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By Derek Deutsch | Mary Jane McQuillen
Seeding Sustainability Enablers in Tech
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, industrials and materials sectors led the benchmark Russell 3000 Index, which rose 7.18%. Weakness in mega cap companies dragged down the consumer discretionary and communication services sectors as a mixture of ending pandemic-era tailwinds, rising costs in a tighter monetary environment and nascent fears of slower spending in 2023 took hold.
Against this backdrop the Strategy modestly trailed the index, with our consumer discretionary and real estate positioning contributing strongly but being offset by weakness in the industrials, utilities and consumer staples sectors primarily.
Growing macroeconomic concerns weighed on mega cap names in the portfolio, with consumer discretionary holding Amazon (AMZN) feeling pressure from a slowing macroeconomic environment that could weigh on e-commerce and AWS segments. Our underweight position, combined with our not owning Tesla (TSLA), whose shares dropped 54%, drove strong relative consumer discretionary performance. Also in the sector, Nike (NKE) delivered an earnings beat driven by stronger revenue (particularly from North America) and better gross margins. Nike has been pressured by an uneven global recovery that led to surplus inventory. While near-term earnings estimates may have some risk, much of the multiple contraction is in the current value of Nike shares and sentiment has shifted, with the shares bouncing ~40% higher during the quarter.
Real estate holdings Equinix (EQIX) and Prologis (PLD) were standouts in a sector challenged by materially higher interest rates. Equinix is a best-in-class data center REIT with record leasing and backlog and a conservative balance sheet that should position it well in a downturn. Logistics real estate, meanwhile, has some of the most attractive market dynamics of all real estate subsectors, and Prologis is a clear leader within the group. Logistics real estate should continue to benefit from secular tailwinds of rising e-commerce penetration, ever faster delivery times, and supply chain resiliency (“just in case”).
Our industrials overweight was beneficial in the fourth quarter, as was strong performance from Deere, which continues to thrive from a strong upgrade cycle as record farmers’ income is driving broad and rapid adoption of the company’s precision agricultural equipment. Weaker relative performance in the sector was driven by Regal Rexnord, a diversified industrial company focusing on electric motors, electrical motion controls, power generation and power transmission products and a large active position in the portfolio, when it announced it would be acquiring peer Altra Industrial Motion in an all-cash deal. Shares of Regal Rexnord fell on the news as often happens to acquirers in M&A transactions, but we are confident the market will reward the synergies as well as the scale and diversification offered by the deal over time.
Rising interest rates remain the key risk to renewables utility Brookfield Renewable (BEP), an underperformer in the fourth quarter, though we view Brookfield’s stable fundamentals (with >90% of contracted cash flows having an average term of 14 years), inflation protection (~70% of power purchase agreements are indexed to inflation) and long-term growth opportunities as attractive in the current environment. Brookfield’s balance sheet is also relatively well-protected against rising rates given it has 97% fixed-rate debt with an average term to maturity of 12 years.
In consumer staples, Costco (COST) was slightly down on an earnings miss in its latest financial results, driven by weaker general merchandise sales in November and increased clearance activities.
Biotechnology stocks led our health care holdings: Gilead Sciences (GILD) shares rose sharply following strong quarterly results driven by increased sales of its HIV, cell therapy, hepatitis C and Trodelvy products, while BioMarin Pharmaceutical (BMRN), which researches and develops treatments for rare and orphan diseases, many of which are life threatening or limiting, has delivered a strong launch for Voxzogo, which treats dwarfism, and we expect approval for Roctavian, a Hemophilia A gene therapy. The Voxzogo trajectory and upcoming launch of Roctavian should give BioMarin strong near-term growth drivers while it continues to focus on early-stage opportunities.
Portfolio Positioning
We were active in a volatile quarter positioning the portfolio, in particular in the IT sector, where we added Accenture (ACN) and ASML, making room for them with the sales of Workday and Intel.
Accenture is a leading global professional services company that helps clients build their digital infrastructure and optimize their operations. We view Accenture as a resilient, high-quality business with consistent earnings and cash flow, a strong balance sheet and very attractive returns on capital. Secular drivers like cloud migration and digital transformation, as well as new, innovative technology deployments like data security, block chain, AI and machine learning position Accenture well for continued growth. It is also currently rolling out a suite of sustainability tools that offers a comprehensive view of a company’s goals, progress and performance across financial and ESG measures, so it is an enabler of ESG for its clients. We exited our position in software-as-a-service company Workday to fund the position, largely on better relative risk/reward, in our view.
ASML makes semiconductor chip manufacturing equipment and is a leading supplier of lithography systems to the semiconductor industry. We expect ASML to grow above expectations as its innovative EUV technology is deployed and industry capacity expands. This in turn should lead to margin expansion and earnings leverage. In addition to more visible growth and profitability drivers relative to Intel, ASML also has a stronger balance sheet and higher returns on capital. As a semiconductor capital equipment provider, ASML directly improves the energy efficiency of semiconductor manufacturing, and governance and diversity initiatives at ASML are best in class.
Improving health care outcomes continues to be a major theme in the portfolio. Novo Nordisk (NVO), a new health care position, is the leading provider of diabetes-care products in the world, with almost 50% market share by volume of the global insulin market. The company manufactures and markets a variety of human and modern insulins, injectable diabetes treatments and oral antidiabetic agents. Novo also has a biopharmaceutical segment (constituting roughly 15% of revenue) that specializes in protein therapies for hemophilia and other disorders. Novo has one of the longest histories in the sector of integrating ESG principles into its strategy and compensation. It invests heavily to address unmet needs in diabetes and obesity, delivering breakthrough medications in both areas, and is singlehandedly developing the commercial market for Rx treatment of obesity. The company’s access programs in both developed and lower-income countries are among the most generous and mature, including numerical targets and integration with compensation.
Outlook
The market saw some major multiple compression in 2022, sparked by a significant increase in the discount rate, which reduced the value of future cash flows. It has begun to price in a more subdued outlook for 2023, and while we expect a recession in the coming quarters, its severity is difficult to predict. While weakness in 2022 has improved valuations in many areas of the market, offering some attractive entry points such as those on which we have already capitalized, we are cognizant of the possibility further monetary tightening could lead to more pressure, and negative earnings revisions could create further downside. At the same time, cooling inflation and a potential Fed pivot in the coming quarters would be potential positive catalysts. There is no change, however, to our belief that owning high-quality companies with excellent sustainability profiles will generate outperformance through a full market cycle.
Portfolio Highlights
The ClearBridge Sustainability Leaders Strategy underperformed its Russell 3000 Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in eight of 10 sectors in which it was invested (out of 11 sectors total). The main contributors were the health care, financials and IT sectors, while the communication services and utilities sectors were the detractors.
On a relative basis, overall stock selection was beneficial while sector allocation detracted from performance. Stock selection in the industrials, utilities, consumer staples and materials sectors were the main detractors; a lack of holdings in the energy sector also weighed on relative results. Conversely, stock selection in the consumer discretionary and real estate sectors was positive, as was a communication services underweight.
On an individual stock basis, Gilead Sciences, Deere (DE), Nike, Hartford Financial Services (HIG) and BlackRock (BLK) were the largest contributors to absolute performance in the quarter. The main detractors from absolute returns were positions in Amazon.com, Regal Rexnord (RRX), Apple (AAPL), Brookfield Renewable and Progyny (PGNY).
In addition to portfolio activity outlined above, we exited positions in Hasbro (HAS) and Marriott International (MAR) in the consumer discretionary sector.
ESG Highlights
Governance Changes Can Move the Needle
As one breaks down the components of ESG, governance comes last in the set, but it is often the first and most foundational element for active investors seeking to improve sustainability practices at companies in which they invest. Overall corporate structure, board composition and business ethics are central in creating long-term value. At the same time, in terms of effecting real change, as the World Economic Forum notes, “effective corporate governance is essential to ensuring that ESG enthusiasm translates into concrete action and systemic change.”1 Many companies also view incorporating ESG factors into corporate strategy as tied to revenue growth and resilience to increasing ESG risks (Exhibit 1).
Exhibit 1: ESG Factors Can Be Key to Corporate Strategy
| Source: EY Long-term Value and Corporate Governance Survey, February 2022 (total respondents 200 companies split across 15 European countries and 25 industry segments). |
ClearBridge regularly engages holdings on governance factors such as resource allocation and board composition and oversight in order to lay the foundation for long-term value creation and sustainability improvements. Other topics include audit controls, board effectiveness, capital allocation practices, executive compensation, operating best practices, quality and integrity of management and shareholder rights and controls. Like engagements targeting environmental and social improvements, governance engagements can take place over extended periods of time and involve other stakeholder voices. They too offer insights on the kinds of impact ClearBridge’s approach to active ownership can have on and through public equities.
Governance questions are also thoroughly integrated into how ClearBridge votes proxies and builds proprietary ESG ratings. In terms of proxies, our policy is to vote for management proposals supporting nomination of most qualified candidates, inclusive of a diverse pool of women and people of color, to the board of directors and senior management levels. However, ClearBridge will withhold our vote from a director nominee on the nominating committee when there is no gender diversity and no racial/ethnic diversity on the board (or those currently proposed for election to the board do not meet that criterion). We will vote for shareholder proposals requesting comprehensive disclosure on board and employee diversity and those requesting comprehensive reports on gender and racial pay disparity.
It is also our policy to vote against proposals to create dual share classes unless it is intended for financing purposes with minimal or no dilution to current shareholders and provided it is not designed to preserve the voting power of an insider or significant shareholder.
For management proposals on executive compensation, when management and an external service provider disagree, our policy is to take into account: company performance over the last one-, three- and five-year periods on a total shareholder return basis; performance metrics for short- and long-term incentive programs; and CEO pay relative to company performance, among other factors. Increasingly, we are asking our companies to include ESG performance factors such as environmental and safety goals or diversity, equity and inclusion in CEO and named executive officers’ compensation.
We also have governance factors such as those listed above built in to all proprietary ClearBridge ESG ratings for companies owned and under active coverage. Along the same lines, governance is an important part of our determination of sustainable investments under Europe’s Sustainable Finance Disclosure Regulation. ClearBridge’s own governance of climate-related risks and opportunities also features prominently in our TCFD Climate Report.
Cellnex Hears Shareholder Voices on Capital Allocation
Engaging a company on strategy can sometimes lead to concrete changes. Capital allocation, for example, is a fundamental corporate governance consideration. It is directly relevant to the interests of shareholders, stakeholders and a company’s long-term success. Capital allocation is closely connected to questions of company purpose, strategy, business model, risk appetite and public disclosures – and, ultimately, to a company’s ability to generate sustainable returns. Key capital allocation themes could include the use of debt leverage, the appropriateness of dividend policy and share buybacks, the level of capital spending and executive pay structures — all areas that can involve difficult tradeoffs that balance the interests of shareholders and other company stakeholders, such as employees and customers.
In an October 2022 engagement with Spanish wireless telecom company and ClearBridge portfolio holding Cellnex (OTCPK:CLNXF), we encouraged the company to embrace a fiscally responsible strategy in order to protect the business in a high interest rate environment. In a proactive dialogue with Cellnex management on governance and shareholder feedback, we conveyed our recommendations for a necessary shift in capital allocation and strategic priorities. We insisted that: 1) shareholders and bondholders are unwilling to provide capital for large acquisitions, which increase leverage and uncertainty; 2) Cellnex should commit to obtain an investment grade credit rating, which will limit cost of capital increases; 3) management should focus on refinancing debt maturities immediately to avoid liquidity drying up next year; 4) focus on the balance sheet debt leverage should take priority over dividends and share buybacks.
Cellnex’s response during the meeting was thoughtful and receptive. The CFO expressed the company’s fiduciary responsibility to allocate capital only in a way that enhances shareholder value and stressed the importance of growing alongside its telecom customers, building its networks and investing in projects that save customers money and provide good returns for Cellnex at the same time. He provided updates about financial and refinancing risk management, including: 1) inflation indexation of lease contracts that accelerates earnings in an inflationary environment; 2) $3 billion of available undrawn credit lines that are enough to refinance debt maturities in 2023 and 2024, before free cash flow turns positive from 2025 onward, supporting the refinancing of large maturities in 2026; 3) options to sell assets as a measure of last resort.
In a follow-up call in November, Cellnex announced it would make all the strategic changes we asked it to consider. The CFO acknowledged the current environment provides new factors to take into consideration in Cellnex’s decision process, and said the company is listening to the market. He shared Cellnex’s new unconditional commitment to an investment grade rating. This would include a commitment to 2025 financial guidance, a clear capital allocation framework with conservative assumptions, a focus on organic growth with limited capex and high-return projects, limited M&A activity, and a focus on free cash flow, with excess cash deployed in the best interest of maximum long-term shareholder value. The company now expects free cash flow will exceed debt maturities after 2024.
This ESG engagement was a successful example of an impactful dialogue with management, where concrete results were achieved and real shareholder value was created. ClearBridge was just one voice contributing to the realignment of the company’s strategy, but it was encouraging to witness an overhaul of management priorities that fully matched our clearly communicated recommendations.
Cellnex’s ability and willingness to adapt reduced business and financial risk and significantly lowered the likelihood of a large downside to the share price. This brought a significant positive change in our investment thesis, as we were able to incorporate a lower risk outlook for the company and lift our price target. For example, as a result of the changes, Cellnex bond spreads improved by 180 basis points to 280 basis points, while its 10-year bond yield declined from 6.6% to 5.1% within a span of roughly three weeks, lowering Cellnex’s cost of capital.
Governance Can Strengthen Overall Corporate Sustainability
Governance also provides a direct link to developing strong sustainability practices at a company. Managed care company and ClearBridge holding UnitedHealth Group (UNH), for example, has been making important governance changes in response to investor feedback, with sustainability a growing priority. The company has historically faced criticism, from ClearBridge and other investors, for the long tenure of its board of directors. In response, it has turned over seven board seats in the past five years and split the chairman and CEO roles.
A related change is that, as sustainability has increased in importance, UnitedHealth has revamped and elevated board oversight of ESG. Now the Governance Committee of the board is charged with oversight of UnitedHealth’s ESG initiatives and progress. The company also appointed a corporate Chief Sustainability Officer who is part of the office of the CEO, reports directly to the CEO and attends and presents at each Governance Committee meeting.
Part of UnitedHealth’s existing strong ESG profile has been a focus on “health equity” as it seeks to raise the standard of care in underserved communities in the U.S. This focus includes screening Medicare members for basic social needs such as nutrition and housing, establishing local pharmacies, improving mortality and life expectancy for African Americans, especially women, and addressing mental/behavioral health, with a heightened focus on teenagers. UnitedHealth has also made a $100 million commitment to improving the diversity of the U.S. health care workforce and to enhance what it views as “culturally competent care.” It expects to train 5,000 new minority clinicians and provide “upskilling” for an additional 5,000.
Another recent governance change at UnitedHealth has been the placement of its health care equity goals, in addition to its clinical policy, under the oversight of the board’s Health and Clinical Practices Policy Committee. Also, the Audit Committee will review the quality and accuracy of all ESG disclosures.
Overall, the establishment of a corporate sustainability function that collaborates with the core business functions represents important progress on sustainability at UnitedHealth over the past year, and is a good example of how the voice of ClearBridge and others calling for governance improvements can help improve sustainability practices as well.
Derek Deutsch, CFA, Managing Director, Portfolio Manager
Mary Jane McQuillen, Head of ESG, Portfolio Manager
Footnotes1 World Economic Forum, “Defining the ‘G’ in ESG. Governance Factors at the Heart of Sustainable Business, June 2022. 2 This position applies to Anglo markets, defined as the U.S., Canada, the U.K., Ireland, Australia and New Zealand. 3 George Dallas, “Capital allocation: A governance perspective,” Capital allocation: A governance perspective | Ethical Boardroom |
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