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Commentary

Large Cap Value Strategy

Second Quarter 2019

Key Takeaways
  • U.S. equities’ solid returns were fairly broad-based across market cap and style and driven by hints of monetary easing and trade optimism.
  • Looking at the impressive market performance year-to-date, one can easily miss underlying monthly volatility on display during the period.
  • Portfolio activity during the quarter continued to focus on high-quality franchises, while remaining valuation sensitive and reducing cyclicality.
Market Overview and Outlook

The U.S. equities market continued to generate solid returns in the second quarter, with the broad S&P 500 Index generating a 4.30% return and the benchmark Russell 1000 Value Index advancing  3.84%. Gains were broad-based across market cap and style, with the Russell 1000 Growth Index up 4.64% and the Russell Mid Cap Index rising 4.13%. The small cap Russell 2000 Index trailed with a 2.10% gain. Financials led the market higher despite expected net interest income pressure from a 40 basis point decline in the 10-year U.S. Treasury yield to 2.0% and a 50-basis point reduction in the projected year-end federal funds rate. Materials and information technology (IT) stocks were also strong. Energy was the only sector to generate a negative return, despite higher oil prices during the period. Meanwhile, the health care and real estate sectors generated relatively more modest, but still positive returns in the period.

The quarter was bookended by positive returns in April and June as investors were cheered by hints of a more accommodative policy turn by the Federal Reserve and optimism that a trade deal between the U.S. and China would be reached. In May trade tensions reappeared and threatened to broaden: the U.S. administration raised tariffs from 10% to 25% on $200 billion worth of Chinese goods and raised the specter of tariffs on imports from Mexico. It also stepped up actions against Huawei, banning the Chinese telecom giant from doing business in the U.S. and effectively barring U.S. suppliers from selling to the company. In June, however, Mexican tariffs were off the table as the Mexican government agreed to contain the flow of migrants, the U.S. and China were back at the negotiating table, and the Fed dropped the word “patient” from its statement and said it would “act as appropriate” to prop up the economy. Risk assets were in vogue again.

Looking at the impressive market performance year-to-date, one can easily miss underlying monthly volatility on display during the period. Slowing global growth remained a concern in the second quarter, with China’s GDP growth rate declining, the euro area economy losing momentum and trade tensions dampening business confidence. Reflecting a more pessimistic outlook, 10-year U.S. Treasury yields dropped to 2.0% and the yield curve inverted.

Our holdings in the IT and communication services sectors drove the Strategy’s outperformance. Within IT, both Motorola Solutions (MSI) and TE Connectivity were up about 19%. MSI, a top five holding, is the leading provider of two-way radios and wireless local area network products for public\ safety, government and enterprise customers, which offer a stable end market. Growing security concerns and the administration’s efforts to reduce the U.S. government’s (and its allies’) reliance on Chinese technology vendors should further benefit the company as it gradually migrates its business model toward software and managed and support services, where it should enjoy recurring revenues, as well as higher margins and cash flows. We trimmed our position modestly on strength during the period.

Another substantial holding, TE Connectivity (TEL) produces a range of connectors and sensors used across the automotive, energy, aerospace, industrial, communications, medical and consumer markets. While TEL is currently facing cyclical pressures, particularly within the automobile industry that represents more than 40% of sales, it should continue to benefit from considerable secular tailwinds over the long term. For example, electrification and infotainment adoption within the automotive industry results in TEL per vehicle content growth outpacing automotive production volumes across the geographies. Similarly, the Internet of Things (IoT) requires connectivity — on the factory floor, in health care, between appliances, cars, airplanes, etc. Therefore, there is a long-term demand for connectors and sensors to enable connected “everything.” We added to our position in December 2018.

Our communication services holdings such as DISH Networks and Charter Communications had good quarters. DISH emerged as a potential beneficiary of the proposed Sprint/T-Mobile merger. The companies are wrangling with the Department of Justice, the Federal Communications Commission and the states’ attorney generals, trying to work out an agreeable framework to attain approval of the transaction, while addressing anti-trust concerns. Against this backdrop, DISH’s existing spectrum portfolio has uniquely positioned the company as a viable alternative carrier potentially able to preserve the competitiveness of the wireless industry. The stock reacted positively to a potential transaction that could highlight the value of DISH’s spectrum holdings. Charter, meanwhile, has been executing well and is beginning to enjoy some of the synergies of its 2016 acquisition of Time Warner Cable.

Political rhetoric about changes to Medicare and scrutiny of prescription drug prices continued to sour sentiment on the health care sector. Stocks of managed care companies such as Anthem and UnitedHealth were particularly impacted by Democratic presidential candidates’ plans advocating “Medicare for All” alternatives. Shipping and logistics giant UPS was weighed down by concerns of a global slowdown as economic data indicated deceleration and interest rates collapsed.

 

"Though the market is willing to pay high prices for perceived safe assets, we are sensitive to valuations in our existing holdings and in our pipeline."

 

Financials led the benchmark returns in the second quarter, and we participated through our positions in JPMorgan Chase, American Express, U.S. Bancorp and Bank of America. Other financials holdings did not perform as well under the increased interest rate pressure. Bank of New York Mellon and State Street have seen deposit levels come under pressure. In addition, recent yield curve movements present challenges to spread income growth for them both, as well as for Charles Schwab. State Street has continued to face competitive price pressure and a challenging macro-economic environment. After reducing our exposure to State Street in 2018, we exited our position in the second quarter.

In addition to our sale of State Street, we reduced our exposure to the energy sector by closing our position in Halliburton. We had trimmed Halliburton in the first quarter on concerns that the company was less able to leverage its historical cost advantage in North America despite rapid growth in unconventional supply. Over the past few years, we have witnessed heightened cyclicality in North American oil field services and more intense and frequent supply/demand imbalances as U.S. shale has become a swing producer. While in the long term, technological advancements may become a bigger point of differentiation benefiting large oil field services companies, it may take years before we see tangible results.

Meanwhile, we added to our positions in Anheuser-Busch InBev, Berkshire Hathaway and United Technologies, all high-quality names at attractive valuations in our assessment. We continue to focus on such high-quality franchises while reducing cyclicality in the portfolio. Though the market is willing to pay high prices for perceived safe assets, we are sensitive to valuations in our existing holdings and in our pipeline, and we remain underweight consumer staples and utilities. We continue to maintain a disciplined investment approach that focuses on competitively advantaged companies with strong franchise characteristics capable of generating superior returns across cycles.

Portfolio Highlights

The ClearBridge Large Cap Value Strategy outperformed its Russell 1000 Value Index benchmark during the second quarter. On an absolute basis, the Strategy had gains in nine of the 11 sectors in which it was invested for the quarter. The largest contributions came from the financials, IT and communication services sectors. The energy and consumer staples sectors were the sole detractors from Strategy performance.

On a relative basis, overall stock selection and sector allocation contributed positively to performance. In particular, stock selection in the IT, communication services and materials sectors contributed to relative results. The Strategy’s stock selection in the industrials, financials and health care sectors, on the other hand, detracted.

On an individual stock basis, the largest contributors were Motorola Solutions, JPMorgan Chase, TE Connectivity, Microsoft and DISH Network. Positions in Halliburton, Philip Morris, Bank of New York Mellon, State Street and United Parcel Service were the greatest detractors from absolute returns in the quarter.

During the quarter, we exited positions in Halliburton in the energy sector and State Street in the financials sector.

Robert Feitler

Portfolio Manager
25 Years experience
24 Years at ClearBridge

Dmitry Khaykin

Portfolio Manager
23 Years experience
16 Years at ClearBridge

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  • Past performance is no guarantee of future results.

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