By Robert Feitler and Dmitry Khaykin
Risk Mitigation Is the Other Half of Upside Participation
Market Overview
U.S. equities pulled back from highs reached in the first half of the year due to signs of economic strain, including fears of slowing consumer spending and the prospect of a sustained period of higher interest rates. The benchmark Russell 1000 Value Index receded 3.17%, roughly in line with the broader market.
Supply cuts from OPEC+ combined with lower U.S. inventories pushed oil prices higher, fueling further inflation and interest rate concerns. While this dynamic was positive for the energy sector, it led every other sector to generate negative returns in the quarter. The consumer discretionary sector was the worst performer, as consumer spending showed some cracks across retail and food services. We have been concerned about the economic impact as the massive fiscal stimulus delivered by the U.S. government during the height of COVID gradually lapses, and there are increasingly worrying signs of a pullback in spending, particularly among lower-income cohorts that have fully depleted their excess savings. Alongside the weakening consumer environment, the 10-year U.S. Treasury yield climbed from 3.9% to 4.6% in the quarter, which negatively impacted rate-sensitive sectors such as utilities and real estate.
The Strategy held up well in this environment, outperforming the Russell 1000 Value Index thanks to a mixture of stockpicking and sector positioning. ConocoPhillips (COP), Chevron (CVX), and Enterprise Products Partners L.P. (EPD) were all among the top contributors in a strong quarter for energy, while our cautionary positioning within consumer discretionary along with ongoing risk mitigation efforts contributed as well.
Long-term holdings Charter (CHTR) and Comcast (CMCSA) delivered strong second-quarter results relative to expectations; their stable recurring revenue streams and undemanding valuations were rewarded in the current environment. Cable multiples compressed over the past 24 months on fears of heightened competition in their core broadband business from fixed wireless and fiber providers. While fiber remains a competitive alternative to cable broadband over the long term, high upfront investments and a materially higher cost of capital are resulting in slower buildouts than previously expected. Fixed wireless also continues to gain traction, particularly in rural markets, but share gains also appear to be moderating. At the same time, both Comcast and Charter are expanding their footprints into rural and adjacent markets while gaining wireless market share, leveraging their mobile virtual network operator agreements with Verizon (VZ). We think both cable companies are well-positioned to continue to grow while generating substantial free cash flows. We added to Comcast during the quarter.
Our health care positioning also fared well, led by managed care company UnitedHealth Group (UNH), which beat expectations and raised full-year guidance, supporting our thesis that it can successfully navigate the recent uptick in utilization among its Medicare patients. We continue to maintain an overweight position to managed care companies via long-term holdings in UnitedHealth and Elevance Health (ELV), as we believe the short cycle nature of their insurance franchises allows them to reprice their book of business in a relatively short time frame, even if health care costs come in higher than previously anticipated.
The health care space provided some opportunities in the quarter, as we increased our exposure to medical device company Becton, Dickinson (BDX) as well as large-cap pharmaceutical company Johnson & Johnson (JNJ). Becton, Dickinson recently received FDA approval for its Alaris infusion pump, which should accelerate revenue growth regardless of economic conditions. Johnson & Johnson recently spun out its consumer health care business, becoming a more focused yet broadly diversified pharmaceutical and medtech company. Though only a marginal contributor for the quarter, our other recent portfolio addition McKesson continues to execute well, leveraging its strong competitive position, rising usage of specialty pharmaceuticals, and rational industry structure to continue to deliver strong profitable growth.
At the same time, we took some money off the table in the areas that benefited from 2023’s AI-related rally, including data center infrastructure company Vertiv (VRT) and social media platform Meta (META). Both stocks have performed exceptionally well and were meaningful contributors to performance.
A higher-for-longer rate mentality taking hold was a headwind for economically sensitive stocks. Rising wages have been one of the main drivers of inflation, and this has proved to be a sticky area, keeping the Fed’s attention and weighing on share prices. For example, United Parcel Service (UPS) renegotiated a wage increase for its union-backed workforce this summer, which weighed on margins that were already being constricted by slowing volumes. While the new union deal will dampen profits over the next 12 months due to the front-end-loaded nature of the new five-year contract, management gained increased flexibility to deploy automation, which we think should further enhance UPS’s strong competitive position and provide a long-term tailwind to profitability.
The current labor negotiations between the United Auto Workers and Detroit’s big three auto manufacturers likewise put pressure on OEMs and the auto supply chain broadly. Our long-term holding TE Connectivity (TEL) generates about half of its revenue by selling highly differentiated connectors to automotive and off-road transportation industries. While it is not immune to potentially lower production volumes as a result of the strike, we believe the company is fairly insulated due to the higher per-vehicle content of EVs, which are growing at the expense of legacy ICE vehicles. We trimmed our position given the cyclical nature of the business. We continue to like TE Connectivity’s strong position with customers and its opportunities for content growth in automotive and data center customers over the next few years, and it remains a sizable active bet.
Top detractor RTX (RTX) saw shares fall after it made an unanticipated announcement that its geared turbofan (GTF) engine family will require accelerated inspections and overhaul to investigate and replace the engines’ high-pressure turbine disks. The stock traded down 10% on the day of the GTF announcement and took another leg down once management framed longer-term financial implications. We trimmed our position to manage risk.
Other detractors included American Express (AXP), which fell on concerns over slower consumer spending and rising charge-offs, as well as wireless tower REIT American Tower (AMT), which was pressured by the increase in rates along with the broader real estate sector. Our two utilities Sempra (SRE) and Edison International (EIX) were also negatively impacted by rising rates, although both outperformed the utility benchmark. We maintain a large active overweight to Sempra and added opportunistically to Edison to reflect its strong fundamentals.
We also added to our position in Intel (INTC) to take advantage of signs that it continues to make progress on its goal of regaining technology leadership. Intel appears to be executing its technology/product roadmap; the company is on track to ramp up PC and server products over the next 12 months on advanced manufacturing nodes that we believe will be more competitive with chief rival Advanced Micro Devices (AMD). We also see green shoots in the PC and server markets, with an increasing possibility of a cyclical recovery in both end markets in 2024.
Outlook
Higher interest rates, a growing fiscal deficit, weakening consumer spending, and rising geopolitical risks – these are just a few of the headwinds and uncertainties facing the market. While we never position the portfolio toward any given macroeconomic outcome, risk management is in our DNA and reflected in every decision we make at both the individual stock and portfolio levels. We believe risk mitigation is equally important to upside participation, and we manage the Strategy accordingly, regardless of the environment. We remain convinced that high-quality, high-return, cash-flow-generative businesses should outperform in most environments, and the strengths of these businesses should continue to shine, especially in more challenging times.
Portfolio Highlights
The ClearBridge Large Cap Value Strategy outperformed its Russell 1000 Value Index benchmark during the third quarter. On an absolute basis, the Strategy had positive contributions from two of the 11 sectors in which it was invested for the quarter. The energy and communication services sectors made the sole positive contributions, while the industrials, information technology (IT) and financials sectors were the main detractors.
On a relative basis, overall stock selection and sector allocation contributed to performance. In particular, stock selection in the communication services, health care, and utilities sectors added to relative returns. A consumer discretionary underweight was also additive. Conversely, stock selection in the financials and IT sectors detracted.
On an individual stock basis, the largest contributors were ConocoPhillips, Vertiv, Charter, Chevron, and Progressive (PGR). Positions in RTX, American Express, TE Connectivity, United Parcel Service, and American Tower were the main detractors.
In addition to portfolio activity noted above, during the quarter we exited our position in Bank of New York Mellon (BK) in the financials sector.
Robert Feitler, Managing Director, Portfolio Manager
Dmitry Khaykin, Managing Director, Portfolio Manager
Past performance is no guarantee of future results. Copyright © 2023 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.
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