- A quasi-recession for earnings in 2019 was more than offset by multiple expansion that drove the S&P 500 Index to a total return above 30% for the year.
- Stock-level contribution was a very modest positive for the year and came despite continued intense headwinds against a valuation-driven process.
- We continue to make an active choice to stick with stocks where embedded expectations are well below their current fundamentals and long-term potential.
Market Overview and Outlook
One of the biggest psychological challenges we all face when confronted with outcomes in our random and complex world is remaining balanced and consistent when faced with good or bad outcomes. This challenge leads to the fundamental attribution error for investors, where we overestimate our skill in good outcomes and blame bad luck for unfavorable outcomes. As our 2019 performance fell behind the index as the fourth quarter progressed, it was very tempting to fall prey to fundamental attribution error and blame disappointing performance on the bad luck of being a valuation-disciplined investor in a momentum- and growth-driven market. There is truth to this, and it remains a difficult investing environment for active value strategies. However, the constant improvement we strive for as investors requires the cold lens of introspection, and a deeper evaluation of where we need to keep improving.
A critical element for continual learning and improvement is to focus solely on what you can control. This is an acute challenge in the complex and extremely noisy environment of financial markets, but one of the “less noisy” levers of control is execution of our investment process at the bottom-up stock level. In 2019, we had to see an improvement in our stock picking from executing our investment process, and we did. However, we still have more progress to make in 2020 despite the continued intense headwinds against a valuation-driven process. How did we improve in 2019 and how will we keep this critical journey going?
"In 2020 investors should enjoy both liquidity-driven valuation support and earnings."
As we detailed in our commentary a year ago, our focus in 2019 was not to compromise between our valuation discipline and underlying fundamentals. The goal, which we achieved, resulted in a portfolio with better earnings and cash flow growth than the overall market, along with a better trend in estimate revisions. We also continued to focus on being even quicker and more systematic in changing our minds when evidence mounts against one of our stock-level investment cases. A principal driver of our investment cases is that embedded expectations priced into a stock are too low. We are right when reality plays out better than what the market originally priced, and wrong when it doesn’t. The key here is that we are not reacting to price moves, but rather how observed events can systematically update an investment case. This updating discipline is essential because in an increasingly passive and momentum-dominated market, the causal and correlative glue between price and fundamentals has in many cases melted. This erosion of the market’s focus on the logic of basic math is a major performance challenge. It helps explain why we still underperformed in 2019 despite a material improvement in stock picking.
Our biggest headwind in 2019 was not owning enough semiconductors, and other prominent growth names, like Disney, that are ironically a big part of our “value” index. With the semiconductor SOX index up 63% and Disney stock up 34% last year, you would think fundamentals must have been terrific. In fact, semiconductor revenues and earnings both fell dramatically, and came in well below expectations. Disney also suffered from negative estimate revisions during 2019, as earnings declined 22%. The key for the stock is that despite negative earnings revisions and growth, Disney’s valuation multiple exploded (Exhibit 1) to a record high as investors blessed the Disney+ online initiative. Semiconductor stocks were also powered higher by multiple expansion that more than offset challenged 2019 fundamentals.
Exhibit 1: Disney’s Multiple Expanded Despite Negative Earnings Growth
Conversely, much of our portfolio suffered the inverse: growth in revenues and earnings beat the market’s and our original expectations but were partially or completely offset by multiple contraction. One of the best illustrations of this inverted logic was Alexion, which was a major active bet for us. Alexion blew away original expectations, with revenue growth of almost 20% and earnings growth exceeding 30% in 2019. Despite these great fundamentals, Alexion’s valuation multiple was more than cut in half (Exhibit 2).
Exhibit 2: Alexion Has Earned, Though Its Multiple Contracted
With the market clearly not playing a game that rewards our focus on fundamentals and valuation at the security level, our challenge is to figure out what game the market is playing, so that we can adapt as much as possible without sacrificing the discipline of our investment process. The dynamic tension inherent in this challenge is immense, but tackling it is a key part of continual learning and improvement. So what game is the market playing?
A major tenet of causal reasoning is to try and figure out the simplest explanation for what you observe. Within markets, the observation of 2018 and 2019 strongly supports the old trading maxim that investors “should never fight the Fed.” In 2018, the Fed was tightening monetary policy and slowly draining liquidity from the system. Despite good earnings growth for the overall market in 2018, it was a tough year as valuation multiples compressed and then collapsed in a historically weak December. As we also discussed in a commentary last year, with the Fed-driven tide of liquidity receding in 2018, some major risk rocks started to surface. It became clear that the global economy was much more sensitive to lower liquidity and higher interest rates than most investors, including us, expected.
Then in 2019 we got the logical inverse of 2018, as the Fed pivoted and committed to restoring a high tide of liquidity to hide all the ugly risk rocks. The result was a global restoration of liquidity that took out the old high-tide records and manifested itself in late summer when over $17 trillion of global debt enjoyed a negative yield (Exhibit 3). Mirroring the 2018 experience, despite a quasi-recession for earnings in 2019, it was more than offset by multiple expansion that drove the S&P 500 Index to a total return above 30%.
Exhibit 3: Negative-Yielding Debt Has Soared
So, the first rule of the current game is to follow the Fed-driven liquidity tide, as it will power markets through valuation changes that overwhelm earnings growth. In 2020, the Fed has signaled that it will keep the liquidity tide high and supportive of valuation. The bonus is that all the global liquidity should also support faster global growth. Thus, the big change in 2020 is that investors should enjoy both liquidity-driven valuation support and earnings. With the two classic drivers of stocks in place, markets are very much embracing risk as 2020 begins, and you cannot rule out that we could get a late-cycle melt up in the market’s favored sectors: large-cap tech, semiconductors and low-volatility defensive stocks.
Which leads to the second challenge of the current game: the liquidity tide doesn’t lift all boats. There has been a huge divide between winners and losers this cycle. This divide is accelerating as price momentum has been amplified by passive flows that ignore fundamentals and valuation. Using the Alexion versus Disney example above, good relative performance increasingly requires surfing the most crowded waves. We fully recognize we have the choice to move closer to the index, and in some cases we have. We are also constantly looking for opportunities across the market, including in the boats flattered by Fed liquidity. However, we will not sacrifice our investment discipline and are making an active choice to stick with stocks where embedded expectations are well below their current fundamentals and long-term potential.
If we get a melt up in 2020 for this cycle’s large cap winners, value will have a poor relative performance year as the current market trend accelerates. However, we are more concerned with the absolute risks to investor capital that are continuing to build beneath the Fed liquidity tide. The risk rock we worry most about lurking beneath the surface is a classic debt cycle, as the harsh reality is that we cannot seem to avoid adding more debt relative to the overall economy with each market cycle. As a result, during every down cycle ground zero for the crisis is typically where the most debt gets added. This cycle it is in U.S. corporate and government debt. On the corporate side, BBB-rated debt has tripled since the Great Financial Crisis to almost 12% of GDP and could prove to be a major issue as this debt is downgraded to junk during the next downturn (Exhibit 4). This abundance of corporate debt has fed (no pun intended) potential excesses in private equity and sustained some business models that will not be able to endure a higher cost of capital. The debacle with WeWork is the most dramatic recent example of this dynamic.
Exhibit 4: BBB Debt has Tripled since the Great Financial Crisis
The key, of course, is what could trigger a problem? The Fed’s about-face in 2019 clearly demonstrates that it has the debt market’s back, but our biggest concern is that with monetary and fiscal policy both targeting reflation and faster growth they may get what they wish for: higher rates as inflationary expectations start to rise. There is very little to suggest this rising interest rate risk currently, and most investors consider it either not a risk or a very remote one. However, what 2018 clearly demonstrated is that the global economy and risk markets will not smoothly transition to higher interest rates and lower liquidity. For now, the Fed’s turn has given a green light to surfing risk waves, but big wave surfing is dangerous. Especially when the waves are increasingly crowded.
During the quarter, we added two new names to the portfolio. In the spirit of trying to adapt to the current market game, we were able to find one name on the market’s winning list that met our valuation discipline: Arista Networks, a leader in high-end data center switches that should gain significant market share as the IT market shifts toward cloud-based consumption.
The second name we added was very much in the value bucket. In the depressed energy sector, we bought EQT, one of the lowest-cost producers of natural gas in the Appalachian basin, whose new management team we believe will lower EQT’s costs even more through an extensive restructuring and well-productivity plan.
As we carefully observe the liquidity tides, we will continue to adjust as much as possible to the current market game, but without sacrificing the investment discipline that will serve us well when the game inevitably shifts. Ultimately, the Fed’s tide of liquidity can only cover up risk rocks for so long. What we can control regardless of the tide is keeping the portfolio positioned with better fundamentals, yet much cheaper valuations than the overall market. The merits of basic math will ultimately prevail.
The ClearBridge All Cap Value Strategy had a positive return during the fourth quarter, underperforming the Strategy’s benchmark Russell 3000 Value Index.
On an absolute basis, the Strategy had gains in all 11 sectors in which it was invested during the quarter. The primary contributors to the Strategy’s performance were the financials, health care and consumer discretionary sectors. The materials, utilities and real estate sectors were the main laggards.
In relative terms, the Strategy underperformed its benchmark primarily due to stock selection decisions during the quarter. Stock selection in the industrials, information technology (IT) and financials sectors detracted the most from relative returns during the period. Conversely, stock selection in the consumer discretionary and health care sectors proved beneficial.
On an individual stock basis, the greatest contributors to absolute returns during the quarter were positions in Citigroup, Murphy USA, Johnson & Johnson, Bristol-Myers Squibb and AES. American International Group, Boeing, Exelon, Vistra Energy and Cisco Systems were the largest detractors from absolute performance.
Besides portfolio activity mentioned above, during the quarter we closed positions in Halliburton and Devon Energy in the energy sector and Cisco Systems in the IT sector.