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By Peter Bourbeau | Margaret Vitrano
Leaning on Health Care Starts to Pay Off
Market Overview
Equities pushed higher in the fourth quarter, ending a volatile year where soaring inflation led to a historic tightening of financial conditions. The S&P 500 Index rose 7.56% for the quarter but finished down 18.11% for the year, its worst annual showing since 2008. With the Federal Reserve raising interest rates by 425 basis points, its most aggressive campaign since the 1980s, long-duration growth stocks bore the brunt of the selling. The benchmark Russell 1000 Growth Index gained 2.20% for the quarter but was 29.14% lower for 2022. Value shares held up better as investors expressed a preference for current profitability, with the Russell 1000 Value Index up 12.42% for the quarter and down 7.54% for the year.
From a sector perspective, defensive and cyclical sectors delivered the best performance in the benchmark, led by utilities (+16.56%), industrials (+15.41%), health care (+13.07%), energy (+12.83%) and consumer staples (+10.01%). Financials (+9.48%), materials (+8.93%) and real estate (+3.55%) also outperformed the benchmark. While the longer-duration, higher-beta information technology (IT, +3.38%) sector finished ahead of the index, the similarly positioned consumer discretionary (-15.65%) and communication services (-6.94%) sectors underperformed meaningfully.
Better than expected corporate earnings and initial signs that inflation may have peaked supported stocks during the quarter, leading to double-digit gains across the market in October and November. But gains were pared in December as the Fed pushed through a 50 bps rate hike on top of a 75 bps move the previous month and indicated that it would keep rates higher for longer to ensure structural inflation does not take hold. Such rhetoric confirmed the views of many pundits that the U.S. economy will fall into recession in 2023 (Exhibit 1).
Exhibit 1: Recession a High Probability in 2023
Data as of Dec. 31, 2022. Source: Federal Reserve Bank of Philadelphia, FactSet.
We have been cautious on the economy and markets for some time, positioning the ClearBridge Large Cap Growth Strategy accordingly for the current environment and what will likely be another unsettled year ahead. As a result of moves solidified during the year, the Strategy outperformed the benchmark in the fourth quarter. Despite negative absolute performance for the year, we are encouraged that our efforts to establish more portfolio balance through a focus on durable businesses and risk management are beginning to show results.
In past commentaries we have highlighted three ways to deliver performance through the bear market. The first is to purchase growth companies that have already suffered losses and seen their earnings outlook reset lower. Nike has been pressured by an uneven global recovery that led to surplus inventory. We added to the position earlier in the year with the view that its inventory write-down should not derail the company’s long-term high-single-digit revenue growth or the margin expansion from its enhanced focus on the direct-to-consumer business. While near-term earnings estimates may have some risk, much of the multiple contraction is in the current value of Nike (NKE) shares and sentiment has shifted, with the shares bouncing 40% higher during the quarter. Netflix (NFLX) is another earnings reset name that has taken decisive actions, developing an ad-supported subscription tier and cracking down on password sharing, that have helped its shares rerate strongly.
“Within secular growth, our asset light industrials names have flexed their strength through the bear market.”
A second way to generate alpha is through ownership of high-quality secular growth companies with countercyclical characteristics. These include several of the health care positions we have added in the last 18 months that were impacted by FX and supply chain headwinds earlier in the year but are now benefiting from the return of elective medical procedures. Advanced medical device makers Intuitive Surgical (ISRG) and Stryker (SYK) have rebounded strongly as hospitals and other payors fund the profitable surgical procedures where they supply robotics-assisted surgical tools and orthopedic implants. DexCom (DXCM), a leading developer of continuous glucose monitoring systems for diabetes care, has also seen its shares rerate as new patient additions accelerated in the second half of the year.
Also within the secular category, our asset-light industrials names have flexed their strength through the bear market. Eaton (ETN) is positioned in the sweet spot of several secular trends: two-way electricity solutions, microgrids and charging infrastructure for electric vehicles. While the company’s housing business is susceptible to near-term weakness, we believe Eaton can grow revenues in the mid-to-high single digits for several decades as its core utility customers have the rate base to cover ongoing electric infrastructure upgrades and buildouts. W.W. Grainger (GWW) also has a visible growth runway, with less than 10% market share in a highly fragmented maintenance, repair and operations business. The company cut catalog prices early in the pandemic to maintain revenues and is now benefiting from its Zoro online platform growing revenues at a high-double-digit rate.
A third approach to return generation is purchasing idiosyncratic businesses that largely control their own destiny. We saw mixed results from this group in the fourth quarter, with paint and coatings maker Sherwin Williams (SHW) benefiting from significant pricing power that will allow it to grow earnings handsomely with only modest revenue increases. Chipmaker Intel (INTC), which we purchased in the first quarter on the premise that it would develop a leading domestic foundry business, has struggled with execution missteps and product delays. We are maintaining the position to provide ongoing exposure to semiconductors.
Portfolio Positioning
Promoting diversification and managing risk continue to guide our transaction activity, with a focus on the earnings trajectory of existing and potential holdings leading to our most recent moves. We are directing our research efforts to identifying names that are closer to the bottom than the top in terms of earnings and valuations, adding to our positions in ASML, the leading supplier of high-end production equipment to chip makers, and Nvidia NVDA, whose valuation has washed out due to weakness in gaming and crypto mining as well as slowing enterprise spending. At the same time, we have been trimming names with more near-term risk due to exposure to a weakening consumer (Tractor Supply), and more discretionary IT spending (Workday, Palo Alto Networks). In addition, we have selectively been taking profits in strong recent performers like Thermo Fisher Scientific (TMO), where a COVID-related revenue surge is starting to normalize.
Walt Disney (DIS) is another name with significant exposure to consumer spending that is showing early signs of weakening. We decided to exit the name as its traditional linear programming business is dissolving more quickly than expected, while its Disney+ streaming business cannot offset the affiliate fees and advertising revenue that the company has relied on for years. Disney’s parks business has done well recently due to strong pricing power but we have concerns that consumers will continue to spend on such discretionary purchases in a recessionary environment. At this point in the cycle, we believe Netflix has more ways to innovate and improve profitability.
The appearance of attractive entry points due to negative earnings revisions led to the initiation of two new positions during the quarter: Estee Lauder (EL) and Tesla (TSLA). Estee Lauder, which manufactures and markets cosmetics, fragrances, skin and hair care products across a number of well-known global brands including Clinique, MAC and Bobbi Brown, adds to our group of secular growers. Estee Lauder is a global leader in the prestige beauty space, which has outgrown the broader home and personal care category since 2010 and has historically been recession resilient. The company has substantial brand and pricing power and is overindexed to the highly profitable prestige skin care category. We believe the company’s most recent earnings report and 2023 guidance update, which was cut significantly due to uncertainty over China’s zero-COVID policy (China and travel retail are key growth drivers), provided an attractive entry point. At this point, we believe the stock has been significantly derisked and could see potential upside from a China recovery.
Tesla, meanwhile, also fits squarely within our earnings reset group. We took advantage of its enterprise multiple falling back to historic lows to initiate a starter position in the leading manufacturer of electric vehicles (EV) and developer of battery technologies. Tesla has a significant structural cost advantage in battery production, EV manufacturing and EV selling, which gives it industry-leading operating margins in EVs. As the auto cycle has softened, the stock has sold off substantially with the rest of the automakers, despite EVs continuing to have a secular growth advantage. Tesla has a clean balance sheet with negative net debt and enormous revenue growth, EBITDA growth and free cash flow generation. Its margin buffer also gives the company the ability to cut prices while still protecting earnings better than competitors, which should help support continued volume growth. There is also significant upside optionality driven by its software offerings, which we do not believe is currently priced into the stock.
That being said, Tesla is highly indexed to a flagging auto market and we expect its earnings outlook to worsen in the near term. We are also monitoring increasing EV competition and the recently emerging risks to the brand and management integrity raised by CEO Elon Musk’s actions at Twitter to determine future position size in the portfolio.
Outlook
Corporate earnings expectations retreated during the fourth quarter, declining 2.8%, the first year-over-year earnings decline since the third quarter of 2020, according to FactSet. As of mid-December, 63 S&P 500 companies had issued negative forward guidance compared to 34 reporting positive projections. We think these trends underestimate the downward earnings revisions still to come and will be closely monitoring the guidance provided by portfolio companies during the upcoming quarterly reporting period.
We see the economic environment as weak and getting weaker, with pain still to be felt on both the corporate and consumer side as the hammer of monetary policy, which acts with a lag, begins to be felt. Led by IT and shadow tech, companies are looking for any way to cut costs, with layoffs increasing among the largest growth companies, including Meta Platforms (META) and Salesforce (CRM). The pandemic savings accumulated by households are eroding, with retail sales likely to struggle in the year ahead. While the consumer remains in good fiscal shape, credit is starting to worsen and it’s totally normal to expect a credit cycle to take hold at this stage of an economic contraction. Paradoxically, a slowdown in inflation could also create headwinds: retailers no longer able to lean on price as a revenue driver may see margins contract.
Mega cap growth companies are struggling as much as other businesses due to downstream weakness of their clients. Cloud spending is being hurt by budget constraints of buyers, the advertising business is slowing and management confidence is being challenged by increasingly negative data prints. In short, all signs point to a challenging earnings year. Despite so much uncertainty, we maintain confidence in our portfolio as the active positioning we have put in place is enabling leadership franchises to flex their advantages.
Portfolio Highlights
The ClearBridge Large Cap Growth Strategy outperformed its benchmark in the fourth quarter. On an absolute basis, the Strategy posted gains across seven of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the health care and industrials sectors while the primary detractor was the consumer discretionary sector.
Relative to the benchmark, overall stock selection and sector allocation contributed to performance. In particular, stock selection in the consumer discretionary, consumer staples and real estate sectors, overweights to the health care and industrials sectors and underweights to the consumer discretionary and communication services sectors supported results. Conversely, stock selection in the IT and industrials sectors and an underweight to consumer staples detracted from performance.
On an individual stock basis, the leading absolute contributors were positions in Visa (V), Nike, Intuitive Surgical, DexCom and Nvidia. The primary detractors were Amazon.com (AMZN), Atlassian, Meta Platforms, Palo Alto Networks (PANW) and PayPal (PYPL).
Peter Bourbeau, Portfolio Manager
Margaret Vitrano, Managing Director, Portfolio Manager
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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.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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