- Massive liquidity and fiscal stimulus contributed to improving economic data that, combined with signs of progress fighting COVID-19, helped equity markets bounce back in the second quarter.
- Stay-at-home orders are accelerating already strong secular growth trends in the connectivity ecosystem to which the portfolio has significant exposure, in many cases via companies that are not household names.
- In a world flush with liquidity, much is unknown, and we continue to balance short-term uncertainty with long-term opportunities by remaining focused on companies with strong competitive positions, attractive end markets and reasonable valuations.
Signs of initial progress slowing the spread of COVID-19, glimmers of improving economic data and massive liquidity injected into the financial system by the Federal Reserve led to a strong recovery for equities in the second quarter. The broad market S&P 500 Index rose 20.5%, its highest quarterly advance since 1998, while the benchmark Russell 1000 Value Index gained 14.3%.
The U.S. economy showed signs of improvement in the quarter. A surprisingly upbeat jobs report that saw 2.5 million jobs added in May was accompanied by positive consumer spending news: personal consumption rose 8.2% and retail sales rose 17.7%. The economy then added another 4.8 million jobs in June, while the unemployment rate fell to 11.1% from 13.3% in May. Similarly, manufacturing activity picked up, with the ISM Manufacturing PMI for the U.S. rising from 41.5 in April to 43.1 in May and into expansionary territory in June with a 52.6 reading. At the same time, surges in the number of COVID-19 infection cases, both abroad and in parts of the U.S., continue to loom over economic reopening.
In the value index, several cyclical sectors outperformed more defensive sectors in the quarter. An improving economic outlook along with OPEC production constraints pushed oil prices higher, boosting energy stocks during the period, although they remain well below levels achieved earlier in the year. Consumer discretionary spending benefited as the economy started to gradually open and people began to cautiously venture outside of their residences where they have been cooped up for months. Meanwhile, financials underperformed other cyclical sectors as fears of credit losses and the prospect of lower for longer interest rates limited investor enthusiasm. Information technology (IT), often perceived to be somewhat cyclical, continues to perform well as workers remain connected remotely. Defensive, income-oriented utilities and consumer staples underperformed in the period.
"Wireless traffic is growing 30%+ annually even before 5G adoption, boosting wireless tower operators and spectrum holders."
Stay-at-home orders have altered consumer and business behaviors in ways that are accelerating secular growth trends to which the portfolio is well-exposed. Apple, which we bought opportunistically in 2019 when it was pressured by a lull in handset sales, is benefiting from its strong services business and tailwinds in its Mac/iPad businesses due to work-from-home measures. Long-time holding Microsoft is also a key beneficiary of work from home as well as accelerating cloud adoption. Sensitive to a fuller valuation, we trimmed Microsoft in the quarter.
TE Connectivity (TEL), also in IT, was a strong performer. TEL makes connectors for a wide range of uses, including automobiles, data centers and medical devices. TEL’s transportation/automotive segment revenue is outgrowing light vehicle production as electronic content per vehicle continues to grow, and TEL is a major beneficiary of the secular trend of vehicle electrification (EV), enjoying double the per-vehicle content for EVs compared to traditional internal combustion engine vehicles.
Another long-term portfolio holding, American Tower, which is in the sweet spot of connectivity and burgeoning 5G deployment, contributed strongly in the quarter. Unlike Apple and Microsoft, American Tower is not a household name. In the real estate sector, the company is the largest wireless tower operator in the world and has been a global beneficiary of robust wireless data traffic growth. It leases space on its towers to wireless carriers on a long-term basis with price escalators. Wireless traffic is growing 30%+ annually, even before 5G adoption, generating strong revenue and cash flow growth for American Tower.
Dish Network, in the communication services sector, is one of the leading providers of pay-TV services and a player in streaming video. The company also owns about 100 MHz of valuable nationwide wireless spectrum it is readying for deployment to build out a greenfield 5G network. The stock rebounded as the merger between Sprint and T-Mobile finally closed and resulted in Dish gaining favorable wholesale access to T-Mobile’s wireless network on a multiyear basis. The arrangement highlighted the value of Dish’s spectrum and its unique ability to become a viable and potentially disruptive fourth wireless carrier.
T-Mobile shares also rose as the merger closed and investors focused on strong synergies and possibly years of competitive advantages for its network. We initiated a position earlier this year and subsequently added to it twice. We expect the company to continue to execute well, realize substantial merger synergies and gain share over time with the benefit of its superior spectrum position and fast 5G roll out.
Lam Research, a leading technology hardware company that makes capital equipment used in the semiconductor manufacturing process, was also a strong contributor. Lam’s technologies are crucial to the miniaturization of semiconductor technology, which reduces device size and energy consumption for chips. This helps to offset the water intensity of the etch and deposition process used in producing semiconductors. Lam should benefit from a strong rebound in semiconductor demand. We added to our position and believe its strong balance sheet and durable franchise will enable us to grow value over the long term.
"Our financials holdings are focused on national brands with superior risk profiles and strong deposit franchises."
The Federal Reserve responded to virus-induced lockdowns by shoring up financial markets, quickly lowering short-term interest rates to virtually zero and executing yet another round of quantitative easing. This now all-too-familiar zero interest rate policy has created a challenging environment for balance-sheet-intensive financial services companies such as Charles Schwab and U.S. Bancorp, for whom lower long-term rates act as a headwind to net interest margins. In financials we are focused on national franchises with strong brands such as JPMorgan Chase and Bank of America, which made positive contributions. These large, diversified banks should be supported over the long term by their superior risk profiles and strong deposit franchises.
The Strategy’s energy holdings held up relatively well in the first quarter as the sector sold off heavily and trailed in the second quarter as those highly cyclical and more commoditized areas bounced back. Royal Dutch Shell weighed on performance, as lower commodity prices contributed to a $22 billion write down in assets and a 66% dividend cut. While Shell’s profitable integrated natural gas segment should benefit from growing natural gas demand, uncertainty over underlying commodity prices as well as relatively high balance sheet leverage, hence a higher required oil breakeven price, caused us to exit our position.
We put the proceeds toward a new position in ConocoPhillips, a large independent exploration and production company with one of the best balance sheets in the industry. ConocoPhillips is positioned to be a survivor of the current energy market downturn and thrive in an eventual recovery. Management’s focus on return on invested capital through the cycle has resulted in the company proactively lowering its breakeven point by exiting higher-cost basins and deleveraging its balance sheet. The quality attributes of the business are also evident in management’s ESG focus, specifically with respect to solid governance practices, the board’s effective oversight of management and the company’s leadership in methane flaring.
While the market is pricing in a fairly robust recovery, or perhaps simply following the old edict of not fighting the Fed, we expect the recovery to be choppy and take some time to play out. Some industries, such as commercial aerospace or travel and leisure, will continue to face headwinds while providing potential opportunities for patient investors. For example, we added to Raytheon Technologies (RTX) in the quarter. The company is the outcome of the merger of Raytheon (RTN) and portfolio holding United Technologies (UTX) and the simultaneous separation of legacy UTX commercial businesses of Otis (a global elevator leader) and Carrier (HVAC) into independent and separately traded public companies. RTX stock has been under pressure due to pandemic-induced global travel restrictions resulting in sharply lower flight hours. This has decimated airlines’ profitability and put severe pressure on the entire commercial aerospace industry, including RTX’s highly profitable airplane engine maintenance business. However, with the expected useful life of a typical engine of several decades, the airplane engine aftermarket business offers a fairly certain long-term revenue and cash flow stream, while legacy Raytheon and United Technologies defense businesses remain largely unaffected by the pandemic and will continue to supply a steady cash flow over the near and medium term.
Volatility has increased significantly in recent months as two powerful forces have collided: the largest economic slowdown since the Great Depression and the largest fiscal and monetary support programs ever created. As initial jobless claims soared, the Coronavirus Aid, Relief and Economic Security (CARES) Act in March delivered nearly $2 trillion in stimulus to the U.S. economy, the largest such package ever. The Federal Reserve meanwhile expanded its balance sheet with loans and asset purchases, to historic levels (Exhibit 1).
Exhibit 1: Federal Reserve Balance Sheet Has Grown Significantly
In a world flush with liquidity, much is unknown. We continue to balance short-term uncertainty with long-term opportunities. We remain laser-focused on companies with durable competitive advantages and strong balance sheets, especially in cyclical industries, and are opportunistically taking advantage of market dislocations to initiate or add exposure to high-quality companies we feel comfortable owning throughout the economic cycle.
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 all 11 sectors in which it was invested for the quarter. The strongest contributions came from the communication services, IT and health care sectors. The utilities, consumer staples and real estate sectors were the main laggards.
On a relative basis, overall stock selection and sector allocation contributed to outperformance. In particular, stock selection in the communication services, IT, consumer staples and real estate sectors added to relative returns. Underweights to the consumer staples and utilities sectors and an overweight to the IT sector were also beneficial. Conversely, stock selection in the energy, industrials, financials and materials sectors and an underweight to the consumer discretionary sector detracted.
On an individual stock basis, the largest contributors were Dish Network, Apple, Microsoft, Home Depot and American Tower. Positions in Royal Dutch Shell, Edison International, Raytheon Technologies, Berkshire Hathaway and Carrier were the sole detractors from absolute returns in the quarter.
Besides portfolio activity discussed above, during the quarter we received shares of Otis (OTIS) and Carrier (CARR) from the merger of Raytheon and portfolio holding United Technologies, retaining Otis while selling Carrier.