- The portfolio showed resilience amid the market downturn in the fourth quarter.
- Our stock selection in IT helped our holdings in that sector stand up relative to the broad technology sector.
- We are working with portfolio companies, both makers of EVs and those in the supply chain, to promote sustainable and fair production and consumption of EVs.
Market Overview and Outlook
Equities declined sharply in the fourth quarter as slowing global growth, exacerbated by escalating trade tensions with China, and rising short-term interest rates raised concerns about the sustainability of the U.S.’s robust domestic economy. Meanwhile, in the face of lofty expectations and impressive stock performance during 2017 and the first nine months of 2018, the bellwether tech companies sold off even harder than the broader market, putting in doubt their market leadership going forward. While the market steadied somewhat in November when U.S. midterm elections produced a split Congress, viewed as more conducive to stable policy, this was short-lived. By year-end fears of slowing economic growth and tightening monetary policy in the U.S. negatively impacted investor sentiment, resulting in further declines.
Despite fears, the U.S. economy continues to grow steadily while the labor market remains strong. In the benchmark Russell 3000 Index, the fourth-quarter market decline was broad based, with only the defensive utilities sector generating a positive return. Other defensive areas such as real estate and consumer staples were down, but performed relatively better, as long-term interest rates declined midway through the fourth quarter. Industrials, IT and consumer discretionary stocks also fell, largely on worries of global economic cooling.
The portfolio showed resilience amid the market downturn in the fourth quarter. Lack of traditional energy exposure was a significant plus as the energy sector fell over 25% while oil prices dropped to their lowest levels in a year.
As investors fled from risk assets and falling Treasury yields made income sectors more attractive, the portfolio’s overweight to utilities, led by NextEra Energy and Ormat Technologies, was also beneficial. NextEra is one of the highest-quality utility companies, operating a lower-risk growth profile and developing the largest renewables market. The company is the world’s leading producer of wind and solar power and continues to prudently manage its assets in the best interest of shareowners. Ormat is a market leader in the geothermal energy industry. Its proprietary technology has enabled it to rapidly gain market share, and with geothermal expected to be an increasing source of base load renewable energy around the world, we believe the company is well positioned to capture this growth. Geothermal is a low carbon alternative that consumes less land and water while exerting much lower impacts on the environment, compared with conventional fossil fuel combustion.
While consumer discretionary companies were among the largest hit in the market, Starbucks stood out among the portfolio’s consumer discretionary holdings, delivering strong earnings in the third quarter. Starbucks’ turnaround from a rough second quarter looks to be happening faster than expected: new initiatives such as automation tools and training have helped sales in the Americas, while a new product platform boosted same-store sales in China.
In the industrials sector, Vestas Wind Systems, a maker of wind turbines to generate electricity, also provided some support. Vestas reported strong orders as global demand for wind energy strengthens. Through our ownership of renewable energy companies such as Vestas, ClearBridge is finding economic opportunity in a technology that will also help the planet. The energy production from a 100 megawatt wind park Vestas recently successfully bid for in Singapore, for example, will offset roughly 330,000 tons of CO2 per year.
The portfolio’s meaningful exposure to Apple and Alphabet meant it was not immune to the sharp de-rating among momentum-driven large cap information technology (IT) companies. Signs of weakness among these market leaders — slowing iPhone sales for Apple, and ongoing privacy concerns and regulatory risks for Alphabet — made IT the largest detractor in the portfolio on an absolute basis.
Even with the drag of Apple and Alphabet, our stock selection in IT helped our holdings in that sector outperform on a relative basis. SolarEdge, one of the best positioned component suppliers to the solar industry and a recent addition to the portfolio, outperformed the market. Recently added Lam Research, a leading technology hardware company that makes capital equipment used in the semiconductor manufacturing process, also had a good quarter relative to the market. Lam’s technologies are crucial to the miniaturization of semiconductor technology, which reduces device size and energy consumption for chips.
In materials, Ecolab, a water technology company that reduces consumption, enables reuse of water across a variety of industries and manages 1.1 trillion gallons of water, helping with water safety for 27% of the world’s processed food and 42% of all processed milk supply, did well on a relative basis.
In the quarter we initiated positions in Evoqua Water Technologies and Bank of America. Evoqua designs, manufactures and operates water treatment systems for industrial facilities and municipal water treatment plants, mostly in North America. The water treatment systems that Evoqua sells are often mission-critical — water is an essential component in many industrial production processes, so unavailability of proper water purity, specifications or quality can lead to significant production constraints, downtime and/or increased operating costs. Evoqua’s products and services help its customers improve water use efficiency and ensure adequate quality of water returned to the environment. As such, an increasing focus on corporate sustainability and concerns around water efficiency, quality and scarcity are key drivers for the company’s business.
We added Bank of America on the basis of an attractive valuation and improving fundamentals. Bank of America will benefit from its scale in operations, technology investments, and effective branding and marketing. Relative to other large banks, Bank of America has a more conservative credit risk profile and has less capital markets risk. While Bank of America’s business impacts the environment less than many other businesses, such as manufacturers or mining companies, it is a large organization and changes in its goals and practices can make a difference. Bank of America tracks and manages the environmental impact of its operations, using the Global Reporting Initiative Standards. The company tracks GHG emissions by types of consumption and across geographies, providing detailed reporting. Such focus on tracking has enabled it to meaningfully reduce direct and indirect greenhouse gas emissions over the past seven years (including 14 indirect categories including purchased goods/services, employee commuting, business travel, waste). Bank of America’s priorities regarding the treatment and composition of its workforce are also positive: 51% of global employees and 42% of global management are female, and 45% of its U.S. workforce is of diverse races or ethnic backgrounds.
The integration of sector-specific ESG considerations into our fundamental research process leads us to new opportunities like these. We believe this integration not only helps us identify companies with sustainable business models that are suitable as long-term investments, but also helps us make an impact through the active and intentional selection of public equities with best-in-class ESG practices.
The ClearBridge Sustainability Leaders Strategy outperformed its Russell 3000 Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in none of the 10 sectors in which it was invested (out of 11 sectors total). The least negative contributors were the utilities and materials sectors. The primary detractors from performance were the information technology (IT) and financials sectors.
On a relative basis, both overall stock selection and sector allocation contributed positively to performance. Stock selection in the industrials, consumer discretionary and materials sectors helped relative results. A lack of exposure to the energy sector also boosted returns. Conversely, stock selection in the real estate and consumer staples sectors was detrimental.
"Lack of traditional energy exposure was a significant plus in the fourth quarter."
On an individual stock basis, Starbucks, Vestas Wind Systems, NextEra Energy, Ormat Technologies and Unilever were the largest contributors to absolute performance in the quarter. The biggest detractors from absolute returns included positions in Apple, Lowe’s, Microsoft, Alphabet and Trex.
During the quarter, we established new positions in Evoqua Water Technologies and Bank of America. We exited our positions in Acuity, a North American lighting company, due to increasing price pressure in certain product categories and a slowdown in the lighting market, and 3M, as the company had been struggling to demonstrate the level of growth that we were expecting the company to deliver.
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.
"Shareholders of both fleet buyers and manufacturers are poised to benefit from greater commercial EV adoption."
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.
Suppy 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.
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 1).
Exhibit 1: EV Climate Impact Beneficial Under Any Energy Mix
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.