Commentary

Key Takeaways

• The portfolio is positioned for a low growth environment and trailed in a market discounted a much faster pace of growth.
• ClearBridge relies on strong relationships with investor relations teams to facilitate meaningful company ESG engagements.
• An underweight to cyclical names was a performance headwind, but we took advantage of attractive entry points to increase our cyclical exposure over the quarter.

Market Overview and Outlook

Equity markets maintained their linear rise in the first quarter, led by a rotation into higher beta growth stocks. The S&P 500 Index gained 6.07%, the Russell 1000 Index advanced 6.03% while the Russell Midcap Index added 5.15%. The benchmark Russell 1000 Growth Index (+8.91%) outperformed its value counterpart by 564 basis points for the quarter.

Optimism surrounding President Trump’s pro-growth agenda and solid economic numbers helped extend the post-election rally. The economy expanded 2.1% in the fourth quarter, based on the final reading of GDP growth. Hiring cooled in March with just 98,000 jobs created while February’s payroll total was revised downward by 19,000 jobs to 219,000. The unemployment rate edged down to a post financial crisis low of 4.5% even as more individuals entered the labor force looking for work. Wages grew 2.7% year-over-year in March and core inflation increased 1.8%, close to the Federal Reserve’s 2.0% target. These data supported the Fed’s decision to raise short-term interest rates 25 basis points in March. The central bank stuck with its plan for two additional rate increases in 2017 rather than adopting a more hawkish stance.

The Strategy lagged its benchmark for the quarter as our exposure to counter-cyclical names, mostly in the health care sector, were a headwind. We have carefully constructed our portfolio to thrive in a low growth environment; however, the acceleration of equity returns since the election is discounting a much more rapid pace of economic growth that has yet to materialize. Deep cyclical stocks most directly tied to GDP growth and U.S.-focused companies poised to see a bigger benefit from corporate tax reform than multinationals have done exceedingly well post-election.

We are underweight those areas in the portfolio but have made several moves recently to increase our cyclical exposure. These included the purchase of Pioneer Natural Resources in the energy sector and the swapping of General Electric for Honeywell International in the industrials sector. We added a position in Chipotle Mexican Grill in the consumer discretionary sector late in the fourth quarter.

Health care has not benefited as much from the Trump trade as other parts of the market. Given the underperformance, we took advantage of attractive relative valuations to add to each of our biotech holdings during the quarter. Pricing pressure has held back biotech and pharmaceutical stocks for more than a year, but we believe our targeting of companies making scientific breakthroughs to serve unmet needs and offering innovative therapies for cancer and other conditions will ultimately be rewarded. Portfolio holdings Biogen and Regeneron Pharmaceuticals recently won approval for treatments with multi-billion dollar potential and we are optimistic that changes at the FDA under the new administration will allow new compounds to get to market faster.   

Energy is another area experiencing near-term weakness, but where we see positive catalysts. The increase in U.S. shale production has created inflationary pressures in raw materials and drilling equipment, which should lead to margin expansion for oilfield services companies like Schlumberger. New holding Pioneer is a vertically integrated exploration & production company that owns many of the services that other shale producers must hire out for, including its own sand mine and pressure pumping for fracking, shielding it from service inflation.

The hope for higher growth in the economy and subsequently better corporate earnings is based on the premise that the new administration successfully passes its full agenda of tax cuts, deregulation and increased infrastructure spending. The failure of the president and the Republican majority to a pass a replacement health care bill to the Affordable Care Act (ACA), however, suggests that much resistance stands in the way of reflation efforts. House Majority Leader Paul Ryan indicated in early April that tax reform is still in its early stages and could take longer to implement than replacing the ACA.

"We have been told by IR that our interest and support for sustainable business practices and disclosure has made a difference."

Our discussions with company managements indicate that many are taking a wait and see approach as Washington works through its policy proposals. The rise in interest rates, while beneficial to financial stocks, has also caused a pause in commercial and industrial lending. Lenders are also reporting the first signs of distress in consumer credit. At the same time, small business sentiment is strong and a survey of corporate technology officers points to the first increase in IT spending in several years.

Against this mixed backdrop, we maintain our focus on owning a diversified basket of quality growth companies that reflects our highest convictions. The sharp run up in stocks to start the year - the benchmark is on pace for a strong double-digit annual return - reminds us of the high growth, high beta market we experienced in 2013. We managed to outperform in a year that saw the benchmark return 33% due to strong contributions from a range of stable and select growth stocks across industries. While cautious about the current strength of the economy and the equity market, we are confident that we continue to own a portfolio with similarly diverse growth drivers.   

Portfolio Highlights

The ClearBridge Large Cap Growth ESG Strategy underperformed its Russell 1000 Growth Index benchmark during the first quarter.   On an absolute basis, the Strategy had gains in six of the sectors in which it was invested for the first quarter (out of eight sectors total).  The main contributors to performance were the information technology (IT) and consumer discretionary sectors.   

On a relative basis, Strategy underperformance was impacted primarily by stock selection and sector allocation. Stock selection in the IT, industrials, health care and financials sectors detracted the most from relative performance. An overweight to the energy sector also hurt results. On the positive side, stock selection in the consumer discretionary sector and underweights to the consumer staples and telecommunication services (no positions) were the largest contributors to relative results.

On an individual stock basis, Akamai Technologies, Schlumberger, United Parcel Service, Palo Alto Networks and General Electric were the greatest detractors from absolute returns in the first quarter. The largest contributors to absolute returns included Amazon.com, Facebook, Adobe Systems, Red Hat and Apple.

During the first quarter, we initiated positions in Pioneer Natural Resources in the energy sector and Honeywell International in the industrials sector and closed positions in Aetna in the health care sector and General Electric in the industrials sector.

Pioneer owns the best acreage in the best basin in the Permian, giving it visibility on double-digit production growth well into the future. The company also maintains a strong balance sheet with very low debt exposure and expects to be cash flow positive in 2018 which should allow it to fund share buybacks. Honeywell provides additional cyclical and aerospace exposure in a name that should see upside from improving end markets in oil & gas, defense and insulated panels that use its innovative Solstice material. Management has positioned the company to improve free cash flow and returns on invested capital. Additionally, we believe margin expansion, share buybacks and synergies from its integration of recent acquisitions should lead to high single-digit earnings growth.

The judicial ruling that blocked Aetna’s merger with Humana invalidated our thesis for owning the stock. We believe a combined Aetna-Humana would have been a formidable competitor to managed care market leader UnitedHealth Group (also a portfolio holding) and a major presence in the Medicare Advantage market. GE shares, meanwhile, re-rated as recent divestitures have shifted it from a conglomerate to more of a true industrials company. Our thesis for owning the stock was based on the conglomerate business model.

ESG Highlights

Direct engagement with companies where we are shareowners is one of the most impactful ways to promote progress on environmental, social and governance (ESG) issues. But often lost in the big picture ESG goals we discuss with companies is the critical role played by their investor relations (IR) teams. At ClearBridge, we have always recognized the importance of IR and it has provided us access to senior management, such as the CEO, CFO and Board of Directors, that other investors may not have. As part of our ongoing effort to raise awareness of corporate ESG practices, we have helped educate IR teams through presentations to local National Investor Relations Institute chapters as well as a recent presentation at the NYSE to 200 corporate IR officers about ESG and shareholder value from an investor’s perspective.

 

Exhibit 1: Who Handles ESG Communications? 

Source: SRI Connect.

 

Education is conspicuously needed as ESG issues remain a low priority for the majority of IR teams at U.S. public companies. Just 24% of IR professionals surveyed in 2015 were directed by their companies to communicate the value of sustainability in contributing to profitability; nearly 40% were given no direction on sustainability reporting while nearly 80% did not regularly include ESG talking points in investor presentations¹. Some of the confusion may be a result of different companies assigning different groups to lead their ESG communications efforts (Exhibit 1).

We have witnessed shortcomings as well as notable breakthroughs in our three decades of experience working with IR that provide useful perspectives on the value of these partnerships. To encapsulate the three main categories of IR awareness and responsiveness to investor outreach on ESG issues, we have laid out the landscape as follows:

The Good

At its very best, IR can serve as a company communicator, facilitator and internal advocate on ESG. Good IR officers have the ear of the CEO and CFO and are well informed on the sustainability strategy of the company. Most of our successful engagements with companies have been facilitated through IR. These productive communications have included a consumer products company that, due to their CEO’s commitment to sustainable business practices, involves ClearBridge’s consumer staples analyst in their sustainability advisory outreach. The CEO of a biotech company has IR reach out specifically to our health care analyst for investor feedback and sustainability recommendations. Meanwhile, the CFO of a large media company, who oversees IR outreach and sustainability initiatives, provides our media analyst with regular updates on their progress.

The Bad

Unfortunately, IR teams can also work to the detriment of ESG efforts. In these instances, IR plays the role of gatekeeper, blocking or limiting access to company management due to indifference, defensiveness or being overly skeptical of the value of ESG. For example, IR for a major retailer would for years put the general counsel on calls with our analysts whenever the words “environment” or “labor” were mentioned. Prior to the 2010 explosion of the Macondo well, IR for an oil services company told our energy analyst that everything was fine and no questions needed to be addressed about the environment or safety. Meanwhile, IR for a media company questioned why we were interested in sustainability and we had no business asking his company about such topics.

The Uninformed

Some IR teams are simply unaware of what is taking place internally in ESG, have no idea there are corporate sustainability initiatives and believe investor engagement is only about governance and executive compensation. IR may be unaware of the E, S, or G issues their company faces - from both a competitive and a sustainable shareholder standpoint. However this situation can be turned around and is well worth the time our sector analysts spend on engagement, as we have found many companies we invest in will rise to the challenge.

For example, ten years ago an IR officer for a major retailer said he had no idea about sustainability, but he would "find some people in the company" and he would listen in as well "to be educated on ESG." The company has evolved into an industry leader in promoting ESG best practices. IR for a financial services company, meanwhile, couldn't understand why we were interested in carbon emissions as they were not an oil company. This company was overlooking the tremendous amount of power used for their offices around the country and for business travel. We informed the IR manager that if he reviewed the Carbon Disclosure Project (CDP) for the Financials Sector, he would see that not only had his company’s peers been reporting for some time, but these competitors were already in the top 10% of sector reporters to the CDP. A technology company IR rep told us he would be the only one who would understand sustainability at the company and that he would figure it out when he had the time. The company gave this same response for two years. Our IT software analyst has since placed the company under review for lack of engagement.

As a top 20 share owner of many of the companies in our portfolios, we have been told by IR representatives over the years that our interest and support for sustainable business practices and disclosure has made a difference. Specifically, it has helped move the needle internally to promote innovation, transparency, and integrated reporting (which combines elements of the company’s sustainability reporting with the annual report). Interestingly, the eight companies (none U.S.) with the highest rates of sustainability disclosure in financial investor reports all have legislation that requires it.

IR teams in the U.S. will often ask for our direction on sustainability reporting and we have shared feedback on what is helpful to our sector analysts, who formally assign an internal ESG rating for every company under their coverage. Our guidance has included reporting on why sustainability may provide competitive advantage (e.g., better energy efficiency, lower costs, top line growth, stronger reputation) as well as goals and targets on key metrics that are relevant to that company’s industry or business model (e.g., emissions reductions, water volumes recycled, diversity goals, lost work days, living wage).

The goal of our engagements with IR is to turn these crucial corporate contacts into our ESG advocates within the companies where we are share owners. When properly educated about the growing importance of sustainability to investors, IR teams become valuable communications conduits to the ESG decision makers within our covered companies. As illustrated by the progress of previously “uninformed” IR teams, these groups can be change makers that increase awareness, improve disclosures and assimilate ESG considerations into the business models of the companies they represent.