- Investors reacquainted themselves with several risks during the quarter, including higher interest rates, supply chain pressures on margins and policy legislative issues.
- Consistent with our fundamental approach that seeks balanced exposure to industries and the growth and value spectrum, performance was driven by companies from diverse sectors.
- Public equities are moving the needle on the four goals of COP26 and ClearBridge is spurring and guiding this activity through our role as large shareholder and trusted partner in advising on sustainable business practices.
Market Overview and Outlook
Equity markets were volatile during the third quarter, with averages dipping in July, grinding higher through most of August and then fading in September. The benchmark Russell 3000 Index returned -0.10% for the three months, driven by the financials (+2.83%), utilities (+0.99%) and information technology (IT, +0.94%) sectors, while materials (-4.65%) and industrials (‑4.30%) felt pressure from supply chain shortages and rising raw material costs.
Investors reacquainted themselves with several risks during the quarter, including: 1) a wave of the Delta variant of COVID-19, which has since begun to decline; 2) rising interest rates late in the quarter as the economy remained firm despite some headwinds and as the Fed sent mixed signals about the tightening cycle ahead; 3) strong corporate earnings that are facing difficult comparisons, with supply chain issues increasing costs and depressing near-term earnings for many industries; 4) the collapse of property developer Evergrande in China stoking fears of financial contagion that could spill into other markets; and 5) a number of policy and legislative issues being fiercely debated in Washington, including the infrastructure and “Build Back Better” bills in Congress and whether to raise the debt ceiling.
The Strategy modestly outperformed the benchmark; consistent with our fundamental approach that seeks balanced exposure to industries and the growth and value spectrum, performance was driven by companies from diverse sectors. Microsoft, which develops software including the Windows family of products, the Microsoft Office system and the Azure cloud platform, and is a leader in data protection and customer privacy as well as human rights and diversity, contributed strongly as earnings maintained positive sentiment. Microsoft is seeing a number of businesses reach a new, higher level of engagement, adoption and momentum. Diversified health care company Danaher, a top contributor in the second quarter, had a strong third quarter as well, posting a strong beat-and-raise driven by COVID-19 testing, a rebound for in-person activity and no impact from variants/renewed shutdowns. Membership-only big-box retail store Costco continued to execute well, managing costs and enjoying strong membership trends. And Ball, the largest manufacturer of recyclable aluminum beverage cans in North America, bucked headwinds for the materials sector with strong quarterly results and was supported by contracts indicative of further growth.
The communication services and industrials sectors detracted the most from performance during the quarter. Within communication services, not owning Alphabet hurt us on a relative basis, as did our holding in T-Mobile, which is facing a difficult competitive pricing environment. In industrials, Herman Miller and Resideo Technologies both struggled with supply chain issues and rising logistics costs during the quarter. In health care, Amgen, a biotechnology company, has endured several pipeline setbacks recently, including a slow transition of its Lumakras treatment into first-line lung cancer, a slower than expected development of its treatment for myeloma as well as the company’s asthma treatment Tezepelumab missing its primary endpoint in a Phase III study. We remain positive on the stock, with Amgen’s investments in biosimilars and its pipeline part of our long-term thesis.
"We believe generating attractive returns and promoting positive stakeholder impact are not mutually exclusive."
True to our high-conviction approach, the portfolio did not see many changes in the quarter. Within consumer staples, we sold out of Unilever, a great company and sustainability leader that we believe faces margin headwinds as it invests to promote growth, and replaced it with McCormick, a leader in food seasonings and flavors. McCormick is a high-quality business that has lagged recently due to the negative COVID-19 impacts on the business, which provided us with an attractive entry point. The company is also levered to the healthy eating trend, as seasonings are a healthier substitute for sugar and fat.
We also added ON Semiconductor, which designs, manufactures and markets semiconductor and power management components. We view ON as an attractive restructuring opportunity under a new management team. It is also levered to attractive sustainable growth markets like electric vehicles (EVs). This has the dual benefit of improving the environment through lower emissions and driving growth, since EVs have 5x more silicon content than gas powered vehicles.
We believe generating attractive returns and promoting positive stakeholder impact are not mutually exclusive; ON Semiconductor is one example of how this is being achieved as we invest thematically in climate change solutions. Our ownership of a number of renewable energy companies is another contribution to this theme. Other themes reflected in the portfolio include natural resource conservation, through holdings that use recycled materials in their manufacturing process, enable efficient use of scarce resources, and prioritize sustainable packaging; improving human health, through biotechnology, life science tools and diagnostics and managed care companies; and diversity and economic inclusion, through companies that provide financial access and education and promote a diverse workforce.
Our process relies on bottom-up, integrated fundamental and ESG research that seeks out high-quality companies with excellent sustainability profiles. We do not manage the portfolio from the top down and attempt to forecast the macro environment. That being said, we will be closely watching the risks discussed above, such as COVID-19 cases, interest rates, corporate margins and policy developments. In general, we feel fairly confident economic growth will continue to trend in the right direction but likely at a slower pace than the first half of the year. We think the supply chain and logistical issues many companies are facing will eventually loosen up and that corporate earnings should also trend higher next year. Of course, we can’t predict with a high degree of confidence the direction of interest rates, the prospects for Chinese financial contagion, or what will happen in Washington. But we will be monitoring these issues and the potential impact on our holdings, and we are prepared to react if conditions warrant.
The ClearBridge Sustainability Leaders Strategy outperformed its Russell 3000 Index benchmark during the third quarter. On an absolute basis, the Strategy had gains in six of 10 sectors in which it was invested (out of 11 sectors total). The main contributors were the IT, financials, materials and health care sectors. The industrials and communication services sectors were the main laggards.
On a relative basis, overall stock selection contributed positively to performance. In particular, stock selection in the materials and health care sectors contributed the most, while stock selection in the communication services sector detracted.
On an individual stock basis, Danaher, Microsoft, Costco, Regal Rexnord and Hartford Financial were the largest contributors to absolute performance in the quarter. The main detractors from absolute returns were positions in Herman Miller, Resideo Technologies, Amgen, Shoals Technologies and Enphase Energy.
In addition to portfolio activity outlined above, industrials holding Regal Beloit (RBC), which makes electric motors and controls, merged with Rexnord’s (RXN) process and motion control segment to become Regal Rexnord (RRX), and is retained in the portfolio.
ESG Highlights: COP26 Underscores Climate Opportunities in All Sectors
The conference that brought us the Paris Agreement in 2015 is meeting again in November in Glasgow, where the 26th U.N. Conference of the Parties (COP26) will seek to accelerate action to fight global warming. The four goals of COP26 — 1) speed emissions reductions, 2) protect communities and natural habitats, 3) mobilize climate finance, and 4) build public-private-civil partnerships — intersect in many ways with those of ClearBridge’s ESG integration practices. We are excited to see topics ClearBridge regularly addresses with portfolio companies take center stage as governments increase their focus on climate change.
ClearBridge and other investment firms play a crucial role in providing climate financing, one of the main goals of COP26, in ClearBridge’s case through our stewardship of capital and our outreach as a
large public shareholder. Many companies ClearBridge owns and engages with are playing important roles in meeting the goals of COP26. Importantly, these contributions come from innovative companies working across the economy. We believe contributions to large-scale challenges related to climate change will have to come from all sectors (Exhibit 1). We know renewables cannot do it on their own.
Exhibit 1: Share of Global Greenhouse Gas Emissions
COP26 Goal 1: Speed Emissions Reductions
The first goal of COP26, to speed emissions reductions through activities such as phasing out coal, accelerating the adoption of electric vehicles (EVs) and encouraging investment in renewables, speaks to investment themes across ClearBridge, where emissions reductions are being enabled by companies across sectors. We have written extensively of our engagements with AES and Vistra Energy, two power companies retiring and disrupting coal power, expanding into renewables and improving their valuations. Similarly, ClearBridge holdings across the EV value chain, such as TE Connectivity and Aptiv, which make connectors, and even coatings company PPG, which provides thermal, fire and corrosion protection for EV batteries, are helping speed the switch to EVs.
While renewable energy from utilities or solar and wind equipment makers in ClearBridge portfolios is having an impact, many innovations outside of renewable energy are combating climate change and its effects. Resideo Technologies is enabling greater sustainability in the home with “behind the wall” products that enable energy and water conservation. With motors consuming 45% of global electricity production, electric motor and control maker Regal Beloit’s focus on improving efficiency can have a meaningful impact on greenhouse gas (GHG) emissions among its customers. Digital infrastructure company Equinix, in the real estate sector, serves hyperscale cloud companies; it is a leader in renewable energy sourcing and supporting co-location computing efficiency and data security provision. Recyclable aluminum beverage can company Ball has introduced an infinitely recyclable stadium cup and continues to raise the goals for worldwide aluminum recycling from 69% today to 90% in the future. Recycled aluminum only uses 5% of the energy needed compared to that for virgin aluminum.
A diversified mega cap company like Amazon.com could also be a large contributor, given its reliance on and involvement in heavy transport. The company is creating a fleet of 100,000 electric delivery vehicles to help reach a goal of at least 50% of all shipments being net-zero by 2030, and it has a clear opportunity, given its volume and reach, to implement climate-friendly changes to delivery infrastructure, including air and rail, that would benefit all e-commerce and society at large.
COP26 Goal 2: Protect Communities and Natural Habitats with Resilient
Infrastructure and Agriculture
While we work to reduce emissions, managing the effects of climate change will require protecting communities through weather resilience, part of the second goal of COP26. Across U.S. states facing extreme weather events, one lesson seems to be that early movers in adapting to climate-related threats are better positioned to thrive; their preparedness and resilience protect the community and pave the way for better investor returns.
In the U.S., we’re seeing significant impact of climate change on the West Coast. Wildfire season, which used to generally run for four months, now lasts six to eight months due to earlier snow melts and delayed rain seasons. The extent of wildfire damage has been increasing. According to the California Department of Forestry and Fire Protection, which has looked at the largest wildfires in the state since 1932, 9 of the 20 largest fires happened in 2020 and 2021. The average acreage burned by wildfire over the course of the 2020–2021 wildfire season exceeds the five-year average by almost 3x.
We spoke to Edison International recently, who observed that the majority of fires so far this year were from dry lightning and not caused by utilities. This lack of utility-related fires reflects the better operational preparedness of the companies and the state’s increased focus on the issue. With the passage of California’s sweep of wildfire prevention, mitigation and response bills in 2019, the state has sizably increased its funding for wildfire prevention and suppression efforts and vegetation management. The wildfire bill requires utilities to pass annual wildfire safety certification and allocate significant spending to wildfire mitigation measures.
"ClearBridge and other investment firms play a crucial role in providing climate financing."
In addition to legislative changes, utilities in the state are making operational improvements, directing spending to resilience measures such as better insulation or undergrounding of transmission lines, regular line inspections, vegetation management, weather condition monitoring and focusing on circuit-specific mitigation plans. Both the state and companies have also invested in firefighting abilities through expanding firefighting crews.
California utilities are adapting to climate change realities, and we notice a trend of early movers thriving while better protecting the community. Following wildfires in San Diego Gas & Electric’s territory in 2007 and 2008, Sempra Energy (SDG&E’s parent) began what is now a decade of enhancements to infrastructure and technology to limit the risk of utility-related wildfires, and, with a state-of-the-art wildfire monitoring system among other resources, the company is now a recognized industry leader in this regard.
COP26 Goal 3: Mobilize Climate Finance
Financial services companies ClearBridge owns and engages with are also doing their part, making big commitments to support climate-friendly businesses through climate financing, the third goal of COP26, as well as through their own operations. Bank of America, for example, recently announced a goal of deploying and mobilizing $1 trillion by 2030 in its Environmental Business Initiative in order to accelerate the transition to a low-carbon, sustainable economy. JPMorgan Chase has pledged to facilitate over $2.5 trillion over 10 years to address climate change and contribute to sustainable development. It has also developed a method for measuring GHG emissions of its financing clients in order to set Paris-aligned targets for carbon reductions. These involve a goal of a 41% reduction in carbon intensity for new autos, including tailpipe emissions, a 69% reduction from electric power generation and a 35% reduction in operational carbon intensity from oil and gas. Morgan Stanley has pledged to mobilize at least $750 billion of low-carbon solutions; its institutional securities business also issues a wide variety of green bonds that may include financial advisory and underwriting services designed to improve the environmental impact of borrowers.
Large financial institutions are looking to help companies they invest in change their businesses to be better for the environment, and we view these commitments as ambitious, realistic and appropriate to the size of these institutions. They come against an encouraging backdrop of growing green debt issuance, which, while historically trailing finance related to fossil fuel, is closing the gap and in 2021 looks poised to overtake it (Exhibit 2).
Exhibit 2: Green Project Financing Near a Milestone
Private Equity Also a Source of Climate Financing
On the private equity side, alternative asset managers are also helping meet the third goal of COP26. Blackstone has set a goal of reducing carbon emissions by 15% within the first three years of buying any asset or company across its portfolio. The goal, equating to 5% in reductions each year for three years, is scientifically aligned with an overall goal of getting halfway to net-zero by 2030. Blackstone also invests in climate solutions and has spent $11 billion over the past three years on companies and projects supporting the energy transition. Projects include the Champlain Hudson Power Express, which will deliver a 24/7 firm supply of renewable energy to New York City, and 10 million square feet of solar panels all together on the rooftops of Blackstone’s large portfolio of U.S. logistics warehouses and on Stuyvesant Town, a residential development in New York City.
Meanwhile, Apollo Global Management invests in and lends to many companies in the renewable energy space, and it has over $1.6 billion in capital committed or invested in renewable investments. It has also participated in debt syndication with sustainability-linked covenants, where companies can lower the price of their debt by cutting carbon emissions. The company is working to introduce similar covenants to deals it originates privately.
In an ESG program in place now for 13 years, Apollo asks its companies to measure upwards of 156 environmental, social and governance metrics. Through the program, Apollo transforms the operations of portfolio companies, improving transparency around emissions and instilling efficiency-boosting best practices that reduce emissions (Exhibit 3). In a recent ClearBridge engagement with Apollo Global Management, the company discussed its success in implementing lasting sustainability changes in operations of portfolio companies even after Apollo had exited its ownership position.
Exhibit 3: Apollo Reporting Companies with Fuel Reduction Initiatives
COP26 Goal 4: Build Public-Private-Civil Partnerships
The fourth COP26 goal, to work together to deliver on the Paris Agreement, affirms ClearBridge’s partnership approach and throws into relief the value of ClearBridge’s participation in investor-led initiatives and climate-focused organizations. We believe investors working together is crucial in terms of articulating expectations on behalf of the investment industry to government. For example, ahead of COP26, ClearBridge has signed the 2021 Global Investor Statement to Governments on the Climate Crisis, which unites 587 investors representing over $46 trillion in assets and aims to deliver on the Paris Agreement by raising climate ambitions and implementing meaningful practices. We also maintain active relationships with many organizations that support climate-related ESG goals, such as CDP, Ceres Investor Network on Climate Risk, Net Zero Asset Managers Initiative, Climate Action 100+ and the Task Force on Climate-Related Financial Disclosures (TCFD).
Public equities are moving the needle on the goals of COP26 and ClearBridge is proud to be spurring and guiding this activity through our role as a large shareholder, fiduciary and trusted partner in advising on sustainable business practices.