ClearBridge Large Cap Growth ESG Strategy Q4 2023 Portfolio Manager Commentary

By Peter Bourbeau & Margaret Vitrano

Engaging on Climate Making Impact for Growth Names

Market Overview

Stocks surged in the fourth quarter to end the year near all-time highs, boosted by plunging bond yields and growing optimism that the U.S. economy will pull off a soft landing. Signs of cooling inflation and a slowing labor market not only reversed a two-year climb in yields but also increased the likelihood that the Federal Reserve had completed its tightening cycle, sending the S&P 500 Index (SP500, SPX) 11.69% higher for the quarter and 26.29% higher for the year. The technology-laden NASDAQ Composite (COMP.IND) advanced 13.56% for the quarter to finish up 43.42% for 2023.

With the 10-year Treasury yield (US10Y) declining 70 basis points during the quarter, growth remained in favor among larger cap stocks, with the benchmark Russell 1000 Growth Index rising 14.16% and outperforming the Russell 1000 Value Index by 467 bps. For the year, the growth index climbed 42.68%, outperforming value by over 3,100 bps, second only to 2020 as the largest performance differential in investment styles since both indexes launched in 1987.

Much of that differential can be attributed to the performance of the Magnificent Seven (Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia and Tesla), a basket of mega cap growth stocks that accounted for 47.8% of the benchmark return for the quarter and 65.4% for 2023.

The ClearBridge Large Cap Growth ESG Strategy maintains exposure to six of the seven stocks, with overweights in Amazon.com (AMZN), META and Nvidia (NVDA). Those three stocks, as well as Microsoft (MSFT), were among the leading contributors to Strategy performance for the quarter. Microsoft and Nvidia continued to be supported by strong execution and leadership positions in the implementation of generative artificial intelligence (‘AI’), Amazon benefited from strong margin expansion across segments, most notably its core e-commerce business, while Meta saw accelerated revenue growth and share gains in online advertising.

These are high-quality, cash flow generative businesses that we will continue to own, actively adjusting our positioning sizes based on risk/reward and portfolio construction priorities. With Nvidia shares more than tripling in 2023, we opportunistically took profits throughout the year, an approach that continued in the fourth quarter with additional trims that brought the position down to 6% of overall assets.

Active management of our mega cap exposure contributed to the Strategy outperforming the benchmark both in the fourth quarter and through the narrow leadership market of 2023. We also attribute these improved results to solid stock picking, being opportunistic in adding to or initiating new positions in growth companies at or near the bottom of their earnings cycle, and maintaining a commitment to diversification across our three buckets of growth: select, stable and cyclical.

Portfolio Positioning

We tactically shifted our bucket allocations throughout the year to best position the portfolio for a slowing growth environment. While skeptical about the likelihood of a soft landing, we are less concerned about whether the economy falls into a recession than about the duration of that downturn. As a result, our actions in the fourth quarter involved taking some profits, consolidating small positions among select growth names and shifting more assets into companies in our stable and cyclical buckets.

Evolving our fundamental research and portfolio monitoring process to promote better ongoing collaboration with ClearBridge’s Sector Analyst Team has enabled us to identify opportunities and risks more efficiently and take decisive actions in a timely manner. We exited our position in DexCom (DXCM), for example, during the quarter by looking past the broadly negative noise about GLP-1 impacts on medical devices and understanding that our assumptions about DexCom’s long-term growth rate, particularly in the Type-2 diabetes market, now seem more aggressive than we had previously thought. We directed the proceeds of the sale into our higher-conviction health care holdings, including Thermo Fisher Scientific (TMO) and Stryker (SYK).

Our other exit in the quarter was Unity Software (U), a select growth name purchased in early 2022 to participate in the growth of the global video game market, as our thesis no longer remains valid. Via M&A, Unity has diversified away from its game engine subscription business into the less differentiated advertising segment and most recently saw negative customer reaction to price increases, calling into question the offering’s pricing power.

We added some ballast to the stable bucket with the purchase of Intercontinental Exchange (ICE) in the financials sector. ICE operates securities exchanges, fixed income and data services as well as mortgage technology solutions. The timing of its recent acquisitions (Ellie Mae and Black Knight) has increased exposure to a mortgage market in a cyclical downturn, compressing the stock’s multiple and offering an attractive entry point to build a position. Exchanges offer high operating margins, strong free cash flow generation and limited interest rate and credit risk while benefiting from the increasing complexity and globalization of capital markets and demand for data and analytics. ICE’s business offers diversification across asset classes, high barriers to entry and wide competitive moats, supported by a mix of recurring revenues from data/service subscriptions and transaction-driven fees.

Outlook

After the first three quarters of market returns dominated by the Magnificent Seven, market breadth improved to end 2023 with the small cap Russell 2000 Index rising 14.03% during the quarter and the Russell Midcap Index adding 12.82%. While AI will remain a key trend supporting parts of technology, we believe broadening participation should be supportive of our diversified approach. After healthy returns in 2023, parts of the IT sector, for example, appear fairly valued, leading to better risk/reward opportunities in other areas outside of technology and shadow tech.

Our discussions with company managements point to a broad macro deceleration, from package volumes at UPS, to weaker iPhone sales at Apple and weaker food revenues at Target. In addition, price cuts are no longer stimulating demand and costs are not falling as much as revenue. Taken together, we expect this to lead to greater volatility in the year ahead.

Portfolio Highlights

The ClearBridge Large Cap Growth ESG Strategy outperformed its benchmark in the fourth quarter. On an absolute basis, the Strategy posted gains across the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the IT, industrials and communication services sectors.

Relative to the benchmark, overall stock selection contributed to performance. In particular, positive stock selection in the communication services, industrials and IT sectors drove results. Conversely, an underweight to IT, an overweight to health care and stock selection in the health care, real estate and utilities sectors detracted from performance.

On an individual stock basis, the leading absolute contributors were positions in Microsoft, Amazon.com, Netflix, Meta Platforms and Nvidia. The primary detractors were Aptiv (APTV), DexCom, Unity Software, Tesla and United Parcel Service (UPS).

ESG Highlights

An Enhanced Internal Engagement Initiative

Engagement to drive positive change in public equities has been a longstanding part of ClearBridge’s investment decision making and active ownership. As a long-term shareholder with an average stock holding period of five years, ClearBridge has cultivated strong and lasting relationships with company management teams. With this unique position and decades of industry experience, we’ve taken steps to better structure, measure and communicate the progress and outcomes of key engagements, and in 2022 we launched an enhanced internal engagement initiative, Engage for Impact (EFI).

The initiative encourages targeted engagements that we believe have a strong likelihood of creating positive impact, which we define as the creation of long-term positive environmental or social outcomes for the benefit of all stakeholders in public companies: their investors — our clients — and their employees, customers, suppliers and communities.

While we believe our work can often influence significant improvement at the company level, we also recognize we are one of many shareholders working to create change. In many cases this collective voice is what ultimately leads to positive, real-world impact.

As a part of this new initiative, investment team members develop specific “asks” or areas of improvement for priority target companies. Progress against these “asks” is then monitored and reported on over time.

As long-term investors, our company engagements can take place over a multiyear period. Therefore, throughout the course of the engagement, we track and categorize company progress by stages (Exhibit 1).

Exhibit 1: Engage for Impact Progress Framework

Using this framework, we can better monitor and track a company’s responsiveness and progress against key performance indicators and report on these outcomes over time. EFI engagements follow a consistent structure, prioritize topics closely aligned with value creation, represent a wide variety of sustainability topics (Exhibit 2), and are often rooted in firmwide focus areas like net zero, biodiversity, human rights, as well as diversity, equity and inclusion.

Exhibit 2: Engage for Impact Asks by Category

Given this enhanced initiative is still in the early stages, most of our EFI company asks are currently categorized as early stage or in-process (Exhibit 3). Examples of company asks focused on reducing emissions, improving labor relations, expanding electric vehicles (EVs), improving board effectiveness and implementing total shareholder return (TSR) metrics convey the spirit and overall benefits of the initiative.

Exhibit 3: ClearBridge Engage for Impact Asks by Stage

Decarbonizing Aviation: United Parcel Service

Reducing emissions is a common ask among ClearBridge’s company engagements broadly. For an EFI with United Parcel Service (UPS), we acted on the opportunity to formulate a specific ask for a reduction in Scope 1 and 2 emissions from its aviation fleet, which comprises ~300 planes. We actively engage with UPS on setting aggressive carbon reduction targets as its stock is held in a strategy that is in-scope for ClearBridge’s net-zero commitment.

In our engagements with UPS, we have discussed how due to heavy reliance on future technologies such as sustainable aviation fuel, the company recognizes it cannot credibly set a company-wide target approved by the Science-Based Targets initiative (SBTi) at this time. However, the company has acknowledged our ask as a key area of focus over the next 10-15 years and recognizes decarbonizing its aviation fleet is a key part of the global energy transition. It also recognizes the need to align all other parts of the business with a net-zero pathway in an effort to decarbonize. Efforts currently underway include investments in electrical vertical takeoff and landing aircraft and full electrification of its ground fleet, with a 2025 goal of 40% alternative fuel for ground vehicles, up from 24% today. We will continue to engage UPS as a stage 2 EFI to monitor progress against other reduction targets and continue to urge the company to decarbonize its aviation fleet.

Bettering Driver Relations and Expanding EVs: Uber

In stage 3 of an EFI the company has acknowledged the ask and has developed a credible strategy to address it. The company may even have begun and be well along in addressing it, as is the case with UBER and two asks we have formulated to: 1) improve driver satisfaction, and 2) expand its adoption of EVs toward achieving its net-zero goal.

We’ve engaged Uber since its IPO in 2019 as concerns over employee classification have led to questions of worker pay and benefits that we felt overshadowed other merits of its rideshare business, for example rideshare’s democratization of transportation and Uber’s impressive safety record.

In December 2019, we met with the company to discuss driver earnings and shared our view that drivers should remain contractors with added benefits and pay protection. At that time, Uber had already shifted its operating philosophy to a more conciliatory approach and improved relationships with contracted partners with guaranteed pay minimums, portable benefits and bargaining rights.

We continued the conversation as part of regular meetings with the company over subsequent years, and at a January 2024 meeting with Uber’s CEO, CFO and other representatives, we were pleased with progress made against both asks. Management highlighted improvements made to the driver experience, including technology, earnings and worker flexibility. Specifically related to driver earnings, the primary concern, drivers on the platform currently earn an average of ~$36 per utilized hour on a gross basis and low-$20s net of expenses and overhead. Up-front fares, which are now being rolled out globally, provide improved earnings transparency. On fairness, where drivers see anywhere from a 0% to 50% take rate (the percentage Uber takes of gross margins), Uber plans to share weekly reports with drivers clarifying take rates and distributing make-whole payments where appropriate.

To achieve its SBTi-approved net-zero goal by 2040, Uber is focusing on driver incentives and education to drive adoption of EVs across its platform. Results so far are promising and getting better: 4.7% of Uber’s trip miles driven in the U.S. and Canada are completed in zero-emission vehicles, even though EVs represent just ~1% of total cars on the road in the U.S.

Enhancing Board Quality and Operational Efficiency: Comcast

Comcast (CMCSA) is also at stage 3 in its EFI action as it is making measurable progress on EFI asks regarding 1) addressing some concerns from third-party governance research providers on overboarding and board effectiveness, 2) setting verified science-based targets and 3) addressing efficiency of operations, specifically as it relates to suppliers.

In December 2019, we engaged Comcast on a variety of ESG topics and raised the issue of board independence. We followed up in May 2020 when we discussed a proxy proposal on the split Chairman and CEO role. Following this meeting, Comcast improved the independence of its board, upping the percentage of independent director nominees from 80% in 2019 to 89% in 2022, as well as improving board diversity, from 40% of director nominees being diverse by gender or race in 2019 to 44% in 2022.

In December 2022, we continued the conversation around board effectiveness and engaged the company on its board structure, raising concerns around overboarding or having board members sit on too many boards, which may compromise their ability to serve the board effectively. This issue has been flagged by third-party governance research providers.

In a December 2023 engagement, Comcast shared that it was making progress addressing overboarding by bringing down the average tenure of its board by incorporating a policy on director overboarding into its corporate governance guidelines that limits the number of public company boards on which directors may serve. As part of the policy, no director who also serves as CEO at a public company may serve on more than three public company boards. A notable example is lead independent director Ed Breen, who is also the current CEO of DuPont de Nemours. He proactively sought to reduce the number of boards he sits on and chose not to stand for re-election to the board of International Flavors & Fragrances at the company’s 2023 annual meeting.

Also at our December 2023 meeting, Comcast disclosed its Scope 3 emissions for the first time and committed to setting a verified science-based target. The company has begun engaging suppliers on committing to set a verified target, and going forward, it will set clearer targets around Scope 3 emissions. Regarding our ask around operational efficiency, Comcast has reduced the electricity needed to deliver each byte of data across its network by 36% since 2019 and is pushing its suppliers to be more efficient.

Improving Incentive Metrics and Committing to Net Zero: Western Digital

In a completed EFI journey, Western Digital (WDC) has implemented a strategy to address asks we made over several engagements to 1) institute relative total shareholder return (TSR) incentive metrics to evaluate shareholder value creation compared to industry peers, 2) improve energy intensity levels of manufacturing in line with industry peers and 3) commit to a net-zero target.

Specifically, Western Digital reduced the energy intensity of manufacturing its products by >13% from FY21 to FY22. It added relative TSR metrics to its incentive comp, which we view as positive as it aligns management compensation with execution, whereas before management would benefit from the fact their industry is growing faster than the broader market. On the third ask, in June 2023 the company announced an ambitious target and has committed to net zero Scope 1 and 2 emissions across its operations by 2032. Its target includes goals to reduce Scope 1 and 2 emissions by 42% by 2030 and to reduce Scope 3 use-phase emissions/terabytes by 50% by 2030, both from a 2020 base year. Its targets were approved by SBTi in 2021, and since then Western Digital has achieved nearly 15% absolute Scope 1 and 2 emissions reductions.

We look forward to sharing more successful EFI case studies in the future as our EFI target companies continue to make measurable progress against our asks.

Peter Bourbeau, Managing Director, Portfolio Manager

Margaret Vitrano, Managing Director, Portfolio Manager

Click to enlarge

Original Post

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