- We reoriented the portfolio for a more cyclical market in the fourth quarter and saw good performance in these areas from structural growth companies.
- A rotation out of growth stocks into value on improving hopes for a global recovery and a sharp rise in bond yields weighed on the Strategy’s emerging growth names.
- The long-term dynamics for international growth companies remain compelling due to their generally more attractive valuations, the less efficient nature of non-U.S. markets and their key role in enabling digitalization across regions and industries.
International equities delivered marginal gains in a risk-on first quarter that saw a continuation of trends from late 2020 toward more cyclical and value-oriented areas of markets. While the U.S. benefited from a widespread COVID-19 vaccine rollout, other regions — primarily Continental Europe and most emerging markets — have fallen behind in vaccine distribution. This will push back an economic reopening and has weighed on stocks. The benchmark MSCI EAFE Index rose 3.5% in
the first quarter while the MSCI Emerging Markets Index added 2.3%. Small caps once again outperformed larger stocks with the MSCI EAFE Small Cap Index adding 4.5%. International value stocks outperformed growth stocks significantly, with the MSCI EAFE Value Index rising 7.4% compared to -0.6% for the MSCI EAFE Growth Index (Exhibit 1).
Exhibit 1: MSCI Growth vs. Value Performance
Aggressive U.S. stimulus policies caused the bond markets to react with a meaningful rise in 10-year Treasury yields. Global markets followed with a significant rotation into economic recovery plays. This rapid steepening of the yield curve greatly impacted growth stocks as the risk-free cost of capital increased. This was especially painful for stocks whose value is more back-end loaded, specifically the Strategy’s emerging growth bucket, which did extraordinarily well last year as rates were slashed to cope with the pandemic. Beginning in the fourth quarter and continuing into the new year, we took profits in some of our biggest winners (SolarEdge Technologies, Shopify, Spotify). This was not enough, however, to neutralize the sharp moves of the first quarter, causing the Strategy to underperform the benchmark.
Growth stock performance was weak due to a combination of broad profit taking by investors and the market’s optimism about a recovery from the pandemic. Areas that had been hard hit in 2020 recovered including energy (+10.6% for the quarter), financials (+9.7%), industrials (+5.4%), materials (+5.2%), and cyclicals in every area. Information technology (IT, +2.4%) underperformed and our emerging growth names underperformed the overall sector.
Many areas that moved upwards, like energy, steel and auto companies, are not areas where we see sustainable long-term growth. We reoriented the portfolio for a more cyclical market in the fourth quarter and saw good performance in these areas from structural growth companies like Atlas Copco and Canadian Pacific Railway, which we added to during the quarter.
We have always been clear about when we expect the Strategy to underperform. In sharp, narrow market moves, the index will always have the exact amount of whatever is moving; we may or may not. The first quarter was exactly the type of market where we would expect to face headwinds. However, the extent of that underperformance was more than we anticipated. We believe roughly 60% of the underperformance vis-à-vis our core benchmark was market related, while a few of our larger positions, including London Stock Exchange (LSE) and TeamViewer, underperformed due to stock-specific news.
A contributor to performance for many years, LSE saw profit taking after providing guidance of the need to invest ahead of market expectations in the Refinitiv acquisition. The deal is sensible as this moves the company towards its goal of becoming a data provider with a higher proportion of recurring revenues vs a more cyclical flow business, however the market was not prepared for management’s guidance of higher integration investments in 2021-2022. The conservative guidance is appropriate given the risk environment and we expect that by the second half of the year numbers should reassure the market of the merits of the deal.
TeamViewer was a strong performer in 2020 through COVID as its software allows remote connectivity access and control of devices. The company has evolved its freemium software model for enterprise customers and is expanding through small acquisitions, salesforce investments and working to increase its presence in Asia and other locations. After strong numbers, TeamViewer announced sponsorship deals with British football team Manchester United and Formula One/Mercedes to increase brand exposure, something that likely works over time but in the near term impacted earnings. We believe the pullback in these stocks has been overdone and they will be good future performers.
We have observed that new additions to the portfolio often do not take off right after purchase. We make investments in companies where we believe the market hasn’t properly appreciated their future long-term performance, meaning they usually take a quarter or two for our thesis to play out. Results for recently purchased stocks are in line with this trend. This quarter, we increased our cyclical exposure with companies we expect to benefit as the reopening expands across Asia, Europe and emerging markets. These include CRH, a diversified global building materials business with leading positions in aggregates, cement and concrete materials/products. The Ireland-based company is increasing its focus toward higher-margin business in developed markets and should benefit from infrastructure spending in the U.S. and Europe. We believe the market underestimates steady M&A additions to the business. Sweden’s Sandvik is a global manufacturer of drills for mining and high-end machining solutions. Its mining and rock technology division is very profitable with an after-market business oriented toward mining and construction.
The job market is already coming back in the U.S. and other international markets will likely follow suit in the year ahead, providing substantial earnings growth potential for Recruit Holdings. The Japanese human resources and marketing support company owns U.S. job search platforms Indeed and Glassdoor and holds a 50% share of Japanese online advertising for small business hiring. Recruit has a unique, entrepreneurial culture and is one of the most innovative in Japan, where the use of technology is still underpenetrated and the company is well-positioned to increase share.
Compass Group is the largest global contract caterer, serving corporate dining cafeterias, sports/leisure food service and education facilities. Its business was severely impacted by the COVID-19 lockdowns, but we believe margins have troughed while customer retention rates remain high. A return to pre-pandemic levels is likely even prior to a full global recovery due to adaptations Compass made to its business model in the downturn that increased flexibility and should lead to durable cost savings.
"Growth as an investment strategy is relatively new overseas and thus represents good potential for expansion. "
On the consumer side, we are paying close attention to how traditional retailers are pivoting to new growth areas. We participated in the IPO of Dr. Martens, the iconic British footwear company that has restructured under new management. It’s post-COVID-19 strategy includes selective store openings and a strong contribution from e-commerce. The retailer has new offerings but its key product remains the 1460 boot, which has helped it produce generous cash flow, yet we believe the market underappreciates its long-term earnings profile. We are also monitoring how those reliant on travel spending, like spirits and cosmetics companies, are adapting. Diageo, for example, is seeing travel come back quicker, especially in Asia, and is expanding into online sales.
The Strategy has purposely underweight banks versus the benchmark due to mediocre growth prospects in a low-rate environment, favoring financials exposure in areas like exchanges, insurance and digital payments. We made three financials-related purchases in the quarter, the largest in Nihon M&A, the best placed merger and acquisition intermediary in Japan for facilitating small and midsize company transactions. An aging population and increase in the average business owner’s retirement age is driving the need for M&A. We also sold out of Erste Bank, our last traditional bank holding,
during the quarter. The pandemic has increased the need for larger loan loss provisions and regulators are changing dividend payouts for the banking sector in Europe. Erste has a good growth engine in Eastern Europe, but we believe the slow growth in Western Europe will delay a recovery in its share price.
While we maintain high conviction in many of the emerging and secular growth names in the portfolio, despite the short-term headwinds created by the current reflationary environment, our commitment to risk management caused us to exit several positions during the quarter. We sold our stake in Swiss pharmaceutical maker Novartis in favor of adding to Alcon, a Swiss maker of medical devices for eye care.
Among materials names in our structural bucket, we sold SQM as the stock hit our price target. Lithium prices remain at levels well below previous highs and while we expect they may reach higher levels in the future; high pricing likely encourages additional supply onto the market. We redeployed these funds into other names in materials, primarily CRH. Umicore was also sold on stronger performance, driven by precious metals that boosted the results of its recycling division as well as continued growth in the electric vehicle market.
We are not certain when a cyclical recovery will take hold in Europe, Asia and emerging markets, but
equity markets are already anticipating it. While value continues to maintain an advantage over growth, interest rates drive the length of value rallies and we do not see rates going up meaningfully to maintain that momentum. The traditional value sectors of autos, banks and energy may work in the short term, but all are facing disruptive forces. Traditional banks are highly dependent on rates and are being disintermediated by fintech companies taking away their profitable businesses. We have been out of traditional fossil fuel energy for two years and, with the global climate change push, we do not see them as compatible with growth investing. Instead, we continue to add to our renewables exposure through names like EDP. And in autos, we are excited about electric vehicles but would rather own suppliers and semiconductor companies than the capital-intensive OEMs that are still juggling three engine formats.
The long-term dynamics for growth companies outside the U.S. are compelling for several reasons. Valuations are generally more attractive and investment markets are less efficient. Growth as an investment strategy is also still relatively new overseas and thus represents good potential for expansion. Finally, digitalization is continuing apace outside the U.S., with economies like Japan still early in its adoption of digital technologies. This should create a long runway for growth and steady demand for growth stocks.
During the first quarter, the ClearBridge International Growth EAFE Strategy underperformed its MSCI EAFE Index benchmark. The Strategy sustained losses across seven of the nine sectors in which it was invested (out of 11 total), with the IT and financials sectors the primary detractors.
On a relative basis, overall stock selection detracted the most from performance. In particular, stock selection in the financials, IT, consumer discretionary and communication services sectors had the greatest negative impact on results, with weakness in software and IT services and a lack of exposure to banks contributing to the underperformance. An overweight to IT and a lack of exposure to the energy sector also proved detrimental. On the positive side, stock selection in the materials sector and an underweight to health care were the primary contributors to performance.
On a regional basis, stock selection in Europe Ex-U.K., North America and the United Kingdom and an overweight to emerging markets hurt results, while stock selection in emerging markets and an overweight to North America aided performance.
On an individual stock basis, the largest contributors to absolute returns in the quarter included ASML, Atlas Copco, Taiwan Semiconductor, Canadian Pacific Railway and Linde. The greatest detractors from absolute returns included positions in London Stock Exchange, StoneCo, TeamViewer, Elastic and Nintendo.
In addition to the transactions mentioned above, we initiated positions in argenx in the health care sector, InPost and Ashtead Group in the industrials sector, Nestle in the consumer staples sector, as well as Vinci Partners and 3i Group in the financials sector. We also closed positions in Kao in the consumer staples sector, as well as Constellation Software in the IT sector.