ClearBridge Value Trust commentary for the second quarter ended June 30, 2016.

H/T Dataroma

Market overview

Major indices traded approximately flat for most of the second quarter until the United Kingdom’s vote to leave the European Union, commonly referred to as “Brexit,” hit the market hard near the end of June. But stocks rebounded in the final trading days of the quarter to finish with modest gains, as the heads of the U.K. and EU central banks stressed that they were prepared to act to mitigate Brexit-related economic stress. The run-up to Brexit and the vote itself induced volatility and broader concern about the state of the global markets. Prior to the vote, the implied probability of a Fed rate hike by the December FOMC meeting was 50%, but the Brexit results and more recent cautious comments from Federal Reserve leaders have led to futures markets pushing back the likely timeline for a rate hike far into 2017. The 10-year U.S. Treasury yield fell below 1.5% for the first time in four years in late June, and the yield curve flattened, implying lower rates for longer. The dollar also strengthened about 3% against a basket of currencies in the wake of the announcement, but it still remains nearly 4% below its November high.

ClearBridge Value Trust

U.S. economic indicators were mixed-to-positive during the quarter. Annualized U.S. GDP growth from the first quarter was slightly softer than the fourth quarter of 2015, at 1.1%, but it reflected relative strength in consumer spending. Consumers have continued to help buoy the economy, as retail sales increased in back-to-back months for the first time since November and December of 2015 and average hourly wage growth strengthened to 2.6% year over year in June. While it may be too early to discern a trend, employment growth was a relative weak spot for the U.S. economy in the second quarter, as job growth in the last three months averaged 147,000, well below the 200,000 three-month average job growth during the first quarter. New home sales remained strong in the second quarter, despite a 5% drop from April to May.

Oil prices continued their rise in April from an intra-month low of less than $36 before stabilizing between $45-$50 per barrel in May and June, as supply came down in non-OPEC countries during the quarter. This stabilization supported energy stocks and helped reduce volatility across the market for most of May and June. Market expectations of “lower rates for longer” and margin concerns led to a pullback in financial stocks, particularly banks, which were hit hard after Brexit. The S&P 500 Financials Index was positive on the quarter, but it fell more than 3% in June. However, banks received good news at the end of the month when the Fed announced the results of its Comprehensive Capital Analysis and Review, more commonly known as CCAR, in which 30 of 33 bank holding companies (BHCs) passed and which showed the overall Common Equity Tier 1 Ratio for all 33 BHCs had more than doubled from 5.5% in the first quarter of 2009 to 12.2% this year. Meanwhile, stocks in defensive sectors with higher yields, such as consumer staples, telecommunications and utilities, generally performed well in the second quarter, as did health care. Information technology and consumer discretionary were the only two sectors with a negative return in the second quarter.

The S&P 500 Index closed up 2.5%, while the Dow Jones Industrial Average gained 2.1%. The NASDAQ Composite was approximately flat for the quarter. Small-cap stocks outperformed large-caps during the quarter, with the Russell 2000 returning 3.8%, versus 2.5% for the Russell 1000. Looking at style, value-oriented stocks topped their growth counterparts, as the Russell 1000 Value Index returned 4.6% during the second quarter, compared with the Russell 1000 Growth’s 0.6%.

ClearBridge Value Trust

ClearBridge Value Trust highlights

During the first quarter of 2016, the ClearBridge Value Trust – Class C shares generated a total return of 1.14%, excluding sales charges. In comparison, the Fund’s unmanaged benchmark, the S&P 500 Index, returned 2.46% and the Lipper Large Cap Core Funds category average was 1.98% for the same period.

Using a three-factor performance attribution model,1 relative portfolio underperformance was driven by the interaction of sector allocation and security selection, as well as sector allocation, and this was partially offset by positive stock selection effects. In terms of sector allocation, underweight positions in consumer staples, energy and telecommunication services hurt relative performance as the sectors outperformed the broader index. American Homes 4 Rent, Devon Energy, Amazon.com, CONSOL Energy and Albemarle were the largest contributors to performance, while the biggest detractors included United Continental, Perrigo, Realogy Holdings, Synchrony Financial and Microsoft.

During the second quarter we initiated four new positions: MetLife, Mylan, Mosaic and Alphabet. Four positions were eliminated during the quarter: EMC, eBay, Albemarle and AbbVie.

ClearBridge Value Trust

Top contributors

American Homes 4 Rent was a top contributor in the second quarter, as operating leverage drove strong first-quarter earnings that topped Street estimates. With the recent run-up, the stock has closed its discount to peers materially, but accelerating rent growth and decelerating expenses should drive further upside to close the gap. Additionally, the company has been able to tap capital markets and it could find some accretive deals to add to its portfolio.

Devon Energy traded up in the second quarter on broader commodity price increases, but the company also posted strong operational results, solid production, and meaningful improvement on unit expenses. Devon management also raised production guidance and has reaffirmed their confidence in plans to sell the company’s 50% stake in the Access Pipeline and other non-core assets. The liquidity from these asset sales will allow Devon to materially reduce leverage, and thus alleviate the market’s concerns of financial distress.

Albemarle was a top contributor to performance in the second quarter, and we exited the position on valuation. Positive estimate revisions, due to lithium price gains and decent trends in Albermarle’s core business, have caused the market bid the stock up above our estimate of fair value. And while momentum could continue to drive the stock’s upward trajectory, this is a high-beta stock that has experienced substantial crowding. Thus, the stock is vulnerable to any earnings disappointment or broader market shock, and our analysis indicates a negative risk/reward skew. Therefore, we harvested gains and redeployed the capital to opportunities with greater risk-adjusted return potential.

Top detractors

United Continental declined more than 31% in the second quarter on broader industry concerns and declining business travel. Consolidation over the past decade has largely improved the airline industry, but recently management teams have failed to act rationally, as investors expect. Margins have expanded as jet fuel costs declined with oil prices, leading several airlines to add capacity and offer competitive discounts. This is disappointing on the one hand, given softening demand trends in the U.S. and a stagnant economy in Europe, but partially justifiable given the decrease in fuel prices. United Continental also has experienced mid- to high-single-digit declines in passenger revenue per available seat mile (PRASM), as they have ceded market share to competitors and as their most profitable

1, 2  - View Full Page