Summary
- A challenging year for capital markets highlighted many of the strengths of dividend equities, with Strategy outperformance driven by positioning decisions that reflect our conservative and disciplined approach to investing.
- We took advantage of this year’s selloff to initiate several new positions and concentrate and consolidate the portfolio in our highest-confidence names.
- We expect both inflation and the economy will slow in 2023 but suspect the Fed may have more to do to bring inflation to heel; nevertheless, we anticipate another year of healthy, though lower, dividend growth for our portfolio holdings.
By John Baldi / Michael Clarfeld CFA / Peter Vanderlee CFA
Market Overview
The fourth quarter marked the final chapter of a painful year for investors. There was no place to hide in 2022: all asset classes declined significantly. The ClearBridge Dividend Strategy also declined, but far less than the broader averages. Indeed, while the S&P 500 Index was down 18% in 2022, the Strategy was down less than half as much.
While it was a challenging year for the capital markets, it highlighted many of the strengths of our active management of dividend equities. Strategy outperformance for the year was driven by positioning decisions reflective of our conservative and disciplined approach to investing: stock selection in the three worst performing sectors in the S&P 500 — consumer discretionary, communication services and information technology ((IT)) — where we de-emphasized higher-multiple, more crowded names; our defense holdings Raytheon Technologies (RTX) and Northrop Grumman (NOC), newly valued in a world of elevated geopolitical risk; our insurance holdings such as Travelers (TRV), MetLife (MET) and AIG (AIG), which rose on a strong insurance pricing cycle along with higher interest rates; and our overweight to energy, in particular natural-gas-focused companies like Williams Companies (WMB) and Chesapeake Energy (CHK). At the same time, within energy, we seek relatively less direct commodity exposure, so this was a detractor in a year where E&P companies led the sector as well as the broad market.
The Strategy also outperformed in a risk-on fourth quarter, outpacing the S&P 500’s 7.56% gain by roughly two-thirds. The above trends observed throughout the year held in the fourth quarter, with Apollo Global Management’s resilient earnings adding to our financials strength, while recurring revenue stalwarts in software [Oracle (ORCL), SAP (SAP)] and payments [Visa (V), Mastercard (MA)] helped drive IT outperformance in a period of slowing IT spend. Sliding natural gas prices led to weakness for EQT, although prices are still elevated by historical standards and the structural supply/demand dynamic remains very attractive.
We took advantage of this year’s selloff to initiate several new positions. In past commentaries we’ve highlighted new positions in natural gas E&Ps Chesapeake and EQT (EQT) as well as copper producer Freeport-McMoRan (FCX), companies providing critical materials to displace oil and coal and enable electrification, respectively. We also found attractive entry points in enterprise software company SAP, a major player in the cloud transition where it should enjoy predictable and higher-quality revenues, and General Motors (GM), which reinstated its dividend, is poised to launch several new electric vehicles in 2023 and offers optionality from new software business models.
In the fourth quarter, challenging valuations combined with rising headwinds led us to concentrate and consolidate the portfolio in our highest-confidence names. We exited animal health care company Zoetis (ZTS), regional bank U.S. Bancorp (USB) and alternative asset manager Blackstone (BX).
We took advantage of a swoon in REIT prices to high-grade our real estate exposure. Amid prolonged concerns regarding work-from-home’s long-term impact to office fundamentals, we exited Boston Properties (BXP) and bought apartment REIT AvalonBay Communities (AVB). AvalonBay is one of the largest apartment owners in the country and possesses a portfolio of high-quality, suburban properties in coastal markets with relatively high barriers to entry. The company has a robust balance sheet and currently enjoys double-digit same store revenue growth. While growth is slowing, rent increases commenced in 2022 position the company for continued revenue growth in 2023 despite softening market conditions. High interest rates and inflation combine to support a healthy supply/demand balance in the apartment industry. Today’s interest rates make it prohibitively expensive for renters to buy a home and, combined with inflation, make new multifamily construction uneconomic. AvalonBay sports an attractive upfront yield, and we expect long-term dividend growth in the mid to high single digits.
Outlook
While we hope the worst of COVID-19’s health care challenges are behind us in the U.S., many of the problems we face today — climate change, income inequality, social and political acrimony, war and unsustainable public finances — will be with us for years. As we reflect on the year that has passed and contemplate the year ahead, we sense the world is undergoing a regime change.
"We underwrite our investments based on conservative, disciplined, fundamental and independent-minded analysis — not recent trends or fads."
Gary Gerstle describes this process in his excellent new book The Rise and Fall of the Neoliberal Order. A political order , he argues, “is meant to connote a constellation of ideologies, policies and constituencies that shape American politics in ways that endure beyond the two-, four-, and six-year election cycles.” Just as the New Deal framed policy from the 1930s to the 1970s, a neoliberal order has shaped U.S. political economy since Reagan. This order has been defined by increased globalization, freer markets, deregulation, lower taxes and the priority of shareholders over workers.
As we look around today, many of these forces appear to be ebbing. Supply chains are re-nationalizing, industrial policy is becoming more statist and protectionist, anti-trust enforcement is re-awakening and labor is extracting higher wages. It does not seem rash to argue that the world is undergoing a profound shift.
Amid such uncertainty, complexity, and volatility, we endeavor to remain flexible and embrace the inherent uncertainty of investing in public markets. We do not possess specific forecasts for GDP growth, interest rates or valuation multiples. Rather, we try to understand the range of potential outcomes and position our portfolios so that we will perform adequately under most of them. We underwrite our investments based on conservative, disciplined, fundamental and independent-minded analysis — not recent trends or fads.
With the spate of significant interest rate increases, we expect both inflation and the economy will slow. It is unclear, however, that inflation has been tamed or the Fed’s job is near complete. Employment remains robust, wage gains remain strong and savings, though down, continue to be well above pre-pandemic levels. In times like this, when interest rates are on the rise, dividend growers tend to outperform (Exhibit 1).
Exhibit 1: Dividend Growers Dominate
Source: BMO Capital Markets Investment Strategy Group, FactSet, Compustat, FRB.
While interest rates present a headwind to the economy, recently enacted legislation — such as the Infrastructure Investment and Jobs Act and the Inflation Reduction Act (IRA) — provide a long-term tailwind given their sheer size. These programs will create winners in new industries and losers in other industries. Over the long term, the IRA will unleash vast, low-cost renewable power. The road to get there, however, will be bumpy and likely entail significant dislocations in energy markets that may at times negatively impact broader economic factors such as growth and inflation.
As we navigate the uncharted waters that lie ahead, we remain steadfast in our consistent investment approach. We emphasize high-quality companies with strong balance sheets, strong dividend profiles, recurring/predictable revenues, pricing power, high returns on invested capital and strong free cash flow. We invest with management teams we like and trust, and who can ably run their companies. Critically, and in contrast to the valuation-agnostic ethos which has dominated markets over the last many years, we echo the CEO of Apollo Global Management, one of our largest holdings, in our belief that “purchase price matters.”
As we look to 2023, we anticipate another year of healthy, though lower, dividend growth. Amid inflation and rising interest rates, growing dividends not only provide an attractive stream of income, they also protect our purchasing power and help to offset the impact of higher prices.
Portfolio Highlights
The ClearBridge Dividend Strategy outperformed its S&P 500 Index benchmark during the fourth quarter. On an absolute basis, the Strategy saw positive contributions from 10 of the 11 sectors in which it was invested for the quarter. The financials, IT and health care sectors made the strongest contributions, while the real estate sector was the sole detractor.
On a relative basis, stock selection and sector allocation contributed positively for the quarter. In particular, stock selection in the financials, IT, consumer discretionary, communication services and consumer staples sectors, underweights to the consumer discretionary and communication services sectors and overweights to the energy, materials and financials sectors benefited relative performance. Conversely, stock selection in the energy and industrials sectors detracted.
On an individual stock basis, the main positive contributors were Apollo Global Management (APO), Raytheon Technologies, Merck (MRK), JPMorgan Chase (JPM) and Linde (LIN). Positions in EQT, Apple (AAPL), Intel (INTC), Walt Disney (DIS) and Zoetis were the main detractors from absolute returns in the quarter.
In addition to portfolio activity discussed above, during the quarter we exited positions in Otis in the industrials sector and Public Service Enterprise in the utilities sector.
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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
Dividend Virtues On Full Display In 2022