2023-04-22 22:45:00 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’s bias toward larger banks with strong and diverse deposit bases provided a measure of defense during the bank selloff, with our financials holdings performing well on a relative basis.
- The selloff in the health care space provided an opportunity to add to our position in a medical device company and initiate a new position in a company distributing pharmaceuticals to retail drug stores, physicians’ offices and hospitals.
- From a portfolio perspective, we continue to focus on high-quality companies and look for opportunities to take advantage of dislocations, preferring businesses that would hold up well in a challenging environment.
By Robert Feitler & Dmitry Khaykin
Elevated Uncertainties Call for Discipline
Market Overview
U.S. equities rose in the first quarter, driven by hopes the Fed is nearing the end of its hiking cycle and by optimism for a soft landing later in 2023. The prospect of a dovish pivot from the Fed helped longer-duration technology stocks outperform and made for a strong quarter for growth stocks, with the Russell 1000 Value Index’s 1.01% return far behind its growth counterpart’s 14.37% gain — a near mirror reversal from the previous quarter.
In March, markets focused on the U.S. banking system after significant market losses in Silicon Valley Bank’s securities portfolio spurred a run on the bank’s deposits and resulted in the second-largest bank failure in U.S. history. This sparked a crisis of confidence across small and midsize regional banks, as consumers shifted their deposits to larger banks perceived to be more stable. Although contagion concerns had eased by the end of the month, the crisis intensified concern over the probability and severity of a recession as banks are likely to tighten lending standards.
The Strategy’s lack of exposure to less diversified banks with more concentrated deposit bases acted defensively during the bank selloff, with our financials holdings performing well on a relative basis versus the benchmark. Our concerns over financials with asset/liability mismatches and those making very long-duration bets led us to reduce our bank exposure in 2022 for example, with trims to Charles Schwab ( SCHW ). We trimmed Schwab further in the quarter due to the potential for more regulatory scrutiny and heightened risk of “cash sorting” as customers shift low-yielding deposits into higher-yielding options such as money market funds and U.S. Treasurys. While this impacts the company’s earnings in the near term, roughly 80% of its deposits are FDIC insured and we believe the vast majority of the deposits are likely to stay inside of the Schwab ecosystem where the company can still collect fee and spread income over time.
Our quality bias has always led us to gravitate toward banks with strong and diverse deposit bases; those we own tend to be the larger players, which we also expect to be the biggest beneficiaries from a flight to safety in terms of deposits. JPMorgan Chase ( JPM ) comes to mind especially here, but so does Bank of America ( BAC ) despite its weakness in March, as well as U.S. Bancorp ( USB ), to which we added opportunistically in the quarter.
"Our quality bias has always led us to gravitate toward banks with strong and diverse deposit bases."
Other financial holdings were among the top contributors, such as American Express ( AXP ), whose business is less sensitive to changes in the yield curve than most financials, and Progressive ( PGR ), which has minimal interest rate mismatch exposure. Progressive continues to demonstrate superior underwriting practices with consistent share gains in the personal auto insurance market while maintaining strong profitability. The company pioneered the use of in-vehicle telematics, providing it with a substantial amount of differentiated user data that it uses to reward better drivers while also reducing its risk of losses. These data-driven insights enabled Progressive to lead the industry in raising prices to offset higher losses. Subsequently, as competitors have been forced to sharply raise prices in order to restore profitability, customers have shopped for better rates and Progressive has been able to accelerate its market share gains. The company has a conservative investment portfolio, which we believe is likely to prove defensive in a softer macro environment.
The standout contributor for the quarter was META Platforms, which we bought in the fourth quarter of 2022. We still feel good about Meta shares after the rally, with positive drivers that we found attractive in late 2022 — large scale advantages in driving user engagement, the ability to invest in tools to monetize its audience, cost discipline and a strong balance sheet — still in play. While Alphabet ( GOOG , GOOGL ) was another positive contributor in the quarter, we trimmed the position given the launch of Microsoft’s ( MSFT ) new generative AI product (“Bing AI”) which is targeted directly at Alphabet’s core search business. While we believe Alphabet’s business model is likely to remain resilient given the breadth of its user data as well as its internal innovations around AI, we continue to monitor the area closely given the rapid adoption of ChatGPT and other generative AI products.
Elsewhere in the market rotation to tech, a broad recovery in cyclicals such as industrials and the semiconductor supply chain helped long-time holding TE Connectivity ( TEL ). While automotive sales are likely to be pressured as higher financing costs reduce the affordability of new vehicles, we believe TE Connectivity is positioned to benefit from secular trends around automotive electrification and remain believers in the company’s strong competitive position. We also used the strength in the market to sell our position in diversified industrial company Honeywell ( HON ). While a recovery in its commercial aerospace business remains a tailwind, we believe the valuation is extended and industrial demand continues to soften.
The tech-dominated quarter was a headwind for both defensive and cyclical sectors, with shares of health care holdings such as UnitedHealth Group ( UNH ), Elevance ( ELV ) and Johnson & Johnson ( JNJ ) declining after a strong 2022. The selloff in the health care space provided an opportunity to add to our position in medical device company Becton, Dickinson ( BDX ). We believe the company maintains a strong position at hospital customers, where it is able to drive pricing given its differentiated consumable offerings and regulatory hurdles to replace existing solutions. While the company has struggled procuring components due to COVID-induced supply chain challenges, easing constraints should lead to revenue growth in the coming quarters combined with margin expansion as the company focuses on better integrating previous acquisitions, improving operations and reducing product SKUs.
"Rapid adoption of generative AI products is requiring close monitoring and active position management."
We also initiated a new position in McKesson ( MCK ), the leading distributor of pharmaceuticals to retail drug stores, physicians’ offices and hospitals in the U.S. McKesson also has the largest specialty drug and oncology business in the U.S., which is the fastest-growing, highest-margin segment of drug distribution. A stable, cash-flow generative business, the company competes in a stable oligopoly with two other major distributors and, in addition to drug distribution, it is a significant provider of technology and transaction processing to drug stores, commercialization services to drug manufacturers, and basic supplies to physician offices. We expect at least low double-digit earnings growth from a combination of operating earnings, accretive acquisitions and share repurchases.
Oil prices edged down in the quarter as the prospects of further rate hikes and economic fears overcame optimism about demand from a re-emerging China, weighing on exploration and production companies such as ConocoPhillips ( COP ) and Chevron ( CVX ). These names detracted in the quarter after acting as top contributors throughout much of 2022.
Dish Network ( DISH ) was lower for more idiosyncratic reasons. The pay-TV provider, with unique potential to become a viable fourth wireless carrier, continues to face challenges executing its wireless buildout in a higher rate environment where a leveraged balance sheet is a liability. We believe there is still value to be captured for Dish, but it is clearly taking longer to realize, and we are monitoring the stock closely.
Outlook
The quarter’s market optimism notwithstanding, we remain guarded in our outlook given macro uncertainties, the Fed’s ongoing inflation fight and the real possibility of a hard landing. In this environment, it is doubly important to stick to our philosophy of disciplined valuation with a focus on high-quality businesses whose sustainable competitive advantages we believe will drive strong portfolio performance over time.
While consumer spending has remained resilient, the recent bank crisis is likely to drive even tighter financial conditions in the coming months. On the flip side, consumer balance sheets remain healthy and the prospect of elevated growth from China as it relaxes COVID-related lockdowns are likely to somewhat counterbalance tightening lending standards. These crosswinds are likely to make the Fed’s mission of fighting inflation more difficult as it introduces more variability into the optimal state of monetary policy, increasing the risk of policy mistakes.
From a portfolio perspective, we continue to focus on high-quality companies and look for opportunities to take advantage of dislocations, preferring businesses that would hold up well in a challenging environment. A potential recession in 2023 would not change this approach.
Portfolio Highlights
The ClearBridge Large Cap Value Strategy underperformed its Russell 1000 Value Index benchmark during the first quarter. On an absolute basis, the Strategy had positive contributions from five of the 11 sectors in which it was invested for the quarter. The information technology ((IT)) and communication services sectors made the strongest contributions, while the health care and financials sectors were the main detractors.
On a relative basis, overall stock selection detracted from performance while sector allocation was positive. In particular, stock selection in the industrials, health care, energy and materials sectors weighed on relative returns. Conversely, stock selection in the financials and utilities sectors proved beneficial. An overweight to the IT sector and an underweight to the health care sector were also positive.
On an individual stock basis, the largest contributors were Meta Platforms, TE Connectivity, Motorola Solutions ( MSI ), American Express and Intel ( INTC ) . Positions in ConocoPhillips, Charles Schwab, Bank of America, Dish Network and Northrop Grumman ( NOC ) were the main detractors.
In addition to portfolio activity noted above, during the quarter we exited our position in Apple ( AAPL ), in the IT sector, in which we held a marginal position, to focus on higher-conviction opportunities.
Robert Feitler, Managing Director, Portfolio Manager
Dmitry Khaykin, 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: 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. Copyright © 2023 ClearBridge Investments, LLC |
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ClearBridge Large Cap Value Strategy Q1 2023 Portfolio Manager Commentary