ClearBridge Value Equity Strategy Q2 2023 Portfolio Manager Commentary

By Sam Peters & Jean Yu

The Gift of Extremes

Market Overview

One of the most powerful tools we have as investors is to think probabilistically rather than act emotionally. We use probability to adapt to new information when our beliefs are challenged, typically in the form of a surprise, and to exploit extreme dispersion in prices versus historic norms. As mathematician Claude Shannon so brilliantly formulated with his discovery of information theory, “information is the resolution of uncertainty.” Our goal is to constantly compare our beliefs, captured by falsifiable investment cases, against the collective belief of the markets. These parallel belief systems have a common goal of continually trying to reduce uncertainty with new information to properly price risk. Much of the time we agree with how the market is pricing risk. However, opportunities arise when collective investor behavior prices either too much pessimism or optimism into equities. Right now, the market is confidently pricing in a soft economic landing and continued dominance of U.S. mega cap growth stocks. We are practicing humility by assigning a lower probability to these two narrow outcomes, and positioning for potential surprises as the rest of 2023 unfolds.

The Two Big Surprise Events of The First Half

The negative surprise of 2023 was the shockingly rapid collapse of three particularly vulnerable banks to smartphone-enabled bank runs. While we had previously experienced bank runs as investors, we had never seen collapses occurring within days as billions of deposits fled within hours. The uncertainty of these bank collapses was twofold: no one knew how many banks would fail if the fires of fear spread beyond these initial failures, and how it would impact the economy. With regional bank stock volatility and correlations spiking — which is what market prices do in negative surprise events — we exited our modest regional bank exposure before the crisis broke. This reflected our updated belief that risks of regional bank contagion were indeed elevated in banks where depositor and investor confidence was lowest, and the collapses would add to downward pressure on the economy as bank lending slowed materially.

However, the risk pricing that emerged was much more benign than these initial expectations. The failures stopped at the three most vulnerable banks, which each had a high mix of uninsured deposits, and the contraction in bank lending has been mostly isolated to commercial real estate. The result has been a perceived win for markets, as the contraction in bank lending became framed as a helping hand in the Fed’s battle with inflation, as opposed to a recession trigger, raising the probability of a soft landing.

As the reduction in uncertainty gave way to risk we could price, we added a small position in one regional bank stock, First Horizon (FHN). First Horizon reflected a unique opportunity to buy a bank with an extremely strong capital and liquidity profile at a distressed value after its deal to be acquired by Toronto Dominion (TD) was cancelled. Despite this opportunity, we still think the risk of higher funding cost remains, which will continue to put tremendous pressure on regional bank earnings. Thus, we continue to be underweight banks in general, but will take advantage of idiosyncratic opportunities as they emerge.

Fortunately for investors, the much bigger surprise in the first half has been the positively framed emergence of AI as a potentially transformational technology. One of the fastest ways for information to reduce uncertainty is through the compression of an idea through a narrative. Generative AI couldn’t be a more perfect name to launch a story of technological change, and the market reacted accordingly with a significant rally in the Nasdaq.

The generative AI narrative that is emerging characterizes it as a platform technology and game changer for economic productivity, which has the potential to drive faster real growth amplified by lower inflation. There could hardly be a more perfect combination to treat the current malaise of stubborn inflation and aggressive monetary policy than this narrative. In addition, the promise of generative AI is being framed as a new source of long-term growth for AI enablers and winners, fueled by a massive increase in capital spending on computing power.

While we think generative AI will be a long-lasting major surprise event with profound influence, technology hype cycles almost never follow a linear path and risks always emerge after an initial explosion in investor expectations; real change always takes much longer than expected, and many hoped-for benefits are never fully realized. In addition, digital change is characterized by the emergence of a few dominant winners that capture most of the growth and economic rents from technological innovation. The result is that technology hype cycles typically produce many more losers than winners as early participants either fail or simply fade away. The most vivid example we’ve seen was the 2000 dot-com bubble collapse. The Internet has been dramatically more transformational than even the most optimistic expectations during the initial hype stage. However, that didn’t help Pets.com live much beyond the initial hype stage, or for survivor Cisco (CSCO) to not suffer after reality crashed the initial party.

“Technology hype cycles often produce more losers than winners, as early participants either fail or simply fade away.”

The opportunity we see at this stage of the AI hype cycle is related to the massive amount of capital required to scale the computing power required for AI training and inference. The clearest winners from this stage will be the builders and enablers of the compute layer, especially certain semiconductor and hyperscale cloud providers. Accordingly, this is where our exposure will be focused and will naturally be limited to opportunities where the realities, rather than the hype, justify a business value materially higher than our entry price. AI-related stocks have an added benefit in portfolio construction, as they tend to have low correlation to other parts of the portfolio. However, we will manage our overall exposure to AI, anticipating that price and value will start to converge after the hype initially lifts all AI-related boats.

The benign resolution of the regional bank crisis, together with the emergence of the AI hype cycle, has resulted in a collapse in equity volatility and a spike in valuation multiples for concentrated growth leadership. What is required to justify what is now priced into the market? A soft landing on the macro side and AI hype delivering growth in the near term. Both outcomes are certainly possible. However, with the market now priced as if uncertainty has been resolved, active probability-driven investors like us are getting a few gifts from the market: a move back to extreme relative dispersions between value and growth, and low correlation between the two styles.

The Gift of Extremes

What we look for are unsustainable extremes that we can exploit as active managers, and today we have anything but a uniformly priced market. It is bearish for U.S. indexes, while providing a great opportunity to look for mispriced stocks with strong fundamentals beyond the concentrated top of those indexes. We believe we are well-positioned for another surprise which should help things become a little less extreme. Best of all, we are comfortable to wait with low correlations smoothing the ride.

There are no true formulas when it comes to investing, but a probabilistic framework helps us adapt as conditions change. For example:

• When valuation is extremely cheap, measured by valuation spreads at least two standard deviations above average, we concentrate active bets in that area. When spreads are close to average, like they currently are, we try to maximize diversification and spread our investments. The last time valuation spreads were high was 2020, and we concentrated the portfolio to drive absolute and relative returns over the last three years. The portfolio is now much more spread out, which gives us dry powder to deploy when conditions change.
• When capital is highly concentrated in one area that is also above historic average valuation, it is subject to reversal from surprise. We look to minimizing active bets in this area and buy attractively valued stocks with good fundamentals. Even small reductions in concentration, which is almost a sure thing over longer periods, will trigger huge reversals in relative performance in favor of low concentration, exactly as we saw in 2022.
• Low correlation fuels good portfolio construction. We look for stocks with low pairwise correlation, that are selling below business value, to help maximize compounded returns by minimizing the drag from volatility, often referred to as the volatility tax. Pairwise stock correlations are currently low, which is another reason to maximize diversification in the portfolio. By doing this we are achieving decent downside capture relative to our index after avoiding a big absolute loss in 2022. This is critical in driving the compounded returns we are after, while positioning us to take advantage of any negative surprises that spike volatility, correlations and valuation spreads.

Based on our analysis, major U.S. indexes are set up for very poor compounded returns. The valuation of value relative to growth is back to historic highs, being driven by the historic concentration of the top seven stocks in the S&P 500 Index (SP500, SPX, Exhibit 1). Never has so much liquidity been sucked into such a small number of stocks, and the risk may prove a black hole for capital due to the volatility tax.

Exhibit 1: Concentration and Spreads at Historic Highs

The correlation of the big seven bet is also elevated, especially compared to the rest of the market that is enjoying relatively low pairwise correlations (Exhibit 2). We are also observing a very low correlation between value and growth styles, which argues strongly for diversifying any U.S. index bets with value (Exhibit 3). Value has arguably never been better index insurance.

Exhibit 2: The Big 7 Show High Correlation

Exhibit 3: Growth and Value Maintain Low Correlations

The key is that indexes are positioned for extremely low uncertainty, reflecting a soft landing and a near-term growth boost from AI. Risk is always that more things can happen than will happen, and two risks we see not currently priced into the market are a recession (as monetary policy works with a lag) and higher interest rates. The key risk is that concentration in the market is being driven almost entirely by a spike in valuation multiples, despite the continued rise in real rates and the cost of capital. This is not sustainable unless interest rates come down in a benign soft-landing manner, or growth dramatically accelerates. The index is all-in on this one scenario.

“Low correlation fuels good portfolio construction.”

Quarterly Performance

The Strategy outperformed its Russell 1000 Value Index in the second quarter, aided by strong performance in cyclical sectors such as energy, industrials and financials which helped to overcome detractors in the materials and consumer discretionary sectors.

Stock selection in the energy sector was the top driver of relative outperformance during the quarter, as a more optimistic economic outlook drove anticipated demand for energy higher. Performance was particularly strong for EQT, North America’s leading natural gas provider. EQT had seen its share price slide as the lackluster reopening of China and a milder-than-expected winter in the northern hemisphere weighed on natural gas prices. However, as recessionary fears have given way to optimism for greater future demand, both the price of natural gas and EQT’s share price have seen increases.

Conversely, stock selection in the materials sector was the primary detractor from relative performance partially due to a decline in Mosaic, a leading provider of potash and phosphate fertilizers. The company has seen faster-than-expected price declines from the highs reached after the outbreak of the Russia-Ukraine war, as supplies from Belarus and Russia gradually found their way around the global sanctions. Also, higher cost inflation has delayed discretionary fertilizer purchases by farmers. However, we believe the global agricultural cycle remains broadly supportive. With fertilizer prices normalizing above the pre-pandemic levels, pent up demand from farmers’ need to replenish diminished soil land banks, and continued pressure on Belarussian and Russian supplies, we believe the company’s earnings power will remain at above-history levels. Additionally, the company’s commitment to share repurchases and debt paydowns has accreted value to existing shareholders and signaled a commitment by management to continue to do so.

Portfolio Positioning

We initiated a small position in Microsoft (MSFT) during the quarter, which may seem surprising given our concerns about index concentration. However, we seized the opportunity on a compelling entry point below our business value estimate, due to an anticipated acceleration of demand for Microsoft’s Azure cloud business and incremental revenues from integration of Microsoft’s AI Copilot program into its office platform. We believe this could support double-digit growth, while simultaneously solidifying Microsoft’s competitive position as an AI winner. Even as a small position, we believe Microsoft provides a large portfolio construction benefit given low correlation to the rest of the portfolio.

We also added a new position in Eastman Chemical (EMN), a vertically integrated chemical company, reflecting an opportunity to buy an overly depressed cyclical stock with an extremely cheap option on molecular recycling. An eventual cyclical rebound alone is enough to justify a much higher business value as demand will accelerate as destocking ends, allowing Eastman to realize material profit margin expansion as it gets ahead of cost input inflation. Additionally, Eastman is ramping up three molecular recycling plants over the next few years based on its Polyester Renewal Technology, a less energy intensive and lower cost production process. This should drive faster growth while generating compelling returns on capital.

Outlook

As active valuation managers, our task is to balance our exposure to our highest-conviction opportunities while avoiding expensive risk. We believe now is the time to bet against the expensive risk in historically concentrated U.S. indexes. Accordingly, we have a highly active but diversified portfolio selling with a forward earnings multiple below 12x, which is 20% below our benchmark and over 70% below the concentrated seven. Despite these discounts, the portfolio enjoys strong fundamentals supported by self-funding free cash flow generation, fortress balance sheets and better expected growth than the index. Sometimes it is hard to be an active manager, but right now the market is giving us plenty of tools to do our job. That job, as always, is to compound returns to drive real wealth and beat our index in the process.

Portfolio Highlights

The ClearBridge Value Equity Strategy outperformed its Russell 1000 Value Index during the second quarter. On an absolute basis, the Strategy had gains across nine of the 11 sectors in which it was invested during the quarter. The leading contributors were the industrials and financials sectors, while the materials 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 energy, industrials, financials, IT, communication services, health care and utilities sectors benefited performance. Conversely, stock selection in the materials and consumer discretionary sectors, an overweight to the energy sector and an underweight to the communication services sector weighed on returns.

On an individual stock basis, the biggest contributors to absolute returns in the quarter were Meta Platforms (META), Uber Technologies (UBER), Oracle (ORCL), EQT and American International Group (AIG). The largest detractors from absolute returns were AES, Mosaic MOS, AbbVie (ABBV), SolarEdge Technologies (SEDG) and T-Mobile (TMUS).

In addition to the transactions listed above, we initiated new positions in Johnson & Johnson (JNJ) and Gilead Sciences (GILD) in the health care sector, Pioneer Natural Resources (PXD) in the energy sector, Apollo Global Management (APO) and Block (SQ) in the financials sector, Teck Resources (TECK) in the materials sector, Clean Harbors (CLH) and Canadian Pacific Kansas City (CP) in the industrials sector and Alibaba (BABA) in the consumer discretionary sector. During the period, we exited holdings in Bank of America (BAC) and OneMain (OMF) in the financials sector, T-Mobile (TMUS) in the communication services sector, CVS Health (CVS) and Tenet Healthcare (THC) in the health care sector and SolarEdge Technologies (SEDG) in the IT sector.

Sam Peters, CFA, Managing Director, Portfolio Manager

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

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