Commentary: Large Cap Growth ESG Strategy

• Growth stocks were pressured as the Federal Reserve turned hawkish but tend to stabilize and deliver better performance once a tightening cycle is underway.
• Holdings across ClearBridge are driving the shift to renewable energy, leading the way with new technologies and projects that are finding both legislative and market support.
• The market is challenging growth stocks where, in some cases, there is not a fundamental issue. This creates an opportunity for us to underwrite investments where our advantage over consensus is the durability of growth.

Volatility spiked to 12-month highs in the first quarter as Russia’s invasion of Ukraine combined with monetary tightening, stubbornly high inflation and lingering effects of the COVID-19 Omicron variant put pressure on equities. The S&P 500 Index suffered a 10% correction mid-quarter before recovering to finish down 4.60%, while the NASDAQ (-9.10%) flirted with a bear market before paring losses. Growth stocks bore the brunt of the selling, with the benchmark Russell 1000 Growth Index declining 9.04% compared to a loss of 0.74% for the Russell 1000 Value Index.

The Federal Reserve raised short-term interest rates 25 basis points in March, ending a period of unprecedented accommodation, and projected at least six more rate increases through year end. We believe the rate cycle could last through 2023 with the neutral interest rate approaching 3%. Yields were volatile, declining in a flight to safety during the early days of the invasion before resuming their climb, with the 10-year U.S. Treasury rising over 80 bps in aggregate to end the period at 2.3%.

Growth stocks have historically been pressured leading into a tightening cycle and the past three months have tracked that pattern (Exhibit 1). What’s different this time is the speed of the Fed’s shift from a gradual withdrawal of liquidity in the second half of 2021 to an aggressive attack on the highest U.S. inflation in 40 years. Growth equities tend to stabilize and deliver better performance once a tightening cycle is underway and we view the ClearBridge Large Cap Growth ESG Strategy as well positioned to participate in this potential leadership shift.

Exhibit 1: Growth and Value Performance Around Rate Increases

The Russian invasion drew an immediate and united response from Western democracies in the form of economic sanctions on one of the world’s largest commodity producers. Beyond the wrenching humanitarian toll of the conflict, the cutoff of Russian oil, natural gas and raw materials for high-demand applications as semiconductor manufacturing and electric vehicle production has exacerbated global inflation and further complicated supply chain bottlenecks. While the Strategy has no direct exposure to Russia or Ukraine, the effects of rising input costs and constrained raw material availability could further blur already challenged corporate earnings visibility. In the current market, companies are being punished for being conservative in their guidance.

We manage the Strategy to promote diversification and participate through the full market cycle, especially during turbulent periods like the current one. The unusual confluence of factors experienced recently has meant that some typically defensive sectors, in the portfolio such as consumer staples or health care, have not been as defensive as one would expect. While portfolio construction hurt relative returns when a narrow band of mega cap growth names dominated performance, first-quarter underperformance was due to lackluster stock selection. Earnings shortfalls impacted three names in particular: Netflix, PayPal and Facebook (now Meta Platforms).

After being a prime beneficiary of increased viewing patterns during the stay-at-home period of COVID-19, Netflix is recalibrating what a normal growth trajectory will look like as global economies fully reopen. The stock fell sharply after the company modestly reduced its net subscriber additions for the current quarter, calling into question its ability to continue to deliver double-digit subscriber growth.

We believe one of our edges as active managers is our long-term orientation and willingness to be both early and patient with additions to the portfolio. With Netflix, we remain convinced that our thesis for owning the stock is intact. While some fear the U.S. streaming market is becoming saturated, Netflix’s penetration of global broadband homes is still less than 50%, a figure that doesn’t even include the opportunity to attract more mobile-only smartphone users. We believe Netflix can improve returns even if growth is weighted towards lower average revenue per user international markets while the company’s nascent video game strategy and potential pivots into advertising represent upside scenarios not reflected in its current valuation.

Most of the net subscription growth will occur outside the U.S., along with much of the content creation, which will be much lower cost. In retesting the competitive landscape for streaming, we are encouraged that Netflix has been able to pass on price increases without subscriber attrition. Churn remains exceptionally low and engagement exceptionally high. The company is also committed to reducing its content spend if subscriber growth remains challenged.

We entered a position in PayPal in December well aware of the electronic payment platform’s ambitious goals for user growth. The company has started to experience a reduction in revenue growth due to weakening in the macro environment and a deceleration in e-commerce broadly due to reopening headwinds and difficult comps. This led to a sharply reduced outlook for 2022 revenue and long-term earnings that has weighed on the stock. We initiated a position after the shares had already fallen 40% from their all-time high but were wrong in modeling that a muted outlook was already priced in. Nevertheless, we believe PayPal is fundamentally holding share in the industry and is set up for continued growth in e-commerce once reopening headwinds pass. The company onboarded nearly 120 million net new users over the last few years; naturally, many users will churn off the platform. We also see the company’s strategy to add additional use cases to its wallet such as investing, crypto, savings accounts and bill pay as catalysts to accelerate revenue growth over time. In addition, Venmo continues to be under-monetized and a new partnership with Amazon.com will be something to watch.

Facebook shares derated following fourth-quarter earnings results and first-quarter revenue guidance that was weaker than expected. We understood that Apple’s iOS14 privacy changes (measurement, loss of signal) would have a near-term impact on earnings, but high competition in the social media space (primarily from TikTok) further catalyzed multiple compression in the stock.

While TikTok is a competitive threat and Apple’s privacy changes have impacted the industry, we believe these risks are manageable and Facebook retains a number of advantages around user scale, advertiser scale and sophistication of its digital advertising technology that are not being valued at current levels. New product innovation, including Reels, are currently being under-monetized, as were many previous product introductions initially over the last decade. Furthermore, we believe the company’s bigger profile with small and midsize business (SMB) customers, whose reduced spending during the Omicron surge and due to supply chain issues that kept product off the shelves, was partly responsible for its conservative guidance. Facebook properties still have three billion monthly active users and remains the highest return on advertising spend for advertisers.

Among mega caps, Facebook is our second-largest active overweight relative to the benchmark, but we trimmed the position slightly in the first quarter while adding to our overweight in Amazon.com. With Amazon’s capex build largely done in 2020 and 2021, we believe it is now set up to generate robust revenue growth and margin expansion in all three of its key segments: e-commerce, cloud (AWS) and advertising.

Amazon rebounded off post-invasion lows on an uptick in e-commerce. United Parcel Service, a key provider of delivery services for both B2B and B2C commerce, continued to execute well with its pricing power and focus on improving margins (better, not bigger strategy), while Visa is benefiting from increasing debit card usage for purchases, along with early signs of high-profit cross-border travel returning. The portfolio also saw solid performance from cybersecurity names Palo Alto Networks and Splunk, which are gaining prominence as the risk of global cyberattacks increases as part of the Russian offensive.

Growth company valuations tend to anticipate changes to input variables (in this case, interest rates) well in advance, and they have largely derated following a predictive path. That said, valuations are largely in check after a significant drawdown and are now set up much better than just six months ago. The market is challenging growth where, in some cases, there is not a fundamental issue. This creates an opportunity for us to underwrite investments where our advantage over consensus is the durability of growth. Clearly, the impact of higher interest rates has been most acutely felt in the longer-duration assets of the market where interest rate pressures are most acute. Given our overall positioning, we have room to increase our tech exposure and did so with the additions of Unity Software to the select growth bucket and Intel as a cyclical play on the reshoring of semiconductor production.

Gaming is an attractive end market within the media/technology sector with strong growth and a long runway, particularly in mobile gaming. Unity’s platform provides an engine and toolkit for development and monetization of games, e-commerce and industrial applications, adding to our industry exposure, which also includes Nvidia in graphic processing chips and Sea Ltd., which operates an international gaming platform. Unity is levered to growth of the overall gaming market, offering developer tools for designing, rendering and publishing games. It maintains leading share in the third-party game development market and helps game publishers monetize games with advertising tools. The company is also expanding its total addressable market by making its editor and 3D content creation tools available to other industries like auto manufacturers and architecture/design firms (Exhibit 2). Risks we are monitoring include competition in game development, execution risk in balancing growth while nearing profitability and delays in shifts to newer technologies like the metaverse.

Exhibit 2: Growth Potential Outside Gaming is Growing

Intel is the world’s largest manufacturer of semiconductors, especially CPUs for computers and mobile devices. The company had been mismanaged in the past, hurting its competitive position. CEO Pat Gelsinger has completely revamped the organizational structure and eliminated technology sharing between its owned product and fabrication customers to better compete in this latter area. Intel has differentiated technologies and a roadmap to achieve product leadership in its core PC and data center markets and is using operating leverage to reinvest in new business opportunities such as chip production and GPUs. Chip production has become a bipartisan national security and intellectual property issue due to geopolitical tensions and Intel is expected to be a prime beneficiary of U.S. and European government subsidies to develop new leading-edge fabrication capacity outside of Asia.

We believe Intel has underappreciated growth/margin drivers over the next several years as it regains technology leadership. The company’s defensive characteristics should allow it to outperform other semi names in the event of an industry downturn. We are adding Intel as we trim exposures to our other semiconductor holdings more exposed to secular growth trends in electric vehicles (NXP) as well as gaming, data centers and the metaverse (Nvidia).

Other actions during the quarter included the sale of Home Depot. The move is based on where we are in the consumer and housing cycle as we come out of a period of nesting and dedensification and as government stimulus related to COVID-19 expires. The company has effectively pulled forward demand over the last two years and taken share because of in-stock inventory availability relative to peers. Many of those tailwinds are now dissipating and our thesis for Home Depot optimizing the business in terms of merchandising/inventory, omnichannel, PRO/DIY mix, labor and distribution centers has played out. The exit is part of our efforts to reduce our consumer discretionary exposure and provide better downside protection if volatility persists.

We are entering a period of policy reversal that should lead to a normalization of capital market returns and economic growth from a peak everything environment (liquidity, profit margins, global growth). This is the type of environment where GDP growth is likely to slow and liquidity becomes less abundant, favoring our diversified approach to portfolio construction and focus on quality growth. Heightening levels of volatility should also be an advantage, allowing us to be opportunistic given our longer-duration growth horizon for the companies we target and own in the portfolio. We did not deliver on our objective this quarter to have better down capture in a volatile market due to consequential poor performance in a select few names.

We still have high conviction in the benefits of our diversified approach and will not waver from our large cap mandate in pursuit of alpha. Instead, we will continue to apply the learnings of the last several years, both the decisions we got right as well as the situations where we misjudged the timing of improvement stories, the competitive risks of specific industries or the growth drivers of certain mega caps that maintain significant weightings in our benchmark. We will remain patient when our business case for owning a company is challenged by near-term pressures. However, we have been and will continue to be more disciplined sellers if we see fundamental issues or anticipate such issues on the horizon.

Positioning moves through the pandemic were focused on improving our up capture in strong markets through increasing our weighting to select growth companies in technology and shadow tech. More recently, we have been adding countercyclicality to the portfolio with our additions in health care. We believe medical device makers such as Alcon and Intuitive Surgical will see a ramp-up in activity post-COVID-19, while innovators like DexCom, which has leading share in the market for glucose monitoring systems for diabetes patients, stand to benefit. These companies offer more efficient solutions to managing chronic health conditions and provide a key point of differentiation for our portfolio from passive strategies. To make room for these names, we eliminated our remaining therapeutics exposure in BioMarin Pharmaceutical. Delays in approval of the biotech’s hemophilia treatment, concerns around execution and commercial uptake given the size of the opportunity as well as questions over management credibility caused us to move on from the stock.

We are also committed to participating in the most powerful secular growth trends our research efforts have identified. These include cloud computing/software-as-a-service, gaming, digital payments and electrification. A new trend that has emerged with rising geopolitical tensions between the West and China, and now Russia, is the need for reshoring of production and fortifying supply chains. We have exposure to this theme which we believe will require a multiyear, if not longer, commitment by most multinational companies.

The ClearBridge Large Cap Growth ESG Strategy underperformed its Russell 1000 Growth Index benchmark during the first quarter. On an absolute basis, the Strategy suffered losses across seven of the eight sectors in which it was invested (out of 11 sectors total). The leading detractors from performance were in the communication services and information technology (IT) sectors, while the financials sector was a contributor.

On a relative basis, overall stock selection detracted from performance. In particular, stock selection in the communication services sector had the most significant negative impact on results while selection in the industrials, IT and consumer staples sectors was also detrimental. On the positive side, an overweight to the industrials sector, an underweight to communication services as well as stock selection in the health care and financials sectors contributed to performance.

On an individual stock basis, leading contributors to absolute returns in the first quarter included positions in Palo Alto Networks, Splunk, UnitedHealth Group, S&P Global and Visa. Facebook, Netflix, PayPal, Sea Ltd. and Salesforce were the primary detractors.

In addition to the transactions mentioned above, the Strategy initiated a position in Stryker in the health care sector and gained shares of S&P Global in the financials sector following its acquisition of existing holding IHS Markit.

Along with the immense toll it has taken so far on human life, the Russian invasion of Ukraine has highlighted afresh the role of energy security in national security. Roughly 40% of Europe’s natural gas is provided by Russia, a vulnerability that speaks to a broader dependence on fossil fuels that could complicate the timeline of many commitments for net-zero emissions. Europe had already been facing an energy crisis since the summer of 2021, with low gas storage levels contributing to record energy prices in late 2021 and public backlash leading governments to subsidize energy costs.

Yet energy security and the energy transition are not inconsistent. While in some ways today’s energy crises add to the challenges facing net-zero by 2050 ambitions, they are also spurring more aggressive actions to reach those goals that affirm the long-term opportunity presented by the energy transition (Exhibit 3). Holdings across ClearBridge driving the shift to renewable energy continue to lead the way with new technologies and projects that are finding both legislative and market support.

Exhibit 3: Primary Energy and Renewable Energy Sources in Green Scenario

Rather than slow the move to net-zero by retrenching into more oil and gas production, current energy crises should accelerate trends that can propel the energy transition, such as Europe’s need for domestic energy production and the improving economics of renewable energy relative to fossil fuels.

The war in Ukraine underscores that energy security is national security, and the key to energy security is diversity of supply. It should bring forward spending on global energy infrastructure in several areas, given the Herculean task of fundamentally rethinking the source of Europe’s energy supply on a condensed timeline. Europe must shore up natural gas supply locally, but sources are limited. Instead, it will import more natural gas from a range of sources — the U.S., Southeast Asia, Australia and Qatar. To support this, the REPowerEU plan, released by the European Commission in February following the start of the war, designates gas storage as critical infrastructure and allows incentives for refilling. Germany announced construction of two liquefied natural gas (LNG) re-gasification terminals. We expect Europe to contract for new LNG capacity globally over the next several years.

Yet the desire to have energy independence will also increase demand for energy derived from sources other than fossil fuels. The REPowerEU plan accelerates the clean energy transition by enabling more investment in renewables and in effect links the need for energy security with decarbonization. Seeking to reduce Europe’s dependence on natural gas and coal in different sectors of the economy — in homes, buildings, industry and power systems — the plan prioritizes:

• Reduction of natural gas consumption in all sectors, including energy, housing and industry.
• More rooftop solar panels, heat pumps and energy savings to reduce EU dependence on fossil fuels, making homes and other buildings more energy efficient.
• Speeding up renewables permitting.
• Doubling the EU ambition for biomethane for 2030, in particular from agricultural waste and residues.
• Replacing demand for Russian gas with 15 megatons of renewable hydrogen, both imported and domestic.

The residential sector in Europe accounts for roughly 40% of natural gas usage, so replacing gas in the home with electricity, electric pumps and heating is on the agenda. Likely increases in tax incentives for charging infrastructure and electric vehicles (EV) will speed up the electrification of transport.

ClearBridge holding Legrand is a significant beneficiary of energy efficiency and electrification trends. Its low-voltage products, sensors and smart thermostats are essential to reducing energy use in commercial and residential buildings. Legrand products also support the growth in EV charging stations infrastructure. Portfolio holding Eaton manufactures electrical equipment products to enable the electrification of the power grid as well as EV charging infrastructure.

The key issue with renewables is intermittency and battery energy storage is the clear solution. We are seeing increased penetration of utility-scale storage in the U.S. where wholesale prices average around $0.09 per kilowatt hour (kwh). However, with Europe paying up to $0.35/kwh and as much as $0.45/kwh in Germany, which gets 55% of its gas from Russia, we would expect to see increased adoption of storage systems to accommodate a ramp-up in renewables.

High and rising utility costs combined with policy support are driving increased penetration of residential solar plus storage systems in Europe. Enphase Energy and SolarEdge Technologies expect to see significant growth in solar installations in this market, led by Germany and Italy. Consumers are demanding not only solar on the roof but also a complete system solution, including batteries. This phenomenon is accelerating revenue growth for these companies.

The replacement of demand for Russian gas with green hydrogen positions ClearBridge holdings Air Products and Chemicals (APD) and Linde well. Green hydrogen, made by using renewable energy to split water into its basic elements, hydrogen and oxygen, and subsequently cleanly burn the hydrogen as fuel, is seen as key to lowering emissions in hard-to-decarbonize industries such as steel and cement, as well as transport. APD’s major green hydrogen project in Saudi Arabia, Neom, where hydrogen is generated with the use of renewable energy, should benefit from accelerating demand in Europe. The project is slated to be operational by 2026. In 2021 Linde announced a long-term agreement to provide European semiconductor maker Infineon with onsite production and storage of green hydrogen for the company’s site in Villach, Austria. The facilities are expected to be operational in 2022. Securing a clean, domestic source of energy for semiconductor manufacturing appears strategic today amid heightened concerns of reliable supply from Taiwan.

While higher oil prices have been a boon to the energy sector in recent quarters and a challenge for renewable energy stocks, it is important to remember that fossil-fuel-based energy and renewable energy are in essence substitute goods, albeit imperfect; the higher cost of one increases the relative attractiveness of the other.

While higher natural gas prices boost short-term returns for the traditional energy sector, they also drive demand for renewable energy, lifting those stocks (Exhibit 4). This will include commercial and residential solar, in which SolarEdge, which makes power inverters and optimizers for solar installations, is an industry leader. Improved commerciality of new higher-power inverters, increasing sustainability goals of businesses and rising power prices resulting from increased fossil fuel costs and carbon prices are driving demand for commercial and industrial (C&I) solar in the U.S. as well as in Europe, Asia and the Middle East. This is concurrent with secular growth in home rooftop solar both in Europe and in the rest of the world. SolarEdge is also expanding its storage capacity for residential and C&I energy storage with the ability to ramp up capacity significantly should it be needed to meet demand.

Exhibit 4: Recent Energy Run Leaves Long-Term Renewable Leadership Intact

Reducing energy use through energy efficiency is another key value driver, and ClearBridge holdings helping make progress in this area will benefit from the world’s need to reduce energy consumption. For example, Atlas Copco, a Swedish company, makes energy-efficient compressors and vacuum pumps that adapt their speed to production needs. Current high energy prices should drive demand for highly energy-efficient compressors from Atlas as the majority of the life cost of a compressor is energy costs. Investment in a new compressor can yield significant energy savings. In addition, Atlas manufactures large compressors used in the power industry. The call for energy independence and the diversification of natural gas sourcing could prompt investments in the distribution network (gas pipelines) and regasification (LNG) terminals in Europe. This in turn will increase the demand for large gas and process solutions offered by Atlas.

Utilities continue to enable the energy transition. As infrastructure monopolies, both electric and gas utilities have been actively involved in pushing for more efficient use of the existent systems through various demand management and energy efficiency programs. At the same time, these companies have been investing heavily into adding renewable energy to their asset mix. Gas utilities have started adding renewable natural gas (RNG) into their streams while trying to determine an optimal percentage of hydrogen that could be mixed in. On the electric side, several companies have announced early retirements of their coal-fueled power plants and their replacement with solar and wind capacity.

The share of renewable power in the U.S. has been increasing steadily: the Department of Energy’s data indicate that power produced by solar and wind generation increased by 25% and 12%, respectively, over the course of 2021 relative to 2020. The recent increase in natural gas prices should not derail the renewable buildout. On the contrary, the increase in natural gas and electricity produced with natural-gas-fueled power plants make the relative economics of renewables more attractive. Similarly, higher oil and gasoline prices make a stronger case for the adoption of EVs.

Outside of renewables, the energy transition will require massive investments by utilities in their infrastructure. For example, some industry executives estimate a $4 trillion investment will be needed for buildout of the country’s transmission infrastructure alone.

In addition to benefiting from robust demand for U.S.-sourced LNG, Sempra Energy, of which ClearBridge is a top 20 owner, is at the forefront of the industry’s transition to clean energy. The company recently announced a green hydrogen project, the Angeles Link, supporting the Los Angeles manufacturing hub. The interstate pipeline system would bring green hydrogen (hydrogen sourced from solar and wind power) as an alternative fuel for hard-to-electrify industrial processes.

The size and breadth of decarbonization opportunities is also growing for ClearBridge holding Brookfield Renewable, with early opportunities in newer technologies like carbon capture and storage (CCS) factoring into the renewable power company’s energy transition strategy. In March 2022 Brookfield announced its first CCS deal, a convertible debenture with Canadian CCS developer Entropy. While CCS is not economic in most places yet, the Entropy deal provides high-single-digit returns on the downside and fully supported returns at carbon pricing well below the Canadian government rate. Over the long term, Brookfield could offer CCS to its renewables off-takers who have large Scope 1 emissions to capture.

While in the coming decades there will be moments of strong performance from the traditional energy sector as global oil supply and demand dynamics change, the urgency of lowering global carbon emissions remains a key secular trend supporting opportunities for alpha in several sectors. Energy efficiency and innovations in renewable energy technologies such as solar panels, energy storage, green hydrogen and carbon capture remain key long-term growth stories to watch, offering energy-related value creation potential in the industrials, utilities and information technology sectors that can keep the energy transition on track.