ClearBridge Investments International Value Strategy Q1 2022 Commentary

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• The war in Ukraine has catalyzed greater alignment among European nations over energy and military security, and likely increased cooperation on broader economic and social issues.
• The portfolio’s exposure to aviation, automation, electrical, logistics and agricultural equipment businesses should be supportive of continued long-term growth.
• If long-term rates rise too dramatically, central banks will begin to apply yield curve controls, raising the prices of assets, gold, commodities and energy.

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Market Overview

International markets suffered headwinds in the first quarter from increases in inflation, global supply chain disruptions and shifting policy changes in response to the Russian invasion of Ukraine, with the MSCI All Country World Ex-U.S. benchmark declining -5.44%.

European shares fell more than 10% for the quarter with much of the decline following Russia's invasion of Ukraine. Countries with industrial companies reliant on Russian energy, such as Germany and Finland, fared worse than their peers who had more exposure to energy and consumer goods, such as France. Japan, with little exposure to commodities but a leader in consumer staples, also struggled during the quarter. The United Kingdom, with a large weighting in energy, household product and pharmaceutical firms, managed to register a positive return.

Emerging markets underperformed with China, Russia and Eastern Europe accounting for most of the decline. Meanwhile, high demand for commodities and energy benefited exporters Brazil and Mexico. Our process continues to highlight an increasing number of Asian and emerging market stocks as undervalued.

The war and correction in Europe have delayed our expected move to the East, but we expect to increase our exposure to Japan, Asia and developing nations over the remainder of 2022.

Wars tend to be chaotic, and the outbreak of hostilities between Russia and Ukraine is no exception. It should come as little surprise that European markets have been hardest hit by the outbreak of war, as the need for energy and rising costs take precedence over battling climate change. With a level of unity unseen in recent years, Europe issued a formal condemnation of the invasion and agreement on sanctions, with Putin's attempt to divide Europe and weaken NATO generating the opposite effect as Sweden, Finland and Switzerland abandoned their traditional neutrality. However, for all their sanctions, European leaders stopped short of completely cutting off the flow of gas, coal and oil from Russia for fear of an economic crisis. European leaders will act to buy time to transition away from Russian energy with accelerated development of renewable power and a stepped-up search for alternative fossil fuel providers. In response to the crisis, monetary and fiscal policy is likely to remain looser for longer to help both the private and public sectors adjust. The event has catalyzed greater alignment among European nations surrounding energy and military security and will likely increase the level of cooperation on broader economic and social issues.

China is acting transparently neutral and attempting to strike a delicate balance between supporting an end to hostilities while not directly condemning Russia. The geopolitical stance of China is further complicated by internal challenges related to economic disruption due to COVID-19 lockdowns of major population centers. Both fiscal and monetary policy are set to become increasingly stimulative to support the goals of stability and order as growth suffers a temporary slowdown. In the long run the Russo-Ukrainian war will benefit China as a key producer of renewable energy materials and equipment, while at the same time retaining access to Russia's abundant fossil fuel resources.

The obvious risk is an escalation of Putin's invasion or further expansion of China's COVID-19 lockdowns. Both would increase the odds of a global economic downturn while simultaneously keeping commodity prices elevated, resulting in a stagnation environment that would punish stocks and bonds. Additionally, inflation progressing higher still could harm consumer spending enough to cause a recession, especially in the U.S. and U.K. An expected slowdown in global economic activity may lead to central banks delaying rate increases but with still elevated bond issuance and inflation. The result would be a more expansive fiscal policy stance globally as we are already experiencing in Japan, China and India. If long-term rates begin to rise too dramatically then central banks could begin to apply "yield curve control" as in Japan over the past decade, raising the relative prices of real assets, gold, commodities and energy.

Portfolio Positioning

A mix of rising inflation, falling markets, deteriorating earnings forecasts and declining GDP growth estimates created a conflicted environment for the quarter. While value outperformed for most of the quarter, the Ukraine invasion led to a reversal of market style in March, as growth stocks delivered relatively solid gains. While initial investor reaction to the invasion was a return to long-duration bonds and stocks, shifting priorities, policies and secular trends continue to support the emergence of new leadership.

Commodity prices rose during the quarter due to strong demand and war-related supply disruptions. This led to significant outperformance of the energy and materials sectors, which rose to new all-time highs. We believe the outperformance of these shares is likely to continue as valuations remain low relative to earnings and free cash flows due to diminished stockpiles and the significant time lag necessary to bring new production online.

The Russo-Ukrainian war has exacerbated the tight conditions in most basic materials and energy given low spare capacity and limited inventories. Demand is likely to remain strong due to efforts to accelerate the energy transition, improve energy efficiency and renew the global supply chain infrastructure. Our Strategy retains significant exposure to the materials and energy sectors, and we added a new position in Tenaris, in the energy sector, during the quarter. As a leading manufacturer of steel pipes used in oil and gas production, the company's strong balance sheet and services in managing inventory, distribution and handling leaves Tenaris well- positioned to grow market share as new oil and gas production is rapidly brought online and its expanding footprint in the Middle East provides it with good pricing power as oil and gas companies respond to higher prices.

The financials sector posted overall gains as rising interest rates and commodity prices bolstered the economic prospects of Latin America, Canada, Australia and Asian emerging markets.

However, the portfolio faced headwinds from our overweight allocation to European banks, whose shares fell sharply due to the outbreak of war. We continue to believe our focus on these higher-quality European banks still makes sense as they offer the highest shareholder yield (dividends + share repurchases) on record (Exhibit 1), and the European economy would have to contract by 4% for this metric to fall below the long-term average payout. Prices of stocks like Julius Baer, a Swiss-based asset manager, already incorporate projections of a significant economic downturn but offer substantial upside if the Continental economy proves more resilient. The company currently trades at a significant discount to its historical average but is highly capitalized, providing it a significant buffer against the potential of a market and economic downturn. Additionally, Julius Baer is well-positioned to benefit from the increases in market volatility as nearly three quarters of the company's revenue is tied to fees and commissions, as well as benefiting from rising rates driving improvements in the company's net interest income margin.

Outside of Europe, many of the Asian and Emerging Market financials are now screening more positively based upon our valuation and timing models, and we plan to take this opportunity to diversify our geographic exposure within the financials sector.

Exhibit 1: Europe Still Leads in Shareholder Yield

As of Dec. 31, 2021. Source: Bloomberg, MSCI, ClearBridge Investments.

Higher input costs and increasing economic uncertainty also contributed to the underperformance of the industrials sector, with European firms being hardest hit due to the war despite modest direct Russian exposure. While we did slightly reduce our exposure during the quarter as holdings hit target prices, our outlook for the overall sector remains positive. Our analysis is focused upon margin sustainability, and we expect that the portfolio's exposure to the leading firms in the aviation, automation, electrical, logistics and agricultural equipment businesses with record new order books and strong demand, will be beneficial. One of these companies is GEA Group, a German manufacturer of equipment in the food, beverage, chemical and pharmaceutical industries, a customer mix that exhibits lower volatility due to the necessity of their products. The actions taken by the relatively new management team since 2019 to incorporate greater digital technology has helped drive productivity and product innovation, which will generate greater revenue and margin expansion in a world that is looking to rebuild, renew and reopen.

Despite the tightening of monetary conditions, real estate shares declined less than the broader averages due primarily to a rebound in depressed Chinese property companies. During the quarter we reduced our exposure to U.K. homebuilders as deteriorating affordability and rising construction costs are placing growth and margins at risk. Utilities also proved relatively defensive as investors favored high dividend payers.

Rising interest rates, high inflation and supply chain challenges led to an approximately 15% decline in the consumer discretionary and information technology (IT) sectors during the quarter. However, we leveraged this as an opportunity to increase our weighting in Asian consumer discretionary stocks such as Galaxy Entertainment Group, which operates hotels, gaming and resort facilities in Macau. The prospect of further COVID-19 outbreaks and lockdowns has weighed on the vacation destination entertainment operator, but we believe the company to be heavily discounted compared to its post-pandemic potential. Concerns over economic growth weighed on social media and online advertising services company Tencent, who saw a decline in online advertising in its fourth quarter earnings and faces regulatory concerns from the Chinese government. We believe that the headwinds do not accurately reflect its strong fundamental catalysts in business services and fintech, and that this shake-out has created a more attractive entry point for capturing long-term value, and we subsequently added to this position.

The overall health care sector fell in line with the benchmark as highly valued biotechnology shares declined and offset the resiliency of large pharmaceutical stocks. We are underweight the consumer staples sector with little exposure to food producers and prefer cosmetics, household products and beverages. Global packaged food companies are experiencing a significant rise in input costs which is lowering margins and increasing prices.

These stocks have moved back to historically high valuation premiums but are generally unattractive due to the odds of missing earnings expectations.

Outlook

Russia's invasion of Ukraine amplified the trends in place since the COVID-19 pandemic lows of March 2020 as well as adding urgency to a new set of priorities: inflation, interest rates, monetary policy and economic growth.

The shift from indirect monetary policy to direct fiscal stimulus is profoundly changing the relationship between asset prices and the real economy. Putting cash in consumers' pockets funded by government borrowing has boosted consumption, causing a boom in demand for durable goods such as housing and autos. Long stagnant inflation and monetary velocity have both leapt higher, leading to levels of nominal GDP growth last experienced in the 1990s. Real and nominal interest rates are rising from the lowest levels in modern history as central banks begin removing the twin tools of financial repression: zero interest rates and quantitative easing. The two-decade long expansion in the gap between financial assets and GDP has begun to close. Real asset prices are also rising from all-time lows relative to stock and bond values. In addition to spending on decarbonization, infrastructure renewal and to mitigate economic inequality, governments are also committing greater resources to military, food and energy security.

Given the cost of these policies and impact on underlying economics, markets that have spent the last decade inflating the value of long-duration assets have begun discounting the burden of long-duration liabilities. During the first quarter, global bonds experienced a historic drop as a world that must invest trillions of dollars to become less energy intensive will end up being more debt intensive. As a result, we have likely experienced the generational lows in real interest rates and the cost of capital.

This pendulum swing in macro dynamics is leading to a shift in fundamental priorities. Years of favoring share buybacks and senior executive stock-based compensation have given way to investing in labor and improving efficiency. Additionally, the focus on top line growth with little regard to profitability is no longer being rewarded as the rising cost of capital, labor, goods and shipping is placing a greater emphasis on margins. Even in businesses where margins are strong such as metals, mining and shipping, firms have stated they will favor profitability and free cash flows over large capacity expansions. With supply chains breaking down, asset heavy and vertically integrated businesses are at a great advantage compared to outsourcing dependent "platform" companies. Firms built around a seemingly endless global supply of cheap labor, capital and goods are facing unprecedented headwinds that could remain in place for years.

Public and private investment are at post-WWII lows, but this appears to be changing given the ambitious goals of governments and corporations. Japan, China, Europe, the U.S., and emerging nations all plan to increase spending to levels typical of a post-war reconstruction period. The commercialization and mass application of new technologies like electric vehicles, AI, advanced genomics and renewable power will add to these expenditures. Taken together, we may be at the start of a shift to capital spending and productivity boom. However, there are no quick fixes, and ensuring adequate supplies of key materials will require years of significant investments, many of which are complex, risky and unpopular.

The challenge we face as investment managers is successfully positioning the portfolio to benefit amid shifting global priorities, while avoiding a collapse in the price of assets inflated by a decade of cheap labor and capital. However, we continue to rely on our strong fundamental analysis to identify and invest in the companies we believe are best positioned to generate long-term value. While we source investment from all sectors of the market, we adhere to a rigorous selection criteria based on strong free cash flows, healthy margins and generous dividends. While the current market recalibration has certainly created challenges, we believe it has also created opportunities to find superior companies that are significantly underappreciated and undervalued.

Portfolio Highlights

The ClearBridge International Value Strategy outperformed its MSCI All Country World Ex-U.S. Index benchmark during the first quarter. On an absolute basis, the Strategy had losses across seven of the 10 sectors in which it was invested (out of 11 sectors total). The materials and energy sectors were the primary contributors to returns during the quarter, while the industrials, financials and consumer discretionary sectors were the main detractors.

On a relative basis, overall sector allocation effects contributed to performance. Specifically, stock selection in the energy, health care, materials and consumer discretionary sectors, an underweight allocation to the IT sector and overweight allocations to the materials and energy sectors aided performance.

Conversely, stock selection in the financials, industrials and IT sectors and overweights to the consumer discretionary and industrials sectors hurt results.

On a regional basis, stock selection in Europe Ex UK, Japan and North America as well as an overweight to the U.K. contributed to performance. Stock selection in the U.K. as well as an overweight allocation to Europe Ex U.K. and underweight allocations to Asia Ex Japan and North America weighed on performance.

On an individual stock basis, Glencore (OTCPK:GLNCY), Nutrien (NTR), Inpex (OTCPK:IPXHF), Shell (SHEL) and Bayer (OTCPK:BAYRY) were the leading contributors to absolute returns during the quarter. The largest detractors were KION (OTCPK:KIGRY), Barclays (BCS), Industria de Diseno Textil (OTCPK:IDEXF), BNP Paribas (OTCQX:BNPQY) and Infineon Technologies (OTCQX:IFNNY).

During the quarter, in addition to the transactions mentioned above, the Strategy initiated positions in Anheuser-Busch InBev (BUD) and Unilever (UL) in the consumer staples sector. Additionally, the portfolio received shares of JD.com (JD) as the result of a spinoff to shareholders of Tencent (OTCPK:TCEHY). The Strategy exited positions in Bellway (OTC:BLWYF) in the consumer discretionary sector and POSCO (PKX) in the materials sector.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.