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By Robert Feitler | Dmitry Khaykin
Pandemic Ripples Still Uncovering Value
Market Overview
Markets returned to positive territory in the fourth quarter as corporate earnings proved more resilient than expected. Hopes that slowing inflation and an end to China’s zero-COVID policy would help soften a potential recession in 2023 gave a cyclical tilt to market returns in the quarter. The energy, materials and industrials sectors led the Russell 1000 Value Index, which rose 12.42%, a solid quarterly gain that the Strategy was able to outpace due to strength in industrials and information technology (IT) stocks in particular.
Our industrials holdings produced robust absolute returns for the quarter. While the ISM Manufacturing Index fell in November to contractionary levels, our industrial holdings have largely been able to maintain earnings due to strong competitive positions, historically large backlogs and company-specific drivers. For example, Deere (DE) continues to benefit from a strong upgrade cycle as record farmers’ income is driving broad and rapid adoption of the company’s precision agricultural equipment. Our aerospace and defense stocks, such as Raytheon Technologies (RTX) and Northrop Grumman (NOC), should continue to benefit from a rebound in commercial air travel and heightened geopolitical tensions around the world.
Within IT, Oracle’s (ORCL) cloud business is gaining broader adoption as its customers continue to move targeted workloads to the cloud. The stock benefited from management expressing a high level of confidence in being able to grow the business at essentially double its historical rate over the medium term. Motorola Solutions (MSI), a long-term holding that provides mission critical communications products and services to public safety and commercial customers, continues to execute at a high level and should see further upside from stimulus money directed toward public safety investments as well as increasing penetration of its software and services offerings.
The risk-on environment supported by China reopening drove strong returns for the energy sector, despite underlying commodity prices falling from recent highs. In the portfolio, leading E&P company ConocoPhillips (COP) was again among the top contributors; it maintains one of the best balance sheets in the industry and continues to execute well while benefiting from being a low-cost producer and growing liquefied natural gas demand. ConocoPhillips is also investing in field electrification and carbon capture across its portfolio, with ambitions to deliver oil production with industry-low CO2 intensity.
“Capital deployed into hydrogen products globally is finally getting noticed as Europe is looking to diversify its natural gas and the IRA benefits domestic investments in renewables.”
In the materials sector, Air Products and Chemicals’ (APD) ability to recover higher energy costs, particularly in Europe as it continues to execute on its growth projects, has helped it to generate a positive return for the year and made it a strong contributor. The capital APD is deploying into hydrogen products globally is finally getting noticed as Europe is looking to diversify away from Russian natural gas and the Inflation Reduction Act (IRA) benefits domestic investments in renewables, such as APD’s $4.5 billion blue hydrogen project in Louisiana and its $4 billion green hydrogen production facility in Texas. APD is also teaming up with World Energy to build a $2.5 billion sustainable aviation fuel production facility in Southern California, a project that should also benefit from the IRA.
Real estate and communication services sectors generated positive returns but lagged others within the Russell 1000 Value Index. The Strategy benefited from its underweight in the real estate sector with American Tower (AMT) as its only holding. REITs are generally perceived to be interest rate sensitive, which negatively impacted American Tower’s recent stock performance. However, we remain confident in the company’s highly durable and predictable business model, which is supported by long-term customer contracts and insatiable wireless data growth.
As a major beneficiary of COVID-19 lockdowns, the communication services sector was particularly weak during the period. Alphabet’s stock declined as investors grew increasingly concerned with slower growth in the face of weaker advertising and tough comps, while the company seems to be reluctant to adjust its cost base to support margins.
Cable stocks have been pressured for the past year as broadband growth has slowed following a pull forward of demand during the pandemic and the industry faces rising competition from wireless carriers offering fixed wireless access. In particular, shares of Charter (CHTR) were pressured by its recently announced multiyear capex plan to accelerate network upgrades. While this reduces free cash flow available for buybacks in the medium term, it sustains the company’s competitive advantage and should accelerate long-term growth. The company also has ambitious goals to expand its footprint into adjacent and rural markets, taking advantage of the federal and state broadband subsidies. We added opportunistically to Charter on the pullback.
We also initiated and subsequently added to a position in Meta Platforms (META) following a 70% year-to-date decline in its shares. Meta shares derated materially in 2022 as revenue growth slowed due to tough comps versus a strong e-commerce environment during COVID-19, privacy changes put in place by Apple (AAPL), and the meteoric rise of rival social media platform TikTok. The company’s valuation declined to a compelling 10x consensus 2023 earnings, which in our view materially undervalued its long-term earnings and free cash flow generation potential. Despite current revenue headwinds, we believe Meta’s massive platform reach should allow it to continue to attract engagement, a metric that appears to be accelerating with the launch of its short-form video product “Reels”. The company’s ability to target potential customers is also set to improve, driven by large investments in artificial intelligence and improved analytical tools to navigate Apple’s privacy policies. We also welcome the company’s increasing financial discipline, including reining in both capex and opex, which should sustain the company’s high underlying profitability and gain back investor confidence. Meta has also done a good amount of work to improve its social media platforms Facebook and Instagram and has best-in-class practices designed to reduced hate speech and improve privacy.
Outlook
The economy has benefited from the massive monetary and fiscal stimulus that began in the early days of the pandemic, pulling forward demand. The transition to tighter policies will lead to an uncertain and more challenging path. The Fed will remain a large swing factor: with a tight labor market still supporting wage inflation, the Fed is committed to preventing inflation from becoming embedded in expectations. Unable to deal with the supply side, it is determined to slow down the economy enough to loosen labor market conditions and avoid a wage-cost spiral. But it has a mixed record of doing this without setting the economy off the rails. As higher interest rates raise costs and slowing demand threatens revenue, we are beginning to see cost-cutting in the form of layoffs, so far mostly in tech and financial services, but these could expand to the broader economy. At the same time, we’re hearing from companies that jobs are hard to fill, due to older workers retiring during COVID-19 and other factors, making management more cautious this time around in reducing headcounts. This is particularly true for companies reliant on high-skilled labor, including many industrials.
From a portfolio perspective, we continue to focus on high-quality companies and look for opportunities to take advantage of dislocations, preferring businesses that would hold up well in a challenging environment. A potential recession in 2023 would not change this approach. Given the high level of macroeconomic uncertainty heading into the new year, we are not trying to position for a particular scenario but believe that a disciplined approach is best, seeking competitively advantaged businesses with strong balance sheets capable of generating strong returns over time.
Portfolio Highlights
The ClearBridge Large Cap Value Strategy outperformed its Russell 1000 Value Index benchmark during the fourth quarter. On an absolute basis, the Strategy had positive contributions from 10 of the 11 sectors in which it was invested for the quarter. The industrials and financials sectors made the strongest contributions, while the real estate sector was the sole detractor.
On a relative basis, overall stock selection and sector allocation contributed positively to performance. In particular, stock selection in the IT, industrials, financials and communication services sectors were positive for relative returns. Conversely, stock selection in the energy sector detracted. In allocation, overweights to the industrials and energy sectors and underweights to the communication services and real estate sectors were positive for relative results, while an overweight to the IT sector detracted.
On an individual stock basis, the largest contributors were Deere, JPMorgan Chase (JPM), ConocoPhillips, Raytheon Technologies and Chevron (CVX). Positions in Alphabet (GOOG, GOOGL), American Tower, Apple, Qualcomm (QCOM) and Dish Network (DISH) were the main underperformers.
Robert Feitler, Portfolio Manager
Dmitry Khaykin, Portfolio Manager
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Past performance is no guarantee of future results. 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. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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