YLDE - ClearBridge Value Equity Strategy Q4 2023 Portfolio Manager Commentary

2024-01-19 08:20:00 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.
• Rather than anchor expectations to one specific scenario, our process gives us a competitive advantage by constantly learning and adapting rapidly as we observe markets.
• They highlight the importance of active valuation discipline and finding stocks selling below business value in any scenario.
• We believe inflation will be cyclical over the next several years and that, ironically, the decline in rates markets reflected in the fourth quarter may be a trigger for higher inflation later in 2024.

By Reed Cassady, CFA, Jean Yu, CFA, PhD, & Sam Peters, CFA

A Probabilistic Approach to 2024

Market Overview

One of the primary influences on our probability-driven investment process is Dr. Howard Raiffa, a pioneer in decision analysis and the use of probability trees. An equally famous scientist, Dr. Ernest Nagel, once observed Dr. Raiffa in obvious distress and asked him what the problem was. Dr. Raiffa replied that he had gotten a job offer and couldn’t decide whether or not to take it. Dr. Nagel pointed out that, as one of the world’s experts on decision theory, this was a perfect opportunity to use a decision tree. Dr. Raiffa stared back at Dr. Nagel and replied, “Ernest, this is serious.”

We love this story because it captures the constant tension between static human nature in craving certainty and the huge ocean of probabilities we must navigate. There is no formula to eliminate uncertainty when it comes to the future. The best approach, which Dr. Raiffa’s work so effectively illustrated, is to accept it and embrace probabilistic thinking. This is exactly what our investment process is designed to do — give us a competitive advantage by constantly learning and adapting rapidly as we observe markets. We joke that our process has zero tolerance for uncertainty laundering, as our reflection on 2023 and our framework for 2024 below demonstrates.

"Rather than anchoring on false certainty, we expect to adapt to inevitable surprises."

Besides AI, the big event of 2023 was the recession that wasn’t. We estimate that, during the height of the March regional bank crisis, financial markets had priced in a 60% or greater probability of recession. While we shared this view, the recession ultimately failed to materialize. What saved us from a forecasting error, however, was our investment process. When we analyze a position, we unpack what embedded expectations are priced into the stock. Our human nature, which expected a recession, wanted to buy defensive stocks in staples and regulated utilities. The signal from our process, however, indicated that most defensive stocks were already pricing in a recession and were effectively overpriced recession insurance. Conversely, recessionary fears were providing good value in select cyclical stocks, where we could enjoy high free cash flows and fortress balance sheets that made any recession survivable.

Pricing recession risk gave us another opportunity in October. When it became clear to markets that an imminent recession was not likely, interest rates moved violently to the upside. This resulted in a material correction in several defensive sectors, and for a short time recession insurance went on sale and we took advantage of the opportunity.

The key takeaway is that we never build our portfolio around a single forecast. Rather, we invert the process and try to buy as many future scenarios as cheaply as possible. We also adapt if our estimates of business value are either positively or negatively impacted by a major shift in probabilities to a given scenario, especially if there is a cascading impact on portfolio construction from changes in correlations and volatility that impacts our dynamic risk budget. Rather than anchoring on false certainty, we expect to adapt to inevitable surprises as markets constantly change what probabilities are priced.

"We invert the process and try to buy as many future scenarios as cheaply as possible."

This adaptation process is a cornerstone of how we are formulating our thoughts for 2024. The first step is developing a probability framework around potentially key 2024 scenarios, allowing us to update our own probabilities as we observe critical events and to falsify erroneous forecasts as the year progresses. A crucial second step is to try and unpack what markets have priced in, as it allows us to compare our own probabilities against the market’s and identify what surprises could move markets, such as the non-recession of 2023. This leaves us with a couple of sources of potential edge. First, it prepares us to be flexible in updating our beliefs and adapting the portfolio accordingly. Second, if we think a critical scenario is not priced by markets, it will appear in our bottom-up investment process by highlighting low-expectations stocks, which can provide cheap insurance against a low-probability, but potentially significant, event.

A crucial caveat for any market forecasting endeavor is, as stated by Elroy Dimson, “Risk means more things can happen than will happen.” No forecasting process can capture every scenario, and we always place a respectable probability on an undefined scenario that comes from irreducible uncertainty. This is where we imagine the dark thoughts that guide our downside scenarios in our valuation work, and in making sure our companies have the financial strength to survive a severe economic shock and frozen financial markets. Valuation has been forgotten as a risk management tool during the recent years of free money, but we think investors will become increasingly re-acquainted with its central role in navigating risk and uncertainty.

Approaching 2024 Probabilistically

Our team assigned probabilities to three broad scenarios: a recession, a soft landing and a no landing where inflation stays sticky above 2% and starts to re-accelerate. One great aspect of this process is that it surfaces cognitive diversity (as the team’s probabilities vary widely) while also providing a tight range on what the market has priced in, guided by our bottom-up expectations work. Beyond the portfolio management team, we also include our colleagues on ClearBridge’s Economic and Market Strategy team, which helps add a model-driven element to the process and another layer of cognitive diversity. This framework allows us to systematically change our minds as probabilities shift, and to adapt to surprise — something the market does automatically as a complex adaptive system, and which our disciplined investment process mirrors.

• Recession Scenario: Our team estimated that the probability of a recession in 2024 was roughly 30%, with a range of 15% to 60%, while we estimated that the market was pricing in a recession probability of roughly 20%. Why were models so wrong in confidently calling for a recession in 2023? We think markets are too focused on monetary policy and have not incorporated the massive change that is underway from fiscal policy expansion, including infrastructure buildouts and energy transition. In addition, we were wrong in underestimating the continued resilience of U.S. shale oil and gas supply and the Strategic Petroleum Reserve release. There has never been a recession since 1970 without both higher interest rates and an oil spike. With oil down 3% since the Ukraine invasion, a critical recession variable is missing.

Exhibit 1: Oil Prices Show Little Sign of Recession on Horizon

On the adaptation front, our ability to buy cheaper recession insurance in October and the fundamental strengths of our portfolio holdings, with their resilient free cash flows and fortress balance sheets, suggests portfolio turnover in a recession may not be significant. This is particularly true if a recession requires an oil spike, given our large energy overweight. The turnover would come when investors inevitably get scared and valuation spreads spike materially. We are always active during windows of extreme investor fear when the valuation math gets very easy, but the emotions are hard. There are great opportunities to layer in high forward returns from a behavioral overreaction.

• Soft Landing Scenario: Just as markets were confident of a recession in 2023, markets are now very confident of a soft landing. Our team estimated a 50% probability of a soft landing, but we think the market is pricing in a 70% probability amid tight credit and valuations spreads, and very low measures of equity volatility. Volatility is a reasonable measure of how uncertain markets are about the future, and right now equity markets are acting certain. Ironically, fixed income volatility measures have been well above equity volatility measures since early 2021. It’s a bit of a paradox that traditionally calmer fixed income markets can be so much less certain than equity markets, suggesting the equity market is overconfident in its ability to read an uncertain future.

Exhibit 2: Bond Volatility Surpasses Equity Volatility

Adaptation in a soft landing scenario would also likely not require material portfolio turnover. Rather, we would expect the market to continue to broaden out, as it did in late 2023. Even the relative performance of the Magnificent Seven has flatlined over recent months as the soft landing was priced into markets. With indexes at extreme concentration levels, a continued broadening out would channel more capital to areas with strong fundamentals and attractive valuations, places where our active valuation investment process has led us. It would not take much, given how one-sided investor positioning is in mega cap U.S. growth stocks.

• No Landing Scenario: If a soft landing was the mispriced scenario of consequence a year ago, we think a no landing scenario is the event in 2024 that would trigger major volatility if realized. Our estimate of no landing was roughly 20%, which we believe is at least double what the market has priced. Our bias is that inflation will be cyclical over the next several years given massive fiscal expansion and ongoing deficits, accelerating capital investment required for the energy transition and infrastructure buildout, and the shift in geopolitics that dampens structural deflation. If so, we would expect inflation to bounce above 2% and start to cycle higher if we avoid a recession. Ironically, the massive decline in interest rates as markets priced in a soft landing late in the fourth quarter may be the key trigger for higher inflation later in 2024. We are coming off one of the most aggressive loosening of financial conditions ever, and markets are a huge causal factor in driving economic activity via reflexive feedback.

Adaptation in a no landing would require higher portfolio turnover for us than in the other scenarios, but much less than for investors not even considering this possibility. In a recent survey, global fund managers were the most underweight commodities versus bonds since March 2009. This level of complacency in anchoring on one scenario gives us the ability to buy no landing insurance on the cheap. Again, we are not betting on scenarios, but rather inverting the process and seeing where embedded expectations in possible futures are selling well below business value at the stock level. Where we can buy energy and materials stocks at high-single-digit to low-double-digit free cash flow yields, with almost no debt, and attractive dividend and buyback yields, we will take it — especially when we get such a valuable inflation option practically for free.

Regardless of what scenario plays out, our focus remains on finding stocks selling below business value and where we have a more optimistic view of future fundamentals than what the market has priced. This active valuation discipline requires that we get the fundamentals right with very little help from valuation multiple expansion. This strict discipline has served us well during the last few years of severe value style headwinds relative to growth, as the portfolio’s valuation multiple has remained anchored around 12x forward earnings. This showed up again in 2023, with a total return of almost 20% driven by 15% positive estimate revisions, a 2% dividend yield, and a 2% multiple expansion that occurred entirely in the last few weeks of the year. There is a real benefit of asking little of the future and not anchoring on any given scenario that would flatter your returns.

Quarterly Performance

The Strategy outperformed its Russell 1000 Value Index in the fourth quarter, aided by strong stock selection in the financials and energy sectors, which helped to overcome detractors from our overweight allocation to the energy sector and stock selection in industrials.

Energy was the worst-performing sector in the benchmark and the only one to generate negative returns during the quarter, as forecasts for a mild winter, greater than anticipated supply and lackluster demand from China weighed on performance of the broader sector. As a result, our overweight allocation to the sector was the largest detractor from relative performance. However, stock selection within the sector proved positive, as several of our high-quality holdings held up substantially better than their benchmark peers.

Stock selection in the financials sector proved to be the largest contributor to relative outperformance. Banking stocks such as Wells Fargo saw their share price rise during the quarter as investors anticipated Fed rate cuts that would reduce deposit costs while retaining economic strength and minimizing the risk of credit losses. The sector also contained our top individual holding during the period: Block ( SQ ), whose stock price maintained its upward momentum after it announced that Square retailers saw substantial increases in holiday spending trends and transactions, and greater optimism for a soft landing helped alleviate investor concerns over consumer spending.

Our industrials stocks faced headwinds early in the quarter due to fears of a recession, which weighed on some of our more cyclical industrials such as United Airlines ( UAL ). Additionally, the Fed’s pivot and the prospect of rate cuts in 2024 helped fuel a rally in lower-quality industrials that we did not hold, further dampening the performance of our high-quality holdings.

Portfolio Positioning

During the quarter our turnover was primarily driven by the brief window to buy defensive stocks when interest rates spiked during October and price-to-value gaps for some defensive stocks briefly hit our 30% threshold. We took advantage of these conditions to add eight new positions and exit six.

We added a new position in NextEra Energy ( NEE ), in the utilities sector, which acquires, owns and manages contracted clean energy projects in the U.S. The company was at the center of the defensive stock storm when it slowed its renewable growth outlook modestly in late September, and the stock collapsed almost 30% in less than two weeks. We saw this as an opportunity to invest in arguably the best combination of a regulated utility and an experienced renewable operator with good long-term growth options. Even at a much-reduced estimated growth rate from higher financing costs, which will likely prove to be conservative, our estimate of intrinsic business value is materially higher.

We also added PPL , another utility, which provides electricity and natural gas to 3.5 million customers in eastern U.S. PPL is an excellent example of everything we were looking for when defensive stocks got hit in October: a constructive regulatory regime, a good balance sheet and a favorable earnings growth outlook. With the stock down almost 30% from early 2023 highs, we were able to buy the stock at a low-teens earnings multiple with roughly 30% upside to our estimate of fair value. As such, we think this is a compelling entry point for this defensive, bond proxy stock.

Outlook

Just like Howard Raiffa’s job offer, we would love to be able to tell you with certainty what is in store for all of us in 2024. However, our job as probability-driven, valuation-disciplined investors is to accept uncertainty by asking a simpler question: how we can get paid not to know? We do this by investing in resilient companies where the price paid is well below business value in most future scenarios and adapting to inevitable surprises to the best of our abilities. This is indeed serious, and it’s the goal we have spent decades pursuing and refining as we look to deliver for shareholders.

Portfolio Highlights

The ClearBridge Value Equity Strategy outperformed its Russell 1000 Value Index during the fourth quarter. On an absolute basis, the Strategy had gains across 10 of the 11 sectors in which it was invested during the quarter. The leading contributors were the financials and industrials sectors, while the energy sector was the sole detractor.

On a relative basis, overall stock selection contributed to returns while sector allocation effects detracted. Specifically, stock selection in the financials, energy, utilities, materials, real estate and consumer staples sectors and an underweight allocation to the consumer staples sector benefited performance. Conversely, stock selection in the industrials 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 Block, Capital One Financial ( COF ), American Tower ( AMT ), Micron Technology ( MU ) and Expedia ( EXPE ). The largest detractors from absolute returns were APA , United Airlines, Schlumberger ( SLB ), SolarEdge Technologies ( SEDG ) and Noble ( NE ).

In addition to the transactions listed above, we initiated new positions in United Parcel Service ( UPS ) in the industrials sector, Hess ( HES ) in the energy sector, CVS Health in the health care sector, Corebridge Financial ( CRBG ) in the financials sector, Marvell Technology ( MRVL ) in the IT sector and Kellanova in the consumer staples sector. During the period, we exited holdings in SolarEdge Technologies and Taiwan Semiconductor Manufacturing ( TSM ) in the IT sector, Haleon ( HLN ) in the consumer staples sector, Alibaba ( BABA ) in the consumer discretionary sector, United Airlines in the industrials sector and APA in the energy sector.

Reed Cassady, CFA, Director, Portfolio Manager

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

Sam Peters, CFA, Managing Director, Portfolio Manager

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