NicolasMcComber
By Evan Bauman | Peter Bourbeau | Aram Green | Margaret Vitrano
Health Care Proves Its Mettle
Market Overview
Stocks endured a seesaw summer that ended with broad losses as macroeconomic headlines around inflation, interest rate hikes and continuing concerns about a slowing economy presented headwinds. The S&P 500 Index fell 4.9% for the quarter and is down 23.9% year to date, its worst showing at this point since 2002.
Small caps showed more resilience with the Russell 2000 Index down 2.2% for the quarter. Meanwhile, growth stocks held up better than value with the benchmark Russell 3000 Growth Index declining 3.4% for the quarter compared to a loss of 5.6% for the Russell 3000 Value Index. Growth, however, still trails value by nearly 1,300 basis points year to date.
While the first six weeks of the quarter saw equities rally, the last six weeks were dominated by efforts to quell inflation capped by a 75 basis point rate hike by the Federal Reserve in September, its third such move of the year. The 10-year U.S. Treasury yield climbed 82 bps to finish at 3.83%, near its highest levels in over a decade. Rising rates are particularly trying for long-duration growth companies that make up the largest weightings in the benchmark.
We manage the ClearBridge All Cap Growth Strategy with a focus on diversification across different types of growth companies, balancing quality compounders with higher growth disruptive businesses and taking a defensive positioning posture. We look for durable and defensible business models that can withstand periods of economic stress like what we’ve been going through for the last several months, as well as the last few years. That divergence, reflected in the Strategy’s high active share, proved beneficial in the third quarter and led to performance in line with the benchmark.
Recent performance is encouraging as 2022 has been a particularly challenging year for us as active managers. Several of our traditionally defensive businesses, like eye care products maker Alcon (ALC), for example, have not behaved that way through the current bear market despite maintaining solid fundamentals and execution.
We don’t take solace in the fact that we are not alone, as our mega-cap-heavy index continues to outperform most active strategies. We attribute this to the unique behavior of some of the largest constituents in the index that have outperformed in up periods and exhibited resilience during drawdowns.
Instead, the best approach we can take at this point is to stick with our process of fundamental, bottom-up research and stock selection with an eye on how each buy, sell, add or trim impacts the portfolio’s overall risk/reward. Through the two and half years since COVID-19 struck, we have prudently transitioned the portfolio into companies that possess what we view as the most attractive growth profiles over the next three to five years.
As a result, our active share has steadily risen, highlighted by meaningful overweights to health care and communication services as well as the software and services areas of IT, and underweights in consumer discretionary as well as IT overall.
“Our active share has steadily risen, highlighted by meaningful overweights to health care, industrials, software and IT services.”
The Strategy’s differentiated exposure in the health care sector proved beneficial during the third quarter. These tend to be companies generally resilient to economic woes. While we continue to expand our health care coverage into both higher-growth areas like diagnostics and clinical research and countercyclical areas like medical devices, long-time holdings in biopharmaceutical companies developing new or innovative treatments for unmet medical needs demonstrated their attractiveness in the quarter.
Biogen (BIIB) was the leading contributor among several biopharma names, boosted by positive, pivotal clinical data for its next-generation Alzheimer’s treatment lecanemab. In a pivotal trial, the drug proved safe and efficacious in slowing progression of Alzheimer’s disease.
Vertex Pharmaceuticals (VRTX), which has developed the leading treatments for cystic fibrosis, also saw meaningful positive developments in its pipeline in the third quarter around areas like pain, diabetes and blood disorders. Vertex has been able to consistently grow revenues and earnings through the latest period of economic headwinds, enabling investment in R&D to target treatments in these new areas.
We also received meaningful contributions from several disruptive companies across sectors. Within IT, we own companies like Atlassian (TEAM), a leader in the corporate IT workflow space, and Wolfspeed (WOLF), which is using silicon carbide to produce chips that enable and power electric vehicles, one of the largest addressable markets going forward. Similarly, disruptive names in the consumer discretionary sector such as handcrafted goods e-commerce marketplace Etsy (ETSY) and rideshare and food delivery provider Uber (UBER) in industrials executed well during the quarter.
The Strategy was not completely insulated from macro headwinds and some companies saw tough comparisons after strong pull forwards in demand during the COVID-19 pandemic. Media companies including Comcast (CMCSA) and Meta Platforms (META) were hurt by both factors in the quarter.
After extremely strong broadband growth during the early days of the pandemic, Comcast is now experiencing slowing to negative growth in its broadband business due to new competition and less consumer moving activity along with headwinds on the programming side, where advertising budgets have been more stressed.
Meta shares have derated as revenue growth has slowed due to tough comparables to a strong e-commerce environment in early 2021, negative impacts from Apple’s (AAPL) privacy changes and rising expenses. While we have trimmed our position close to 20%, we remain invested as we do not think the stocks’ valuation at about 13x consensus 2023 earnings appropriately reflects its long-term earnings and free cash flow generation potential.
Despite current revenue headwinds, we believe Meta is well-positioned to navigate industrywide changes to advertising targeting and its transition to the Reels short-form video format will monetize in the coming years, helping to re-accelerate revenue growth. We also welcome Meta’s implementation of cost-cutting measures, which should help uncover the company’s high underlying profitability. Lastly, we see Meta’s investments in augmented reality as a call option for long-duration investors.
Within cyclical technology, disk drive makers Seagate Technology (STX) and Western Digital (WDC) and chipmaker Intel (INTC) were hurt by an inventory correction due to slowing growth in their core PC and server markets. While these stocks remain inexpensive on a valuation basis, they clearly saw a business slowdown over the last two quarters.
Portfolio Positioning
Expanding diversification to a greater range of growth companies and improving risk management have guided repositioning over the last year. The outcome of these efforts is a more balanced and diversified portfolio of companies with a stronger growth profile that maintains a valuation discount compared to the benchmark.
As long-term investors, we have approached these moves in a thoughtful way, reducing positions when short-term headwinds cause us to re-examine our investment thesis and only exiting names when we believe with certainty that the reason for owning them no longer applies.
Over the last three months, we exited UiPath (PATH) due to a change to our original thesis as we believe a new go-to-market strategy for its automation software could impact near-term execution. While we think process automation is a growing market, in a slowing macro environment single solutions may be more vulnerable than the platform solutions of software providers who can bundle products to meet a wide range of needs. In addition, the company has a material component of sales sourced in Europe where the economy is more vulnerable.
We also sold out of payments and financial software maker Fidelity National Information Services (FIS), choosing to concentrate our digital payments exposure in PayPal (PYPL), which we believe has a more attractive risk/reward at these levels and more internal levers to generate returns.
We bought FIS in 2019 for its mix of offense and defense with banking software and services as a stable business and payments that could keep up with fintech. The shares outperformed the benchmark up to the sale, illustrating the resiliency of the core business; however, FIS has underperformed higher-growth payment names.
Outlook
We have seen a number of different bear markets over our tenure managing the Strategy. But the confluence of factors over the last three years has been unprecedented. The pandemic and subsequent supply chain disruptions, the war in Ukraine as well as inflation and subsequent rate hikes have all presented challenges to companies. These disruptions make it more important than ever to own good businesses that generate a lot of cash and with strong balance sheets that enable them to take advantage of dislocations in the market and the economy.
We see three ways to generate returns through the bear market. The first is by owning stocks delivering high-quality organic growth like via a combination of high-single-digit revenue growth, the use of free cash flow to drive buybacks and pulling levers to support earnings growth.
We see a number of these opportunities in health care. The second strategy is to purchase stocks after they have derated and established a lower base for future earnings. These include companies like Netflix (NFLX) and PayPal where final demand is normalizing after a pull-forward during the pandemic. The third strategy is buying growth companies with idiosyncratic or stock-specific catalysts unrelated to the direction of the market like Sherwin-Williams (SHW) and Twitter (TWTR).
There has clearly been a rise in consternation and fear. However, as long-term investors, we can take advantage of these periods. Our goal is to outperform the market over a full three-to-five-year cycle. During these periods of stress we feel that good companies get better and emerge stronger financially and competitively. As high active share managers, these are times when we can add the most value.
Portfolio Highlights
The ClearBridge All Cap Growth Strategy performed in line with its Russell 3000 Growth Index benchmark in the third quarter. On an absolute basis, the Strategy had gains in three of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors were in the health care sector while the main detractors came in IT and communication services.
Relative to the benchmark, overall stock selection contributed to performance but was offset by negative sector allocation effects. In particular, stock selection in the health care and industrials sectors drove results. Conversely, stock selection in the IT and consumer discretionary sectors, an overweight to communication services and an underweight to consumer discretionary weighed on performance.
On an individual stock basis, positions in Biogen, Wolfspeed, Netflix, Amazon.com (AMZN) and PayPal were the leading contributors to absolute returns during the period. The primary detractors were Comcast, Microsoft (MSFT), Meta Platforms, Nvidia (NVDA) and Visa (V).
In addition to the transactions mentioned above, we closed a position in Liberty Broadband (LBRDK) in the communication services sector.
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Past performance is no guarantee of future results. Copyright © 2022 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. Performance source: Internal. Benchmark source: Standard & Poor’s. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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