- Heightening uncertainty from trade, geopolitics and manufacturing weakness has turned investors and businesses defensive, hampering capital spending.
- Stock selection had a negative impact on performance, with particular weakness in industrials and health care.
- Innovation is changing the ways we produce, distribute and consume food and creating opportunities and challenges for investors to consider.
Rising risks turned investors defensive in the third quarter, with the largest stocks managing gains while overall market performance was mixed. The S&P 500 Index advanced 1.70% during the quarter to hold onto a 20.55% return year-to-date. The Russell 1000 Index added 1.42% while the Russell Midcap Index rose 0.48%. Growth stocks rallied late in the quarter to retake leadership from value stocks, with the benchmark Russell 1000 Growth Index (+1.49%) besting its value counterpart by 13 basis points for the quarter and 549 bps year-to-date.
From a sector standpoint, real estate (+7.50%) and consumer staples (+5.98%) were the strongest performers, reflecting a rotation into defensive stocks. Information technology (IT, +2.58%) also outperformed the benchmark while communication services (+0.85%) and consumer discretionary (-0.48%), the other areas of the market home to momentum stocks, lagged. Health care (-2.56%) and energy (-7.73%) were the worst overall performers.
Volatility spiked over the last three months on the ebbs and flows of U.S.-China trade tensions, attacks on Saudi Arabia’s energy infrastructure and increasing signs of a global economic slowdown. Mindful of these risks and the potential impact of weakening U.S. manufacturing activity, the U.S. Federal Reserve cut short-term interest rates 0.25% at both its July and September meetings. Following the September move, Fed Chairman Jerome Powell noted that a still strong U.S. economy and low unemployment are being offset by heightened uncertainty that has hurt business spending.
As active managers, we seek to deliver differentiated performance from the market. Over time, stock selection has proven to be a strong contributor to portfolio results. But in the short term, the active risk we take as stock pickers can work against us. This was the case in the third quarter as disappointing results from a handful of companies caused the portfolio to lag the benchmark. Uber Technologies and Grubhub, two of the newest names in our select bucket of higher-risk companies with above-average growth rates, have struggled as they invest heavily to expand market share. We believe both companies possess superior business models and are on the path to improved profitability. Uber dominates the global rideshare market and both companies are leading players in a food delivery market that has a long growth runway ahead.
Health care was also a headwind as political rhetoric heated up over potential changes to the U.S. health care system. We have alluded to the 2020 presidential election as an overhang for the sector and the improving poll numbers for Democratic candidates pushing a “Medicare for All” system has weighed on sentiment toward health care. Biotechnology companies have also been pressured by the risk of prescription drug pricing controls. Alexion Pharmaceuticals was additionally hurt by European regulators’ failure to approve new patents for its Soliris treatment while a competitor has challenged additional U.S. patents for the drug that addresses rare blood disorders.
Technology is another area under regulatory scrutiny, especially among the largest companies in the space, but souring investor sentiment toward the sector has hurt the most recently. The unwind and eventual withdrawal of the WeWork IPO has more investors questioning the growth rates and longer-term profitability of smaller, disruptive companies. This led to a rotation out of IT that hurt portfolio holdings that had run up earlier in the year, including software makers Splunk, VMware and Palo Alto Networks.
The Strategy’s diversified approach to growth, however, did help in a quarter that pressured most momentum stocks and the growth managers that are overweight such stocks. We saw resilient performance from our stable bucket of growth companies that constitute the majority of the portfolio. These are established franchises in leadership positions with the ability to steadily compound earnings and cash flow growth through difficult conditions. United Parcel Service (UPS) rose on strong quarterly results and plans to automate more distribution facilities, which should lower costs for business-to-consumer shipments. Data center operator Equinix maintains a strong business serving hyperscale cloud providers and raised its revenue guidance following better than expected second-quarter results. A robust employment picture has also supported the portfolio’s consumer holdings, with stable names Home Depot and Costco delivering solid results.
Despite a rocky third quarter, growth stocks are up 23.30% for the year, well above our expectations coming into 2019. This strong run has motivated us to take profits in some of our better performers in IT and the select bucket overall and redeploy that cash into stable and cyclical growth companies. As part of this effort, we closed a position in online payment provider PayPal. The stock has been a strong performer for the portfolio since it was spun off from eBay in 2015 and its valuation had reached a level where we believe future growth was priced in.
We gained similar, albeit broader enterprise exposure with the purchase of Fidelity National Information Services (FIS), a leading provider of payment and financial software, transaction processing and electronic payment solutions for banking, asset management, wealth management and retail customers. FIS is a stable grower that generates over 50% of its revenue from banking software and services that are sticky and resilient in a downturn. The company is paid through software sales, which provide a stable and predictable stream of recurring revenues, and has a foothold in mid-sized banks where consolidation of smaller competitors could be a positive. FIS recently acquired global payment processor WorldPay, which should lead to cost synergies and earnings growth as long as the integration goes smoothly. In terms of risks, the company is highly levered and directly exposed to the cyclicality of consumer spending.
"Momentum stocks have lost valuation support and we anticipate a continued rotation into more value-oriented and free cash flow rich companies."
With global economic indicators now flat to down, we reduced the global cyclicality of the portfolio during the quarter by selling out of two more economically sensitive positions. We exited industrial equipment supplier Caterpillar due to slowing GDP growth as well as its direct exposure to a Chinese economy facing the headwinds of tariffs. We also took advantage of case and unit growth at Coca-Cola that was the highest in many years to close out our position. Long-term earnings trends for the beverage maker have been sluggish and foreign exchange continues to be a massive headwind for the company as it does business in 120 countries.
From our perspective as an owner of large, multinational growth companies, the biggest risk for the rest of 2019 is that the fragile support of easing monetary policy will collapse and the global business slowdown already in place will spread to U.S. consumer spending. Our portfolio companies have been communicating a lack of visibility on final demand for the last several months, with tariffs and an impending U.S. profits recession causing managements to delay capital spending. This anecdotal evidence is now showing up in government data on manufacturing, with U.S. industrial activity contracting in August and September.
When businesses had no incentive to spend in 2015, the equity market sold off. We are concerned that the market is not currently pricing in the risks of reduced capex and a myriad of other uncertainties.
Low, and in many cases, negative interest rates have so far masked the full impact of a global economic slowdown. Should the manufacturing recession continue, this will impact company hiring and wage increases, with a knock-on negative impact on consumer spending. In this environment, momentum stocks have lost valuation support and we anticipate a continued rotation into more value-oriented companies and those with rich free cash flows. We are confident that our moves over the last several quarters have the portfolio well positioned to weather swiftly changing market conditions.
The ClearBridge Large Cap Growth ESG Strategy underperformed its Russell 1000 Growth Index benchmark during the third quarter. On an absolute basis, the Strategy had gains across four of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the IT and consumer staples sectors while the primary detractor was the health care sector.
On a relative basis, overall stock selection detracted from performance. Specifically, stock selection in the health care, consumer discretionary and industrials sectors had the most significant negative impact on results. On the positive side, stock selection in the real estate sector and an underweight to health care were beneficial.
On an individual stock basis, leading individual contributors to absolute returns in the third quarter included positions in Apple, UPS, Alphabet, Equinix and Akamai Technologies. Amazon.com, Uber Technologies, Alexion Pharmaceuticals, Facebook and Mettler-Toledo were the biggest detractors.
As recent growth of plant-based protein products suggests, there is an appetite for change in the food industry. Many consumers are seeking to reduce the environmental effects of meat production, or just eat less meat, and newly available burgers, hardly distinguishable from real meat but made with pea, soy or potato proteins, are proving to be a popular solution. But the development of plant-based proteins is just one example of how the food industry is being disrupted by innovation that may have environmental and social consequences.
From the field to the table, and increasingly from the restaurant counter to your door, the changing ways we produce, distribute and consume food are creating opportunities and presenting challenges for investors to consider. As an active owner of companies across the food supply chain, ClearBridge is finding economic opportunity in food industry innovation as companies seek to reduce greenhouse gas (GHG) emissions, improve efficient use of herbicides in agricultural production, scale sustainable packaging and smooth labor tensions and delivery logistics. At the same time, it is important to understand these dynamics in a balanced manner and to scrutinize evidence as it arises.
Disruption is Changing the Food Industry
Arguments against the current amount of meat production focus on the role livestock plays in GHG emissions. One estimate — from a vast 2013 United Nations study and therefore potentially a conservative figure — puts the amount of carbon dioxide equivalent per year produced by livestock globally at 7.1 gigatons, or 15% of all human-produced GHG emissions. In addition to the release of GHG emissions, industrialized animal agriculture can also have other environmental impacts such as water contamination from waste (bacteria, chemicals, hormones and antibiotics). Concerns about environmental impact, negative health consequences, high resource use and animal welfare have even encouraged some countries to consider meat taxes, similar to taxes on alcohol and tobacco.
"As online food delivery aggregators expand, new questions have arisen about food safety and protection for drivers and couriers in the gig economy."
The environmental benefits of plant-based meat products could be significant. A study by Beyond Meat and the Center for Sustainable Systems at the University of Michigan suggests a Beyond Burger generates 90% less GHG emissions, requires 46% less energy, has 99% less impact on water scarcity and uses 93% less land than an equivalent quarter pound of ground beef.
The excitement about plant-based proteins has encouraged traditional packaged food companies to take another look at reinvesting in their somewhat neglected veggie burger brands. Kraft Heinz has reformulated and rebranded its Boca Burger and Kellogg has updated its portfolio of plant-based protein products with the introduction of Incogmeato. ClearBridge holding Nestle is adding its own Awesome Burger to the lineup. Given Nestle’s scale and infrastructure as arguably the largest food company in the world, the impact of a plant-based meat product from the company could be considerable.
Additionally, several restaurants have been launching successful limited-time offerings in partnership with Impossible Foods (currently privately owned) and Beyond Meat. In another opportunity to scale plant-based protein, McDonald’s recently announced it will offer the P.L.T. (plant, lettuce and tomato) burger with Beyond Burgers.
At the same time, it’s important to acknowledge the environmental impacts of large-scale switching to plant-based proteins. These include deforestation, runoff of herbicides and pesticides into ground water and the dangers of monoculture farming, all of which should be considered before accepting meatless “meat” products as a panacea and monitored by investors for risks as plant-based protein businesses grow.
Similarly, the health benefits of switching to meatless burgers may not be so clear cut, as most meatless burgers are heavily processed and high in saturated fat and sodium. At the same time, part of the disruption in plant-based proteins is their increased ability to substitute for meats in vegetarian diets through the addition of vitamins and minerals, such as B12 and zinc (in the Impossible Burger), often found in animal proteins.
Precision Agriculture Reduces Herbicide Use
In a recent engagement with the management of ClearBridge holding John Deere, we discussed how companies in the agricultural supply chain are using technology to improve food production. Deere is a leader in precision agriculture, which applies new technologies in planting, spraying and irrigation tasks to yield more harvest and use less water and pesticides. Its AutoTrac steering system, for example, reads the soil and steers planters to nearly eliminate overlapping passes on the field, reducing unnecessary fuel, seed and chemical use. Similarly, Deere has a technology that improves spraying precision and reduces double-spraying. Its ExactEmerge planter is designed to increase the accuracy of spacing, depth and population of seeds, making for larger and more efficient yields.
In 2017 Deere acquired Blue River Technology, a small company applying machine learning, computer vision and robotics to agriculture. Blue River’s precision sprayer, currently in development, uses computer vision and artificial intelligence to precisely spray herbicides only where they are needed. The sprayer is expected to reduce herbicide application rates by over 30% for all major crops, including a 90% reduction for cotton — in our meeting we learned of one field trial for cotton in which herbicide consumption costs declined to $25,000 compared to $250k the previous year. It is slated for a potential 2021 launch.
Since some of Deere’s farm equipment innovation relies on connectivity, the lack of broadband coverage in rural areas has been a challenge. ClearBridge holding Microsoft’s FarmBeats program is offering one solution in this regard by helping farmers improve their digital technology. FarmBeats is an Internet of Things (IoT) platform that uses unused TV white spaces to create broadband links between a farmer’s home internet connections and a solar/battery-powered IoT station on the farm. Greater internet connectivity on the farm better enables technology-enhanced solutions and, ultimately, more efficient and sustainable agriculture.
Food Along the Last Mile
The technological disruption that brought us rideshare companies like Uber is also enabling a large platform for online food delivery aggregators. For companies with both rideshare and food delivery businesses, the proportionate role of food delivery is increasing (Exhibit 1).
Exhibit 1: Food Delivery Increasingly on the Menu
This is not surprising: food delivery sales in the U.S. for online aggregators are taking off. We are now at $20 billion in gross annual sales, just counting DoorDash, Uber Eats, Grubhub and Postmates, to name four of the larger players (Exhibit 2). Sales through these platforms are growing at around 60% year over year. While this is small compared to overall U.S. restaurant sales (which are an estimated $800 billion a year, including delivery, dine in and drive through), the total pie of digital-enabled delivery is slated to grow.
Exhibit 2: U.S. Online Food Delivery Is Growing Steadily
At the same time, as online food delivery aggregators are offering enhanced convenience and expanded food selection to consumers, new questions have arisen about food safety and protection for drivers and couriers in the gig economy. Food safety questions run the gamut from whether drivers can maintain correct hot or cold temperatures for food in their cars to concerns around food tampering from couriers. Labor questions surround benefits and pay for delivery drivers and couriers, most of whom are working part-time.
Ultimate success of online delivery companies may depend on the strength of partnerships with restaurants, in effect bringing drivers’ incentives into closer alignment with those of the restauranteurs, and the ability to leverage technology to reduce food safety incidents and improve delivery efficiency. ClearBridge holding Grubhub looks to be well-positioned in both regards. Through our regular engagements with Grubhub, we remain in active dialogue on best practices with regards to both food safety and labor relations.
Consumers Are Playing an Increasing Role
The role of the consumer in these changing dynamics should not be forgotten. Consumers voting with their wallets have been successful at changing, or at least helping steer, a whole industry, and this has occurred largely only in the past few years. While a common criticism is that more sustainably sourced foods are usually more expensive and more available to affluent consumers, this situation may be changing, if slowly. ClearBridge holding Costco, is both the largest warehouse food retailer in the U.S. and a top organic food retailer. Given its scale, Costco is making organic and natural food products more price competitive, helping to overcome some cost barriers. At the same time, shopping for organic or sustainably sourced products can be confusing. For example, little consensus and few useful laws regarding organics labelling make determining which products are truly organic a challenge.
From production to consumption, food covers many industries and offers ClearBridge many avenues for understanding and engaging with companies we own both on best practices and on disruptive innovations that are both offering economic opportunities and potential solutions to pressing environmental problems. We continue to work with our portfolio companies to create more ways in which consumers and investors can truly change the food landscape.