Despite the incredibly high starting free cash flow yield, the recent increases in power prices in Vistra's markets are supporting free cash flow sustainability and growth. While the volatility of Vistra's stock is expected to be twice as high as that of our index, this volatility has great portfolio construction utility with a negative correlation to the portfolio over the last year.

Most investors prefer to manage volatility by simply buying defensive low-volatility stocks. This makes sense unless valuations are too high, which we think has been the case for many defensive stocks during the free money market environment. With the recent rise in interest rates many defensive, low-volatility stocks are experiencing very high downside volatility - exactly what investors were trying to avoid. Not surprisingly, as the defensive names get cheaper and more volatile, we are looking for, and finding, opportunities.

We think the valuation risks emerging in more and more areas are a critical sign of a new market cycle. If so, valuation discipline will return to being a key risk management tool. This reality should crystallize if concentrated U.S. indexes experience more downside volatility, such as we observed in 2022, and this is what we expect as the cost of capital is sustained at higher levels.

Quarterly Performance

The Strategy outperformed its Russell 1000 Value Index in the third quarter, aided by strong performance in the energy sector and stock selection in the utilities sector, which helped to overcome headwinds from our industrials holdings.

In energy, oil production companies like offshore driller Noble ( NE ) and energy equipment service providers Baker Hughes ( BKR ) and Schlumberger ( SLB ) rallied on the back of higher oil prices, underscoring their potential for improved cash flows and stable earnings. On top of broader capital discipline across the industry leading to more share buybacks, oil producers like Noble ( NE ) have strong balance sheets and are generating massive free cash flows as energy demand recovers. We expect these companies to be strong long-term compounders as the world has underinvested in energy.

Stock selection in the utilities sector was also a performance boon, despite a late-quarter pullback across the sector, and included two of the top five individual performing stocks, Vistra and Constellation Energy ( CEG ). Constellation's stock price reached a new all-time high after its second-quarter earnings crushed expectations thanks to higher margins within the company's commercial division, which closed several new contracts during the second quarter. As a result, Constellation raised its full-year guidance for investors, which the market rewarded.

After being strong contributors over the past few quarters, industrials stocks came under pressure during the third quarter due to investors growing more skeptical of an economic soft landing, the prospect of higher-for-longer interest rates, and broad trends of inventory destocking. This declining investor sentiment weighed on some of our more cyclical industrials including airline operator United Airlines ( UAL ), manufacturer Siemens ( SIEGY ), and freight rail operator Union Pacific ( UNP ).

Portfolio Positioning

We continue to find compelling opportunities in the market and made several adjustments to the portfolio during the period, such as initiating a new position in Ross Stores ( ROST ), in the consumer discretionary sector, which operates off-price retail apparel and home fashion stores. In addition to being well-positioned to benefit from tightened consumer spending, we believe the company has exposure to the same tailwinds as many other discount retailers and yet still trades at a discount to its peers. We believe that as inflation and supply chain issues continue to normalize, and economic conditions deteriorate, Ross will be well-positioned to see its share price increase.

We exited our position in Black Knight, in the IT sector, which develops software for real estate and mortgage transactions. We exited the position after an increase in the stock price stemming from the company's announced acquisition by Intercontinental Exchange.

Outlook

Our hypothesis is that we have entered a new market cycle that favors value. However, one of the greatest pillars of our philosophy is intellectual honesty. If our hypothesis gets invalidated by new information, we will adapt as much as possible without violating our valuation discipline and incorporating the new information into our investment cases. Currently, we believe that by combining strong current fundamentals with very low valuations, the risk-reward of this new market cycle hypothesis appears to be extremely favorable.

Portfolio Highlights

The ClearBridge Value Equity Strategy outperformed its Russell 1000 Value Index during the third quarter. On an absolute basis, the Strategy had losses across eight of the 11 sectors in which it was invested during the quarter. The leading contributors were the energy and utilities sectors, while the industrials and healthcare sectors were the main detractors.

On a relative basis, overall sector allocation effects and stock selection contributed to performance. Specifically, stock selection in the utilities sector and an overweight allocation to the energy sector benefited performance. Conversely, stock selection in the industrials sector weighed on returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Noble, Vistra, Constellation Energy, Energy Transfer ( ET ), and APA ( APA ). The largest detractors from absolute returns were AES ( AES ), Block ( SQ ), Zimmer Biomet ( ZBH ), United Airlines, and Oracle ( ORCL ).

In addition to the transactions listed above, we initiated new positions in American Tower ( AMT ) in the real estate sector, Union Pacific and Flowserve ( FLS ) in the industrials sector, AGNC Investment ( AGNC ) in the financials sector, Performance Food Group ( PFGC ) in the consumer staples sector, and SolarEdge Technologies ( SEDG ) in the IT sector. During the period, we exited holdings in Hess ( HES ) in the energy sector, Bloomin' Brands ( BLMN ) and MGM Resorts International ( MGM ) in the consumer discretionary sector, Mosaic ( MOS ) in the materials sector, American Electric Power ( AEP ) in the utilities sector and Vertex Pharmaceuticals ( VRTX ) and Zimmer Biomet in the health care sector.

Sam Peters, CFA, Managing Director, Portfolio Manager

Jean Yu, CFA, PhD, Managing Director, 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: Standard & Poor's.

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: Morgan Stanley Capital International. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information. Performance is preliminary and subject to change. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates, or any third party involved in or related to compiling, computing, or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI's express written consent. Further distribution is prohibited.

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