- Extreme concentration of the largest stocks in the benchmark continues to be a performance headwind for the Strategy and other active large cap growth managers running diversified portfolios.
- Industrial names supporting e-commerce and communication services companies enabling the digital economy drove Strategy performance during the quarter.
- Developing the energy grid of the future will require an ecosystem of renewable energy innovators and adopters, and several ClearBridge holdings are playing a role.
Information technology (IT) and related momentum stocks endured their first correction since the onset of the COVID-19 pandemic yet still delivered strong gains for the third quarter as the economy continued to mend. The S&P 500 Index marched 8.9% higher over the past three months, capping its best six-month run since 2009, and is up 5.6% year to date as ample liquidity, improving economic data and a lack of attractive investment alternatives supported equities. Despite a sharp selloff among mega cap IT and Internet names to start September, growth stocks maintained their leadership with the benchmark Russell 1000 Growth Index gaining 13.2% for the quarter, outperforming the Russell 1000 Value Index by over 760 basis points. That advantage for growth has now expanded to nearly 3,600 bps year to date, one of the widest margins in market history.
Consumer discretionary (+20.7%) was the best-performing sector for the quarter, boosted by resilient retail spending and continued e-commerce growth, while IT (+15.0%) and the cyclical materials (+15.1%), and industrials (+13.4%) sectors also outperformed. Utilities (-4.8%) and energy (-4.0%), which have minimal weightings in the benchmark and are not held in the Strategy due to less appealing growth profiles as well as ESG considerations, were the worst performers, while real estate (+1.0%), health care (+5.7%) and financials (+6.4%) also lagged.
The Russell 1000 Growth Index remains concentrated with the largest stocks in the benchmark exerting an outsized influence on returns, creating challenges for diversified active managers. During the third quarter, six stocks (Apple, Amazon.com, Tesla, Nvidia, Facebook and Microsoft) accounted for half of the benchmark’s return. And as of September 30, three of those companies - Apple (11.3%), Microsoft (9.5%) and Amazon (8.1%) - accounted for 29% of the benchmark’s value. Most diversified funds tracked by Goldman Sachs in a September report were underweight the FAAMG stocks - Facebook, Apple, Amazon, Microsoft and Google (now Alphabet).
Passive and index and exchange-traded funds that track the Russell 1000 Growth Index are not impacted by such extreme concentration. Nor are non-diversified growth strategies, many of which have become so by choosing to maintain close to market weight exposure to the FAAMGs. As Goldman Sachs noted, such concentration has led to a performance advantage for these focused strategies and resulted in less than a third of all active large cap growth strategies tracked by Goldman beating the benchmark for the year-to-date period through September 8.
The ClearBridge Large Cap Growth ESG Strategy is underweight the FAAMGs in aggregate, with active overweights to Amazon and Facebook and underweights to Apple and Microsoft. We have no exposure to Alphabet after completing the sale of our Class C shares in the third quarter, which followed the sale of Class A holdings in the second quarter. As we have written in previous commentaries and elsewhere at ClearBridge, the largest capitalization technology and Internet stocks have continued to grow through the disruptions of the COVID-19 pandemic, but we believe the growth prospects of many of these stocks are already reflected in current valuations.
We choose to maintain consistent portfolio construction across all vehicles as we have always believed that a portfolio of companies with a diverse set of growth drivers offers the best opportunity to outperform over a full market cycle. We have managed through periods where one investment style has been a dominant performer for several quarters or even longer, such as momentum is currently. Over the last six to 12 months, the market has underappreciated the zero cost of capital made possible by low interest rates, which has translated into very high price/sales multiples for growth stocks. This cannot continue indefinitely as inflation and higher bond yields will eventually remove the justification for high valuations. As interest rates and inflation normalize with better economic growth, the sector performance with the highest momentum will end, as a rotation to economically sensitive sectors will become more in favor. We want to be positioned to effectively manage that transition.
"A mega trend we are witnessing is the explosive transition to battery electric vehicles as well as greater sophistication of automotive technologies."
As growth investors, we see nuances in leadership and performance every calendar year. The companies we own don’t manage for yearly results and we maintain a similar longer-term view. The accelerated recovery of the stock market makes it easy to forget that we are in the early stages of recovery from a historically deep, albeit short recession and as a result we are still managing the portfolio for a low-growth environment. Nothing suggests we are entering a new renaissance of economic growth, as many sectors remain on life support. What has been different in 2020, however, is how parts of IT have played both offense and defense, a historical oddity.
Our focus on managing a diversified portfolio leads us to seek long-term growth opportunities not only in above-average earnings and revenue growers like chipmaker Nvidia and business software provider Salesforce.com, companies that fall into our select bucket of growth companies and were strong performers in the quarter as leaders in areas around gaming and work-from-home, but also in established franchises who are market leaders and generators of healthy free cash flows. Microsoft, data center operator Equinix and warehouse retailer Costco are examples of the stable growth companies that constitute the largest weighting in the portfolio.
Our third area of focus is cyclical growth companies that operate in more economically sensitive areas of the market or are undergoing a business transformation that should boost earnings growth. These include industrials holdings United Parcel Service (UPS) and C.H. Robinson Worldwide, which were strong contributors in the quarter as key providers of the transportation infrastructure necessary to handle this year’s surge in e-commerce. UPS has positioned itself as more valuable today, as capacity has come out of the system due to COVID-19. As a result, UPS will demonstrate pricing power in the next cycle, as consumers are willing to pay for the privilege of receiving their purchases as quickly as possible. Trucking broker C.H. Robinson, meanwhile, connects shippers with available drivers and has benefited from sharply higher prices for its services while operating without the overhead of physical assets.
Another mega trend we are witnessing in real time is the explosive transition to battery electric vehicles as well as greater sophistication of automotive technologies. We initially gained exposure to these new technologies through the purchase of high-end components maker Aptiv in March and increased our participation in the third quarter through a new position in NXP Semiconductors. NXP develops analog and microcontroller chips for a wide range of communications and sensor applications across the automotive, wireless and industrial markets. NXP supplies the brains that make electronic content in vehicles function properly and should benefit from overall auto production and demand normalizing. The Dutch company also has strong positions in industrial “Internet of Things” applications, near-field communications tools and ultrawide band chips for mobile phones, which we believe offer additional growth opportunities.
Other significant moves included adding to our new position in Alcon, a leader in surgical correction of cataracts and contact lenses. Alcon has major positive product cycles in both of its core businesses that will accelerate revenue and earnings. Additionally, Alcon has a significant opportunity to expand margins by investing in new manufacturing and leveraging its commercial investment. The company had traded expensively since its separation from Novartis, but surgical disruption due to COVID-19 created a unique buying opportunity.
In general, we see parts of health care as offering attractive growth rates at more reasonable multiples than IT and related Internet names. Companies like Thermo Fisher Scientific are seeing a strong uptake from its COVID-19 tests, which augment a diversified lineup of in-demand research supplies and analytics services. Managed care provider UnitedHealth Group is also well-positioned, regardless of who wins the White House, as it maintains a leadership position in keeping overall health care system costs in check. We are a bit more cautious on the biopharmaceutical space as prescription drug pricing will likely remain a bipartisan target of lawmakers. BioMarin Pharmaceutical, which is less susceptible to pricing pressures due to the rare diseases it treats, was a leading detractor in the quarter as the company received a surprise rejection from the FDA for its “valrox” Hemophilia A gene therapy, and the agency is now requiring more data from the pivotal trial prior to approval. We think the stock move is an overreaction and remain confident the product will ultimately be approved.
Beyond health care, we are conducting due diligence in a number of areas, including the financials and consumer discretionary sectors, which could lead to new positions over time. This work is geared toward identifying secular growth stories with sound fundamentals that can balance our exposure to the growth leaders of the moment.
As mentioned above, overall economic growth is constrained and could remain so in the near to medium term. Plenty of risks linger on the horizon, including the outcome of the presidential election and whether consumers and businesses will receive more stimulus to keep demand healthy and workers employed. The primary inflection point we are monitoring is the development of a COVID-19 vaccine. When that medical breakthrough occurs, we expect a movement out of IT and communication services names that have been viewed as a safety trade and into more economically-sensitive areas of the market like retail, hospitality and transportation. As “real world” economic growth picks up, rates would also move commensurately, leading to a shift in investor risk tolerance and potentially bolstering a move in market leadership from digital to physical businesses.
Although the banking sector is well capitalized, we still worry about what a credit cycle will look like over the next 12-18 months as unemployment naturally normalizes at a much higher rate. The global economy was at stall speed before COVID, it’s hard to think that conditions will be improving to the extent that stimulus acts as an accelerant from here. There is no question that the Fed, Treasury (and hopefully Congress) will be acting in good faith for the American worker, but there will be limits to what is possible from a partisan perspective.
Our long-term orientation gives us the latitude to be patient as this transition in the market plays out. The volatility we experienced in early September is expected to continue for at least the next several quarters. We can use this turbulence to our advantage because of the fundamental work we have already done on companies and continue to do. Going forward, we will be ready to make opportunistic purchases when prices are favorable.
What is clear is that leadership companies are demonstrating their ability to pivot and cut costs at an alarmingly fast pace, limiting financial damage through this crisis. That said, recessions have consequences, and it might be too early to tell what the damage will end up looking like for many quarters to come.
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 eight of the nine sectors in which it was invested (out of 11 sectors total). The leading contributors to performance were the IT and industrials sectors.
On a relative basis, overall stock selection detracted from performance. Specifically, stock selection in the consumer discretionary, IT and health care sectors had the most significant negative impacts on results. On the positive side, stock selection in the industrials and communication services sectors contributed the most to relative performance.
On an individual stock basis, leading contributors to absolute returns in the third quarter included positions in Amazon.com, Apple, United Parcel Service, Nvidia and Salesforce.com. BioMarin Pharmaceutical, CVS Health, VMware, Splunk and Nutanix were the worst detractors on an absolute basis.
An Ecosystem of Renewable Energy Is Thriving
Recent developments in the energy and power sector suggest 2020 might be a watershed year for renewable energy and efforts to reduce carbon emissions. Forecasts for global oil demand have declined; the cost of wind and solar have fallen to levels nearly on par with fossil fuel energy sources; and investors have fled the traditional energy sector while boosting stocks tied to renewable energy.
Governments around the world also continue to raise their ambitions for carbon reduction. For example, the EU is now looking at 55% reductions by 2030 (versus 40% previously), and China set a new goal to achieve net-zero carbon emissions by 2060. Renewable energy consumption recently surpassed coal for the first time since the 19th century (Exhibit 1).
It is too early to tell if this pace of change will continue, but we expect to see a steady tide of renewable energy sourcing from several quarters. As an active owner of companies across the renewable energy ecosystem, ClearBridge is finding economic opportunity in an array of innovators and adopters that are enabling this surge and helping the world transition to a less carbon-intensive future, maybe sooner than we think.
Exhibit 1: U.S. Renewable Energy Consumption Surpasses Coal
Corporate Demand for Renewables Only Getting Stronger
Many companies held across ClearBridge portfolios have set aggressive targets for lowering emissions through use of renewable energy. Earlier this year, Amazon.com announced it is on track to run on 100% renewable energy by 2025, five years ahead of schedule, while Microsoft announced it expects to be carbon negative and beginning to remove the carbon it has emitted since its founding, by 2030. The ambition of these measures is made possible by falling costs of renewable energy (Exhibit 2).
Demand for renewable energy has continued to grow even through the pandemic, according to ClearBridge holding Brookfield Renewable. Brookfield Renewable’s globally diversified, multi-technology renewables business, including a large hydro fleet, is well-positioned to help companies achieve decarbonization goals and makes Brookfield an attractive partner as more business and governments seek to lower their emissions.
Exhibit 2: Falling Costs of Renewable Energy Enable More Ambitious Initiatives
Commitments by large companies to increase renewable energy sourcing are felt through their supply chains, providing a competitive advantage to environmental forerunners and encouraging others to catch up. Data center provider and Portfolio holding Equinix, for example, is a leader in renewable energy sourcing. In a recent engagement with Equinix, we discussed how several large customers that have announced their own targets around renewables and lowering carbon emissions were in some cases prioritizing Equinix data centers over competitors as it allowed them to get closer to their goals. Accordingly, we believe Equinix’s goal of reaching 100% of energy sourced by renewables will be a positive for business.
Favorable Economics and Innovation Driving Solar Adoption
Brookfield Renewable has also been adding utility-scale solar in its energy mix. Solar costs have dropped in the past five years from $4 per watt to install to less than $1 per watt, according to the company, which believes solar could account for most of the its production capacity in 10 years’ time (it is less than 20% today).
On the residential side, innovation by ClearBridge holdings SolarEdge Technologies and Enphase Energy, along with cheaper panels, is enabling more adoption by homeowners. SolarEdge makes solar inverters and optimizers for residential and commercial solar photovoltaic (PV) systems. SolarEdge’s system combines power optimizers on the back of each solar panel on the roof (known as “module-level power electronics,” or MLPE) with a string inverter on the side of the building (which converts the direct current power produced by the solar modules to usable alternating current).
Enphase was the first company to commercialize microinverters for residential and small commercial solar PV systems. A microinverter, a type of MLPE, is a small inverter placed directly on the back of each solar module, as opposed to the traditional system of one string inverter on the side of the building.
MLPEs improve the efficient energy capture of a solar PV system by performing maximum power point tracking at the module level, rather than at the array level (all modules combined). They also allow greater flexibility in how modules are installed, in terms of angle, type and number, so houses with multiple roofs at different angles can use more surface area and capture more energy from it.
Storage Next Big Question for Renewables
While good for the planet, renewable power has two main shortcomings: an inability to “match” power consumption peaks and variability of renewable power production driven by weather dependency. California rolling blackouts in August amid record-high summer temperatures, low winds and lower imports of power from neighboring states underscore these drawbacks of renewables and highlight the importance of storage/battery capacity for a reliable power grid.
Renewable energy paired with storage is an increasingly attractive option, and one which utility companies have begun to offer. While most battery technologies today offer only a few hours of power storage, the “near-firm” renewable power resources (solar or wind plus battery that can provide power that is nearly firm, or nearly around the clock) could help alleviate some of the impacts from grid outages, especially urgent in regions currently facing generation shortages. Solar and storage is now cheap enough that it is replacing inefficient peaking units - power plants that run only when there is a high demand for electricity, in order to balance the grid.
Storage remains a focus for several ClearBridge utility holdings, such as NextEra Energy, whose unregulated NextEra Energy Resources segment has the largest battery storage capacity in the world. NextEra Energy believes near-firm renewables will be competitive with all the traditional generation technologies as of 2023-2024 (Exhibit 3). The company’s project pipeline has 2.2GW in battery storage under development and battery storage investments in 2021 are expected to exceed $1 billion. It expects the continued innovation by the automotive industry, improvements in converters and enclosures, and lower balance of system costs to drive down the cost of energy storage by ~16% CAGR between 2020 and 2023.
Exhibit 3: Even with Addition of Storage, Renewables Are Cost Competitive
Yet overall renewables remain intermittent, and while storage improves availability of renewable assets, the combination cannot beat high 90% availability of baseload gas or nuclear plants, at least in the near term. The grid of the future should have a much higher presence of renewables, although a full elimination of the traditional sources of power will likely require some major breakthroughs in storage technology.
Many Businesses Can Thrive in Transition to Renewable Energy
As efforts to combat climate change become more urgent, it is encouraging to see the increasing scale of commitments by corporations as well as state and city governments. Developing the energy grid of the future, which will have to support more cars, trucks and buses transitioning to electric motors, will require an ecosystem of renewable energy innovators and adopters. ClearBridge will continue to seek out and engage with leading companies that can thrive as we progress toward a net-zero future.