- Rising optimism over a reopening of the economy enabled value stocks to lead for the second-straight quarter and close the gap on growth and momentum names.
- We continued to focus on improving the Strategy’s up capture by increasing exposure to the select bucket of growth companies through additions to our software and Internet holdings as well as managing our largest positions.
- We feel very good about the consumer and, with the return of more normal economic activity, we believe the Strategy is well-positioned to participate.
Equities grinded higher to start 2021, boosted by supportive economic policy, improving fundamentals and a widening COVID-19 vaccine rollout. The S&P 500 Index gained 6.2% on rising optimism over a reopening of the economy that enabled cyclical and value stocks to lead for the second-straight quarter. The Russell 1000 Value Index advanced 11.3% in the first quarter, outperforming the 0.9% return of the benchmark Russell 1000 Growth Index. The market action since last fall has closed most of the historic advantage enjoyed by growth and momentum names, with growth stocks up 62.7% over the last year and value stocks ahead by 56.1% (Exhibit 1).
Greater risk taking by investors, especially in a handful of heavily shorted stocks bid up by individual investor message boards as well as in SPACs and cryptocurrencies, also drove lower-quality areas of the market higher while causing several spikes in volatility as hedge funds were forced to unwind positions that went against them. In addition, a surge in bond yields, with the U.S. 10-Year Treasury rising 83 basis points to finish the quarter at 1.74%, pressured higher-multiple growth stocks whose profits are discounted farther into the future.
Exhibit 1: Value Stocks Closing the Gap on Growth
From a sector standpoint, energy (+19.6%) was the best performer in the benchmark as crude oil prices rose 21%, followed by communication services (+8.5%), real estate (+7.1%), industrials (+3.4%) and financials (+2.7%). The consumer discretionary (-1.0%) and information technology (IT, -0.7%) sectors, prime beneficiaries of the work-from-home and e-commerce boom during the pandemic, underperformed, as did consumer staples (-0.7%), another lockdown stalwart.
Against this backdrop, the ClearBridge Large Cap Growth Strategy underperformed the benchmark by roughly 50 basis points. Relative performance improved through the second half of the quarter as the passage of a new $1.9 trillion fiscal stimulus package turned what had been a broadening of leadership into a full-fledged value rotation. Weakness in a handful of the portfolio’s software names, as well as our limited positioning in cyclicals, were headwinds as the broader stock market rallied in anticipation of the strongest GDP growth in years.
We continued to keep our learnings from 2020 in mind during the quarter as we sought to increase the up capture of the portfolio. That effort ramped up in the second half of last year with the addition of enterprise software names Workday and Atlassian, which fall into our select bucket of above-average growers with rapidly expanding end markets. Adding to those names, as well as the purchase of Singapore-based video game platform Sea Limited, increased our select exposure by about 200 basis points in the first quarter to 36% of the overall portfolio.
Sea maintains leading positions in Southeast Asia in video games and e-commerce and operates an emerging digital payments and banking business. While the company is investing heavily into e-commerce and payments, this growth is being funded by its highly profitable gaming segment. We see a long runway for growth across Sea’s businesses with multiple opportunities like e-commerce expansion in Latin America not fully factored into the valuation today. The company also has a well-respected management team that has successfully executed in expanding its total addressable market. Along with existing holding Alibaba, Sea provides exposure to secular growth trends in emerging markets that are harder to replicate through U.S. stocks.
We also made adjustments to the portfolio’s top 10 holdings to increase the participation of select stocks, including Facebook, while trimming our weighting to stable names, which now represent 47% of the portfolio. The FAANGs and Microsoft delivered mixed results during the quarter and we continue to be mindful of our weighting to these mega cap growth stocks to ensure they are not limiting our ability to add diversity through new ideas. Our repositioning has been encouraging so far with the portfolio performing better on up days in the market while maintaining good down capture during more turbulent sessions.
Within IT, we have also increased exposure to a cyclical semiconductor industry currently working through a severe supply shortage due to several years of capacity reductions, COVID-19 shutdowns and one-off production delays as well as demand resilience in areas like autos and smartphones. Two recent additions, specialty semiconductor maker NXP Semiconductors and semiconductor capital equipment firm ASML were among the portfolio’s leading contributors in the first quarter. NXP rose as auto production ramped up and electric vehicle sales continued to expand. ASML, which operates in a virtual monopoly for high-end chipmaking equipment, began to exert pricing power as it works through an order backlog that has stretched to over a year. Both are Dutch-based companies and out-of-benchmark names that provide access to different growth profiles than are available in the U.S. Analog chipmaker Texas Instruments, meanwhile, benefited from better inventory management than peers. The main risk for semiconductors is short-term revenue pressure until capacity catches up with demand, which hurt wireless chipmaker Qualcomm. Looking past current constraints, we expect the industry to see a strong second half and solid growth in 2022.
We also anticipate a strong 2021 for consumer spending as the U.S. and global economies reopen. With the ability to spend on high-ticket items like dining and travel curtailed by COVID-19 restrictions, U.S. consumers amassed over $1.4 trillion in excess savings in the last 12 months (Exhibit 2). Most Americans received another $1,400 stimulus check in March and the Federal Reserve’s commitment to keeping interest rates low longer into the recovery has kept liquidity abundant. Recent housing turnover, spurred by historically low mortgage rates, has also led to more home-related spending.
Exhibit 2: Consumer Balance Sheets are Flush
As the market continues to broaden with the return of more normal economic activity, we believe the portfolio is well-positioned to participate. We added to our consumer holdings in the first quarter, including Home Depot, and also added a new position in Tractor Supply, which is indexed to residential and rural home purchases and improvements. We also have direct exposure to a reopening through names such as Booking Holdings, Visa, Fidelity National Information Services, Disney and Uber.
Tractor Supply, a destination-based rural retailer of supplies for farmers, has a number of attractive retail attributes as it targets the do-it-yourself concept and verticals less likely to be disintermediated by e-commerce competitors. With about 2,000 stores, the company is also well-positioned to benefit from the trends in housing sparked by COVID-19 such as movement to more suburban and rural areas and increasing pet ownership. A new CEO who came from Home Depot has put in place several initiatives to improve store productivity that we believe could add 100–150 bps to same-store sales growth over the next several years while a loyal and growing customer base provides stability.
To take a more discretionary stance in retailing and make room for our additional purchases where we see better opportunities, we closed our position in Costco Wholesale. Costco was a big winner during the most restrictive periods of the COVID-19 lockdowns with its focus on staples, larger basket size, necessities and bulk items, and it remains an exceptional retailer in its category, with a sticky subscription base and non-U.S. growth ahead. However, the company is facing very tough comparisons as well as margin pressure in its core business and we believe its valuation has become stretched.
We also sold biotechnology holding Alexion Pharmaceuticals ahead of its acquisition by AstraZeneca but expect to redouble our efforts in health care through the rest of the year. We see good growth potential in the sector and after full due diligence, have been busy populating our wish list with new names we would like to own.
With all the liquidity being pumped into the economy, we have been keeping a close eye on inflation and what it could mean for the equity market and the companies we own. As mentioned above, the semiconductor industry is positioned to exert pricing power amid a severe supply disruption while select holdings in the industrials sector such as W.W. Grainger are also positioned to pass along price increases. Consumer discretionary companies reliant on raw materials could see margin pressure but appear to be managing the higher costs effectively. Labor costs this year and next will be of particular interest given they are the largest component to broad inflation gauges.
Despite a meaningful rotation out of IT after a terrific 2020, we remain committed to the sector as one of the best places to participate in above-average long-term growth. We view last year’s acceleration in enterprise capex as panic spending to support the work-from-home environment. This year, we are seeing enterprise IT budgets starting to loosen up with the focus shifting to digital transformation. Our software-as-a-service holdings are seeing pull-forward spending on digital initiatives and expect IT spending to remain healthy going forward.
"Our limited positioning in cyclicals was a headwind as the broader stock market rallied in anticipation of the strongest GDP growth in years."
While the Strategy tends to do best in more moderate growth environments than are forecast for this year, we believe the market’s appreciation in 2020 was reflective of expected future GDP growth. This discounting gives us optimism that we can deliver solid performance as the expansion picks up steam. The last several years of relative performance headwinds have been in large part a function of our commitment to diversification and maintaining strong down capture. That down capture comes at a cost in strong up markets like we saw in 2019 and 2020 but we are encouraged with our exposures in what we expect will be a more moderate market for growth stock appreciation in 2021.
Our base case is that we have pulled forward a tremendous amount of retail sales, given the massive support of government transfer payments. We remain constructive, but also feel a level of conservatism is warranted. We have delayed an economic recession, but not completely avoided one. The U.S. government is responsible for 27% of personal income today, an unrealistic level going forward. In addition, ambitious spending plans from the Biden Administration will result in higher taxes across the board. It is too early to tell how corporations and individuals will react to these increases in spending patterns. Lastly, equity valuations have had a huge tailwind of P/E multiple expansion with the Federal Reserve pegging rates near zero. In our view it will be very difficult to control rates (without distorting the yield curve) if we see reasonable economic growth and inflation, which naturally occur coming out of recessions. Higher rates could have a disproportional negative effect on the most expensive pockets within the market.
The ClearBridge Large Cap Growth Strategy underperformed its Russell 1000 Growth Index benchmark during the first quarter. On an absolute basis, the Strategy had gains across four of the eight sectors in which it was invested (out of 11 sectors total). The leading contributors to performance were the communication services, consumer discretionary and industrials sectors while the primary detractor was the IT sector.
On a relative basis, overall stock selection and sector allocation detracted from performance. Specifically, stock selection in the IT, communication services, consumer staples and real estate sectors and an underweight to communication services had negative impacts on results. On the positive side, stock selection in the consumer discretionary sector and an overweight to industrials contributed the most to relative performance.
On an individual stock basis, leading contributors to absolute returns in the first quarter included positions in Facebook, NXP Semiconductors, Home Depot, Microsoft and ASML. Amazon.com, Apple, Splunk, Qualcomm and Palo Alto Networks were the worst detractors on an absolute basis.