ClearBridge Large Cap Value Strategy Q1 2022 Commentary

Market Overview

Following a period of robust multiyear returns, stocks declined during the first quarter as investors grew increasingly concerned with the Federal Reserve ending its extraordinarily accommodative policy and the benefits of aggressive fiscal policy beginning to wane. The Russell 1000 Value Index was down 0.74% while the Russell 1000 Growth Index fell 9.04%. Nine of 11 S&P 500 Index sectors were negative. Inflation reached a 40-year high even before the Russian invasion of Ukraine, which only exacerbated the problem. As a result, the Federal Reserve took an increasingly hawkish stance, signaling multiple rate hikes in 2022, with the first 25 basis point increase in March.

U.S. 10-year Treasury yields jumped from 1.6% to as high as 2.5% during the quarter before ending the period at 2.3%. Mortgage rates spiked, with 30-year rates approaching 4.7%, the highest we’ve seen since the Global Financial Crisis (they averaged under 3% in 2021). All the while the yield curve flattened and came close to inverting; some economists view an inverted yield curve as an early warning sign of a recession in the next 12–18 months and doubt the Fed’s ability to orchestrate a soft landing.

Markets responded with volatility: the Nasdaq entered correction territory in January, the S&P 500 followed in February and the Dow in early March, though all rebounded after the FOMC’s rate hike on March 16. As short-term rates rose and long-term yields edged down, economically sensitive banks such as portfolio holdings JPMorgan Chase (JPM) and Bank of America (BAC) sold off.

Commodity prices were white-hot, with crude oil touching $120 per barrel before finishing the quarter at $100, up nearly 70% over the one-year period. The S&P GSCI Index, which tracks a range of commodities futures, including agriculture, livestock and precious metals, rose 29% in the first quarter, the highest since 1990.

The energy sector, which led a strong market in 2021, generated even more dramatic relative performance in the quarter, advancing 39% and leading the benchmark Russell 1000 Value Index. Years of restrained investment in the energy sector, combined with a strong post-pandemic recovery, contributed to the higher commodity prices. The upward pressure escalated with the Russian invasion of Ukraine. Our energy holdings ConocoPhillips (COP) and Chevron (CVX) benefited from higher commodity prices and were among the top contributors to first-quarter performance.

Energy shortages in Europe were only intensified by the invasion. The conflict and economic sanctions against Russia have brought to the forefront EU dependence on Russian oil and natural gas. As Germany and its EU neighbors look to diversify their natural gas suppliers, some U.S. companies stand to benefit. Within the portfolio, Sempra Energy (SRE) is well-positioned. Sempra’s previously underappreciated portfolio of infrastructure assets, with existing as well as prospective liquified natural gas (LNG) facilities, should benefit from renewed interest in U.S.-sourced LNG. The U.S. commitment to increase LNG exports to Europe over the coming years should create a favorable long-term demand environment and hopefully regulatory framework benefiting Sempra along with other natural gas and LNG suppliers. Sempra’s core utilities operations in California and Texas continue to generate solid mid- to high-single-digit earnings growth, and it enjoys additional growth opportunities from renewable natural gas (RNG), hydrogen and other renewable sources of energy.

The Strategy’s defense stocks, Raytheon Technologies (RTX) and Northrup Grumman (NOC), made strong contributions as the war in Ukraine led to a major re-evaluation of long-standing policies by European allies, with major NATO countries committing to increase defense spending, as well as a change in sentiment toward the defense industry in the U.S.

Industrials holding Deere (DE) was also a strong contributor to performance during the quarter. Through its unmatched 5,000 dealer network across 160 countries, Deere is a major global player in agricultural, construction and forestry equipment, with a particularly dominant position in U.S. agriculture. Deere’s moat around its core equipment capabilities, coupled with years of substantial investments in technology and innovation, further extends its competitive advantage into precision agriculture, which allows for higher farm yields with lower use of fertilizers, pesticides and water, thereby improving farmers’ bottom lines while reducing their environmental footprint. In addition to drought conditions in Latin America, the war between Russia and Ukraine, two major exporters of corn and wheat, is further disrupting the global agricultural commodities market and pushing prices even higher. This should mean higher farmer revenues and greater demand for Deere’s equipment, which is further supported by some of the lowest levels of inventory of new and used equipment on record.

While commodities-exposed areas of the materials sector such as mining and steel fared well in the quarter, we tend to have less direct exposure to commodities across our portfolio. Holdings like industrial gas company Air Products and Chemicals (APD) and paint and coating company PPG Industries (PPG) that use natural gas and oil related products as feedstock into their products faced sharp input cost escalation, driving meaningful margin compression, which was not well-received by investors. While negative in the short term, we remain confident that both companies will be able to adjust pricing accordingly and recover margins over the medium term.

Vertiv (VRT), whose core data center infrastructure business is seeing strong demand growth, struggled in the first quarter as it was too slow to adjust pricing to appropriately recover higher costs attributable to broad-based COVID-19-related supply chain challenges and critical parts shortages. While we are disappointed with the company’s recent results, we expect improved operational performance over the coming quarters.

Portfolio Positioning

We were aggressive in taking advantage of opportunities the COVID-19-driven selloff provided in 2020 and early 2021, adding to holdings in financial services, technology and consumer discretionary. In the first quarter of 2022, we continued to unwind some of those positions to manage overall portfolio exposures.

On the consumer side, we harvested profits by exiting Capital One Financial (COF) after it had a strong run following our late 2020 purchase; we also trimmed positions in online travel company Booking (BKNG) and off-brand retailer TJX Companies (TJX).

Recalibrating our semiconductor exposure, we sold NXP Semiconductors (NXPI), which sells into the automotive market, and trimmed Qualcomm (QCOM), a key chip supplier for mobile handsets. We used the funds to buy Intel (INTC), which should benefit from the U.S. reshoring of semiconductor manufacturing while the company embarks on its dual strategy of regaining technological leadership and becoming a major global foundry player. Meanwhile, we continue to like and maintain our exposure to TE Connectivity (TEL), which makes connectors for a wide range of end markets, from automobiles to data centers and medical devices, and whose long-term opportunities, helped by its diversified businesses, remain strong.

We also added to Charter Communications (CHTR), a historically strong performer that has faced headwinds recently due to a deceleration in broadband subscriber growth following a period of robust results during the pandemic. Additionally, we added to our position in Alphabet (GOOG), whose valuation we found attractive amid the market selloff early in the quarter, particularly given its dominant position in search, its scaling opportunities in cloud services, and its relative insulation from Apple’s (AAPL) privacy initiatives, which do not affect Alphabet’s core search business the way they do other large tech platforms.

Outlook

We remain positive on the medium- and long-term outlook for equities, although we acknowledge the uncertainty created by a change in Federal Reserve policy and the potential for a reduction in fiscal stimulus. During periods of uncertainty, it is as important as ever to maintain our focus on high-quality companies with sustainable competitive advantages, while opportunistically taking advantage of market dislocations as they present themselves. Our holdings are not immune to economic cycles, but we believe they are well-positioned to persevere through challenges and take share over time.

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 gains in four of the 11 sectors in which it was invested for the quarter. The strongest contributions came from the energy, utilities and health care sectors. The information technology (IT), materials and consumer discretionary sectors were the main detractors.

On a relative basis, overall stock selection and sector allocation detracted from performance. In particular, stock selection in the materials, communication services and IT sectors weighed on relative returns. Conversely, stock selection in the industrials, utilities, health care and financials sectors proved positive. An overweight to the IT sector detracted.

On an individual stock basis, the largest contributors were ConocoPhillips, Sempra Energy, Chevron, Deere and American Express (AXP). Positions in Vertiv, TE Connectivity, Home Depot (HD), JPMorgan Chase and PPG Industries were the main detractors.

Besides portfolio activity discussed above, during the quarter we exited a position in T-Mobile (TMUS), in the communication services sector.

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