- A reflation trade begun in November continued, driving a further rotation to cyclical stocks and resulting in strong relative performance of value versus growth.
- The portfolio’s modest overweights to the financials and industrials sectors also had positive impacts on performance, while solar names took a temporary cooling.
- In a hot housing market, many companies held across ClearBridge portfolios are helping make the homes of the future — back deck included — more environmentally responsible spaces.
Market Overview and Outlook
Expedited COVID-19 vaccine rollouts and another massive stimulus package helped U.S. equities deliver a strong first quarter, overcoming concerns that coronavirus variants would delay reopening and inflation would put the brakes on growth. A reflation trade begun in November continued, driving a further rotation to cyclical stocks and resulting in strong relative performance of value versus growth, with the Russell 3000 Value Index outperforming its growth counterpart by 10 percentage points. The benchmark Russell 3000 Index advanced 6.35%.
The Strategy had a strong absolute return but trailed in relative terms amid the sharp cyclical rally. A number of factors helped performance. Fourth-quarter additions CVS Health, Morgan Stanley, Marriot and Resideo Technologies, which we viewed as value stocks at initiation, benefited from the rotation from growth to value in the first quarter.
The portfolio’s modest overweights to the financials and industrials sectors also had positive impacts on performance as vaccine acceleration led to optimism for faster global economic growth.
Higher long-term interest rates supported financials such as Bank of America, which has shown both defensive and offensive characteristics in the past year. We believe it continues to be the least risky large bank from a credit standpoint, with conservative underwriting and controlled risk taking, a leading consumer deposit franchise, scale and technology. It is also a leader in its commitments to sustainability, or as it terms it, responsible growth. Disclosure and reporting at all levels form a large part of this commitment, including gender diversity and equality, environmental commitments and support of communities in which it operates. In the first quarter Bank of America announced it is setting a goal of net-zero greenhouse gas (GHG) emissions in its supply chain and operations, and notably also in its financing activities, before 2050.
Higher rates also boosted Charles Schwab, specifically mortgage-backed securities yields, which represent the majority of its investment portfolio. Schwab has also seen stronger organic growth from a stronger economy and equity markets, which has led to more account openings and higher trading activity.
Our exposure to small cap industrials names was also beneficial. Herman Miller, a manufacturer of sustainable design and ergonomic furniture for home, office — and this year especially, home office use — enjoyed significant retail sales growth in the quarter as well as good results from international sales. Resideo, which provides smart home solutions around comfort, thermal and security, also had a strong quarter, raising targets and shared very positive growth expectations.
Lam Research, meanwhile, had another strong quarter. Lam, which manufactures and markets semiconductor processing equipment used to make integrated circuits, is a beneficiary of growing memory spend trends in 2021 and 2022 and a strong leadership position that continues to expand addressable market share.
Solar energy companies, such as SolarEdge Technologies and Enphase Energy, which had outperformed in 2020, took what we believe is a temporary cooling in the first quarter mainly due to concerns surrounding rising interest rates, which could indicate a higher cost of capital. Array Technologies, meanwhile, also announced a secondary offering that weighed on sentiment. However, we believe the long-term fundamentals for renewables are attractive, and our solar stocks in fact raised guidance for 2021. Global commitments to solar and wind continue to grow, and the stocks should benefit from legislative catalysts such as the pending U.S. bill focused on infrastructure, the proposed CLEAN Future Act, which would provide support for material emissions reductions, and the Green Act, which would boost tax credits for renewables, storage and electric vehicles.
Aluminum beverage and food container manufacturer Ball Corp, meanwhile, delivered fourth-quarter operating income slightly lower than consensus, though this was mainly attributable to higher startup costs for large new facilities coming online in North America. These investments and additional capacity projects will contribute to strong volume growth globally, however. Aluminum cans are infinitely recyclable and offer the best replacement product for single-use plastic beverage containers, in our view. They are more likely to be recycled than single-use plastic and are more energy efficient in production as well.
Having no exposure to the traditional energy sector was a headwind to relative performance, as higher prospects for economic activity and energy use led to a rebound in oil prices and the energy sector. Holdings in renewable energy, which are categorized in a variety of sectors, continued to make strong contributions.
We have been able to find new opportunities even as much of the market appears fully valued. While some information technology (IT) companies felt headwinds from higher rates in the quarter, CIO surveys nevertheless indicate that IT budgets will grow in 2021 due to a combination of pent-up demand and increasing confidence in business prospects.
We added to our software-as-a-service (SaaS) exposure with the initiation of SaaS leader salesforce.com, which develops software for customer relationship management (we added Workday, which enterprise resource planning applications, last quarter). Saleforce.com is well-positioned in the most attractive end markets in software and will benefit from secular drivers such as remote work and the digital transformation. Salesforce.com is a sustainability leader as well, with a commitment to carbon-neutral cloud, toward which it has set a goal of 100% renewable energy for global operations by fiscal year 2022. The company has a strong focus on equality, in terms of equal rights, pay, education and opportunity. As a data company it has been leading on workforce disclosures and seeks to have 50% of its U.S. workforce made up of underrepresented groups by 2024.
"We have been able to find new opportunities even as much of the market appears fully valued."
Also in IT, we added Cisco Systems, which provides IT and networking services in the form of network security, software development and cloud computing. Cisco continues to derive over 50% of its sales from on-premise deployments of its products of enterprise and small and midsize customers, while recurring revenues from software are becoming a larger part of the mix. Return-to-office enterprise spending should offer upside to its core campus business. Cisco was an early technology leader in sustainability over two decades ago, through its Internet-connecting capabilities which supported live concerts in partnership with the United Nations Development Program to raise awareness and funds to fight poverty. Cisco has very strong environmental standards (including driving lower energy consumption in IT departments through new product innovations and a longstanding goal to reduce emissions and reliance on non-renewable energy sources). Its data privacy and supply chain management policies are best in class.
Shoals Technologies, another new position, manufactures electric balance of systems (EBOS) components for ground-mounted solar projects and has been gaining market share for quality of service and price. The company has been primarily operating in the U.S. but is planning to expand internationally with its patented technology, and we see attractive secular growth in Shoals’s end markets.
Unprecedented fiscal stimulus has raised fears of inflation, which have also been expressed in higher interest rates. Further stimulus, including a broadly defined infrastructure bill, would likely add to these fears. At the same time, the pandemic has created pent-up demand for goods and services, while supply chains are still in adjustment. The effects of such large stimulus, higher interest rates and further policy changes, such as potential tax hikes, are material uncertainties we are actively monitoring.
A rapidly changing market with several large unknowns argues for a diversified portfolio with both growth and value as well as cyclical and defensive exposure. We believe the strategy’s quality orientation toward companies with strong balance sheets, high returns, sustainable cash flows and leading ESG profiles continues to be appropriate.
The ClearBridge Sustainability Leaders Strategy underperformed its Russell 3000 Index benchmark during the first quarter. On an absolute basis, the Strategy had gains in five of 10 sectors in which it was invested (out of 11 sectors total). The main contributors were the financials, industrials, consumer discretionary and health care sectors. The materials and consumer staples sectors were detractors.
On a relative basis, overall stock selection and sector allocation detracted from performance. Stock selection in the materials, communication services, IT and consumer staples sectors detracted the most, while stock selection in the industrials and financials sectors proved beneficial. A lack of energy holdings weighed on relative performance.
On an individual stock basis, Shoals Technologies, Bank of America, Hartford Financial, Lam Research and Charles Schwab were the largest contributors to absolute performance in the quarter. The main detractors from absolute returns were positions in Apple, Array Technologies, Ball, BioMarin Pharmaceutical and SolarEdge Technologies.
During the first quarter, besides portfolio activity discussed above, we initiated a position in SunOpta in the consumer staples sector.
We are in the midst of a booming real estate market: prices for many houses are growing the fastest in over a decade thanks to millennial household formation which was increasing before the pandemic, a pandemic-driven acceleration of the exodus from urban centers and a healthier banking system after the global financial crisis. New home sales are elevated even given the winter’s typical seasonal lull (Exhibit 1). Despite a recent pickup in long-term bond rates, 30-year fixed mortgage rates are near historic lows, suggesting the growth could continue. Stimulus money and lifestyle changes engendered by people spending substantially more time at home during the pandemic have also meant more home remodeling.
Exhibit 1: New Privately-Owned Houses Sold
As many people move into new single-family houses or apartment homes, or refresh the existing housing supply, now is a good time to reflect on how green the building and renovation processes can be, as the residential sector contributes a meaningful amount to national carbon emissions (Exhibit 2). A wide range of ClearBridge portfolio companies are working to improve the sustainability profile of tomorrow’s homes, which should help reduce costs over the long term as well. Homebuilders, residential REITs, roofers and insulators, smart home enablers and others across ClearBridge portfolios, are helping make the homes of the future — back deck included — more environmentally responsible spaces.
Exhibit 2: End-Use Sector Emissions of CO2 from Fossil Fuel Combustion (2019)
Homebuilders are beginning to take steps toward building more environmentally friendly homes and disclosing the impact of their own operations. In many cases, the price sensitivity of new home buyers discourages the incorporation of green building in new homes. Homebuilder Lennar, for example, included solar panels in every home it built in California for several years prior to the California Energy Commission making solar standard as part of new construction, although this has not been without consumer pushback.
ClearBridge holding Century Communities, which makes single and attached homes, recognizes homebuilders can be a laggard industry in sustainability disclosures. The company finds that consumers in the past have not been willing to pay a price premium for green features on homes and apartments, even though they say they want them. This has led the industry to generally build to the lowest common regulatory standard, as additional green building practices were dilutive to returns.
Driven by top-down recognition of the strategic importance of green building as well as by demographic changes in home buyers (younger buyers value green features more than older buyers do), Century Communities is taking steps to be a leader in green building by publishing its first ESG
report. Disclosing the company’s Scope 1, 2 and 3 carbon emissions for the first time, the report represents a strategic commitment to increased disclosure and better sustainability practices with the ultimate goal of Century Communities becoming an ESG leader in the homebuilding space. We applaud this step toward clear, tangible results.
While homebuilders face some structural challenges in improving green building (with some exceptions), residential REITs, which take on longer-term responsibilities in owning and operating the properties, are in this way more incentivized to make sustainability gains.
ClearBridge holding American Homes 4 Rent builds, acquires and leases more than 52,000 single-family rental homes across 22 states. The company designs homes with resource-efficient fixtures and appliances. To help residents conserve water, it installs high-efficiency toilets and plumbing fixtures in all development properties and in renovations of existing homes. In arid states such as Arizona and Nevada, it installs smart, water-efficient irrigation features in its landscape design.
There’s More Than Just Bricks in the Wall
Roofer and insulator Owens Corning, also a ClearBridge holding, is helping make the building sector more sustainable. The company operates across 33 countries and has positive environmental impact primarily through its insulation business. In the EU, for example, buildings are responsible for 40% of energy consumption and 36% of GHG emissions. New buildings consume only half of the energy of those built over 20 years ago, according to the company. But as 85% of the buildings in the EU are older than 20 years, and 85%–95% of them are expected to still be standing in 2050, there is need for a massive renovation. Roughly 35 million buildings in the EU will need to be renovated by 2030, according to the company.
Properly insulated homes lower energy intensity and thus the overall carbon footprint of a home. According to Owens Corning, insulation intensity of new homes is on the rise, driven in part by state and municipal rules requiring certain levels of insulation, but also by consumer preference for reducing energy consumption and being greener in the home. The company is helping meet this demand with insulation products that are lighter weight yet deliver stronger performance than higher-weight/higher-density products. The insight that greater density does not necessarily mean better performance has allowed the company to reduce shipping weight and fuel.
Owens Corning’s roofing business also features shingles that use a highly reflective granule technology to reflect the sun, keep roofs cooler and lower air conditioning energy demand. Its composites business also counts wind turbines as a major end use, another positive for sustainability goals.
As part of its 2030 Sustainability Goals, Owens Corning is also looking to grow a circular economy model in which virgin raw materials, waste, energy and emissions are minimized through intelligent design, renewable and recycled input and energy-efficient production.
Smart thermostat maker and ClearBridge holding Resideo Technologies is also helping homes become more sustainable through behind-the-wall innovation. Resideo makes behind-the-wall components and front-facing controls for homes whose purpose is to drive water and energy conservation or improve air quality. Resideo’s smart thermostats help provide the right temperature using the lowest energy consumption; its components and controls for boilers, furnaces and heat pumps help energy conservation; and its leak and freeze detectors aid in water conservation. Currently, of Resideo’s 150 million home installed base, only 6 million are conservation-advantaged “connected homes.” The company’s goal is to grow this mix, while also launching predictive tools for its professional installer customer (a plumber might get an alert once a pipe starts leaking, rather than waiting for the call once a basement is flooded) and working closer with utilities to make the grid smarter and more efficient. Resideo’s smart thermostat, meanwhile, is built into homebuilder Lennar’s new line of Connected Homes.
Home Expansion Offering Green Opportunities
Just as the new home market has been hopping amid low interest rates and the greater need for space, the market for home improvement has also been robust for similar reasons. Decks have been perfect places for safe social gatherings during the pandemic, and ClearBridge portfolio holding
Trex has been meeting demand with its composite decking made from recycled wood fibers and plastic waste.
Trex’s high-performance decking portfolio is made using more than 95% recycled content. Trex uses locally sourced reclaimed wood that would otherwise end up in landfills and so avoids cutting down trees to make its products. The recycled plastic film it uses comes from a variety of sources, including industrial shrink wrap, agricultural plastic sheeting and household plastic such as grocery and shopping bags. With the average 500-square foot composite Trex deck containing 140,000 recycled plastic bags, Trex is one of the largest plastic bag recyclers in the U.S. The company has also innovated ways of recycling dirtier plastics more likely to end up in landfills.
Trex has seen already strong demand get stronger during the pandemic; the company was sold out during much of 2020 and began expanding capacity across the U.S. to meet heightened demand. With lumber prices soaring amid the strong housing market, Trex’s composite decks are increasingly gaining share, especially in price-sensitive areas of the market, which bodes well for both the environment and shareholders.
Sustainability Is Growing in Prominence in the Building Sector
We are encouraged by the increasing number of companies working to build the home of tomorrow more sustainably, which will typically provide an improved return on investment. In addition, the sustainably built home covers expansive geographies and diverse demographics. This is particularly important in the context of climate change, as homes that use water and energy efficiently can also prove more resilient amid volatile energy and water availability and prices. As the EPA notes, homes that maintain habitable conditions in extreme heat, power outages and strong storms are crucial to protecting their inhabitants. If they can be built using sustainable resources by companies actively looking to reduce carbon emissions, all the better.