- Slowing global growth and signs of weakness among the market leaders of the last several years sent stocks to sharp losses.
- The portfolio was supported by our allocation to stable growth companies and diversification across the information technology sector.
- We are working with portfolio companies, both makers of electric vehicles (EVs) and those in the supply chain, to promote sustainable and fair production and consumption of EVs.
Volatility rose sharply in the fourth quarter, sending U.S. equities to broad losses as investors fretted over risks related to slowing global growth, rising interest rates and stumbles by some of the market’s largest companies. The S&P 500 Index suffered its second-worst December on record (-9.03%) to finish down 13.52% for the fourth quarter and register its first annual loss (‑4.38%) since the global financial crisis. The Russell 1000 Index fell 13.82% for the quarter and 4.78% for 2018 while the Russell Midcap Index declined 15.37% for the quarter to finish down 9.06% for the year. The benchmark Russell 1000 Growth Index fell 15.89% for the quarter, underperforming its value counterpart by 417 basis points. The benchmark was down 1.51% for 2018.
Recent market action also reflects a return to normalized valuations and earnings growth rates as monetary and fiscal stimulus measures are simultaneously removed from the economy. The Federal Reserve raised short-term interest rates for the fourth time in 2018 in December as it continued a path of tightening. Meanwhile, the boost to corporate earnings from late 2017 tax reform is starting to wear off as EPS growth is forecast to decelerate and companies face tougher quarterly comparisons (Exhibit 1). Add to this mix the uncertainty over trade and tariffs, which is causing corporate managements to delay capex, and it’s no surprise that volatility remains elevated.
Exhibit 1: Revenue & Earnings Could Be Peaking
Valuations, especially among momentum-driven large cap information technology (IT) companies, had reached unsustainable levels as markets touched new highs in the third quarter. Signs of weakness among these market leaders — slowing iPhone sales for Apple, ongoing privacy concerns and regulatory risks for Facebook and Alphabet — caused a sharp de-rating among the FAANG stocks (Facebook, Amazon.com, Apple, Netflix and Google/Alphabet) and the sectors where they now reside. IT (-18.81%), communication services (-17.30%) and consumer discretionary (-17.17%) all underperformed the benchmark in the fourth quarter.
The portfolio has meaningful exposure to the FAANGs and we believe several are great long-term businesses. We added to our position in Facebook during the quarter as market swings provided attractive entry points.
Amazon remains our largest holding and an overweight compared to the benchmark. While down 25% for the quarter, the stock was up 29% for the year. At current levels, we believe the company is undervalued relative to the sum of its parts. Amazon continues to dominate and innovate at very high levels across its businesses, with particularly strong positions in three key areas related to the Internet: e-commerce, cloud infrastructure with Amazon Web Services (AWS) and advertising. Its Prime service has over 100 million subscribers globally and is growing. AWS is building off an already large lead in workloads moving to the cloud, a total addressable market in the hundreds of billions of dollars. The company also has a new, evolving business in advertising and marketing that features high profit margins and is largely not accounted for by the market.
We are at the point late in the market cycle when it is critical to separate business models and identify companies that can move higher based on strong fundamentals rather than passive fund flows. Bulk retailer Costco, for example, runs a unique, subscription-driven business that has performed well in both healthy and unsettled environments. We consider Costco a stable growth stock, one of three types of growth companies we target in the portfolio to provide diversification and exposure to organic growth through all types of market conditions. Stable growers like Coca-Cola also provided balance to the portfolio during the quarter as pricing power and strong execution enabled it to deliver a positive return in a quarter that saw all 10 sectors in the benchmark suffer losses.
We added to the stable bucket in the quarter with the purchase of IHS Markit, a provider of business and information services to enterprise customers across transportation, financial services, energy and similar industries. The company operates a diverse set of businesses with consistent growth and high barriers to entry, including the CarFax vehicle history service, and produces geological reports that are a standard research tool for oil & gas exploration and production companies.
Communications chipmaker Qualcomm, meanwhile, falls into our cyclical growth bucket of companies facing near-term headwinds that we believe are fixable and will lead to a step change in growth. Qualcomm has multiple options to accelerate earnings that are mostly independent of the smartphone market it serves.
Select growth stocks make up our third bucket and are companies generating above-average growth rates through disruption and innovation. These stocks also carry higher multiples and higher risk. We further diversified our IT exposure in the quarter with the addition of two select growth names, Nutanix and Nvidia.
"Owning companies with defensible businesses will become more important as growth slows and liquidity shrinks."
Nutanix holds significant market share in a software solution for cloud computing called hyperconverged infrastructure (HCI) that enables storage, computing and networking to operate as a single platform. HCI increases the efficiency and scalability of data centers and its usage as a low-cost solution is expected to more than double in the next several years. The company is transitioning into a software-only vendor of on-premise and cloud solutions, which should result in a better long-term business. We also took advantage of an earnings driven selloff to initiate a position in Nvidia, a leading developer of graphics processing units (GPUs) for some of the most attractive markets in technology: PC gaming, data center and artificial intelligence applications.
Owning companies with defensible businesses and self-help characteristics will become more important as growth slows and liquidity shrinks. Instead of using excess cash to buy back shares — an action responsible for about 40% of S&P 500 earnings this past year — we believe companies will start paying down debt. Capex is also expected to slow as the tax benefits of immediate depreciation fade and uncertainty over tariff impacts cause company managements to delay non-critical projects. We will be closely monitoring fourth-quarter earnings reports for guidance on how and when companies plan to deploy their cash flow in the year ahead.
From a portfolio standpoint, we remain positioned for positive GDP growth but at a slower pace than the 3.4% rate in the third quarter. We are slightly underweight industrials and significantly underweight the consumer discretionary sector. The energy sector has also been a headwind to performance as lower demand from slowing global growth and oversupply from U.S. shale drillers, Saudi Arabia and Russia contributed to a more than 35% decline in crude oil prices. Both exploration & production and oil service companies suffer in this type of environment with the market only rewarding energy companies with the best balance sheet discipline. The hesitance of both U.S. and international drillers to spend on new projects may be further hampered by sharply lower commodity prices.
Many of the tailwinds that have driven equities higher through the long-running bull market are turning into headwinds. In this generally less advantageous environment, we believe it is essential to be much more selective in choosing companies to own for the long term. As mentioned earlier, the portfolio is pivoted toward companies and industries capable of generating visible and durable growth and that are more insulated from macro risks than the general market, which today include biotechnology, enterprise software, e-commerce and select names across communication services.
The ClearBridge Large Cap Growth ESG Strategy outperformed its Russell 1000 Growth Index benchmark during the fourth quarter. On an absolute basis, the Strategy had losses across all 10 sectors in which it was invested (out of 11 sectors total). The primary detractors from performance were the IT, health care and consumer discretionary sectors.
On a relative basis, overall stock selection and sector allocation contributed to performance. Stock selection in the IT sector was the primary driver of relative returns. Stock selection in the communication services, materials and consumer staples sectors also helped. On the negative side, stock selection in the health care, consumer discretionary and real estate sectors and an overweight to energy weighed on performance.
On an individual stock basis, leading individual contributors in the fourth quarter included positions in Red Hat, McCormick, Aetna, VMware and Coca-Cola. The biggest detractors from absolute returns were Amazon.com, Apple, Schlumberger, Facebook and Alphabet.
Carbon emissions from vehicles contribute significantly to global warming, and the transportation sector is one of the larger contributors to greenhouse gas emissions (GHG) in the U.S. As institutional investors seek to offset and mitigate the rising levels of carbon and other GHGs, electric vehicles (EVs) are an increasingly viable solution. With sales of EVs growing faster than predicted a few short years ago, the outlook for EV production and adoption is becoming increasingly robust.
We think greater consumer and commercial adoption of EVs will bring environmental benefits as well as financial opportunity for both manufacturers and users and throughout the EV supply chain. It will also involve environmental and social challenges, and we are working with the companies we own, both makers of EVs and those in the supply chain, to help make sustainable and fair production and consumption of EVs possible.
Commercial Adoption of EV Will Be a Watershed
Much of the focus until now has been on consumer adoption of EVs. But there is reason to shift focus to commercial adoption, because as total cost of ownership for an EV falls, EVs are becoming more feasible for commercial use. Shareholders of both fleet buyers and manufacturers are poised to benefit from greater commercial adoption.
ClearBridge holding United Parcel Service, for example, is currently buying a fleet of 1,000 electric vans from Workhorse, a U.S.-based manufacturer of electric delivery and utility vehicles, part of an electrification effort that includes converting up to 1,500 delivery trucks to battery electric and initiating purchase of 125 Tesla Semi trucks and Daimler electric trucks. FedEx has also recently ordered 1,000 electric vans from California-based Chanje for use in commercial and residential pick-up and delivery in California.
Commercial adoption should help the bottom lines not just of logistics companies, but also of large consumer staples companies heavily dependent on transportation. Freight costs are one of the greatest areas of cost inflation among consumer staples companies such as ClearBridge holding Pepsico, which is ramping up its electrification efforts with 100 Tesla Semis on order. Other major consumer staples companies with Tesla Semis on order include Walmart and Sysco. As manufacturers continue to consolidate production in larger, more efficient plants, and retailers carry less inventory and demand delivery within ever more narrow time windows, transportation logistics become an increasingly important competitive advantage.
Commercial vehicles remain an underappreciated source of net-environmental benefit and investment opportunity. We encourage a diversified fleet and view several portfolio companies taking advantage of the increased feasibility of EVs in their operations as significant progress in moving toward sustainable transport.
Supply Chains Present Challenges
While EV adoption has clear environmental and economic benefits, there are also challenges, such as eliminating or minimizing the environmental and social impacts of sourcing critical metals used in batteries. EV batteries contain lithium and cobalt, metals whose production can present several supply chain risks, including environmental damage, forced labor and poor health conditions.
We are partnering with our portfolio companies both to establish responsible and efficient sourcing practices and to reduce reliance on rare earth minerals through innovation.
ClearBridge holding Umicore, for example, is a global materials technology and recycling company based in Belgium. During the year ClearBridge hosted several meetings with Umicore management, engaging the company on several ESG-related topics. One key area of focus in 2018 was the company’s approach to sustainable procurement and ethical sourcing of raw materials. Umicore has been a worldwide leader in the recycling, transformation and marketing of cobalt since 1912 and is aware of the risks that are linked to the sourcing of cobalt.
Umicore not only manufactures cathodes for batteries, it also has a large recycling operation that provides some of the materials needed for cathodes and reduces the impact of materials sourcing by getting some materials like cobalt from internal recycling operations. Umicore is investing in battery recycling technology, which has the potential to be a large business for the company in the future. Where recycling has not been firmly established, Umicore has established top sustainable policies for ethical sourcing of cobalt. These include supply chain traceability to track the origin of cobalt raw materials at the mine level, plant visits and red flag checks that eliminate suppliers engaged in any of several unacceptable practices.
Innovation also provides a path to solving EV supply chain challenges. In a ClearBridge visit with Tesla management in 2018, for example, we noted how Tesla is reducing its reliance on cobalt through the adoption of batteries from Panasonic that use more nickel in the cathode and more silicone in the anode material. We also discussed the eventual need for end-of-life battery recycling as part of the manufacturing facilities and observed Tesla Gigafactory’s integrated recovery systems, which recover energy and save costs through regeneration braking in drivetrain testing and wastewater recovery.
Well-To-Wheel, EV Benefits Add Up
Another challenge is the concern that the total carbon profile of EVs is potentially still significant, given the energy and resources required to build and power EVs. Often, however, these concerns are grounded on incomplete information. Examples of EV energy and resource use, for example, often focus on the energy and resources required to make batteries, but they ignore a comparison to the energy and resources required to make traditional powertrains.
Exhibit 2: EV Climate Impact Beneficial Under Any Energy Mix
A complete vehicle fuel-cycle analysis, or well-to-wheels analysis, however, shows numerous clear benefits of EVs, such as the elimination of tailpipe emissions from population centers. While the life cycle impact of EVs compared to ICEs on climate should consider the nature of the electricity charging EVs (electricity may be generated by coal, for example, counteracting environmental gains of EVs), this impact is positive under any electric grid scenario. There are many academic studies comparing the EV versus ICE impact on the environment throughout the life cycle of a vehicle: from materials extraction to end-of-life recycling. One study concludes that even in the “dirtiest” grid (coal power) a fully electric fleet would result in 25% GHG emission reductions versus a diesel fleet (Exhibit 2).
EVs represent a compelling business opportunity for portfolio companies that can also have significant environmental benefits, and institutional investors are playing a growing role in pushing EVs forward. ClearBridge is a long-standing member of the Investor Network on Climate Risk (INCR), which has organized biennial summits on climate change at the United Nations for institutional investors to convene on how to apply private capital solutions to global warming. Both business opportunities and environmental benefits look poised to increase as EVs are adopted for commercial use. Commercial adoption should also reinforce the need for innovation in battery technology, reducing the need for rare materials and increasing the effectiveness of battery recycling. We will continue to engage with our portfolio companies to foster greater consumer and commercial EV adoption and address the challenges that the EV supply chain presents.