ClearBridge Value Trust commentary for the second quarter ended June 30, 2016.
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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.
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 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.
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 sales in business travel have weakened with the pullback in corporate spending. However, we believe that the company is taking steps to recover market share and close its margin gap to peers by investing in its labor force to improve operations and service while cutting costs. The group overall should also hold up better than in the past cycles with likely positive margin through the downturn. At 5.3x current year earnings estimates, United Continental is significantly undervalued and would likely outperform over the long term.
Perrigo shares tumbled about 30% in the final trading days of April after the now former CEO Joseph Papa abruptly left the company for Valeant Pharmaceuticals. John Hendrickson, the former head of consumer health, was promoted to take over the helm, and he immediately lowered the company’s earnings guidance, pointing to weaker generic drug pricing. As a reminder, we owned the stock last year when Mylan offered a $26B hostile bid for the company, and we sold before the deal fell through. We subsequently initiated a position once the stock had retreated back below our estimate of fair value. While the recent events have been disappointing, our investment case remains intact. We have met with Hendrickson since the management change, and have several positive take-aways. Management is confident that they can reach the $190M in incremental generic sales to reach their new guidance targets, and they are addressing the underperformance of the recently acquired Omega business overseas. However, we are monitoring Perrigo’s quarterly operational performance closely, given the number of moving parts.
Synchrony Financial shares declined more than 10% in the second quarter, largely in response to company’s updated guidance on charge-offs, which are expected to increase incrementally over the next 12 months. Management poorly communicated (considering they had been reiterating former guidance at recent conferences) that the number of borrowers unable to repay is likely to grow slightly in the near term. Shares also declined late in June as a result of the Brexit fallout’s effects on the broader financial sector. We view the sell-off as an emotional overreaction. In our opinion, this is the beginning of credit normalization and not an indication of a broad underlying deterioration in credit quality. If a true deterioration in credit was the catalyst, we would be witnessing materially worse delinquency trends against a backdrop of worsening employment, which simply is not the case currently. Additionally, Synchrony has ample excess cash that will allow them to pay out 100% of earnings to shareholders for a decade and grow at a substantial premium to the industry, according to our analysis. Synchrony is currently our highest-conviction name in the financials sector.
Outlook
Just as betting and currency markets blew the Brexit call, the lack of cognitive diversity in broader markets leaves us very wary of what potential outcomes are currently priced.
The key, of course, is how this wariness translates to explicit scenarios for the near to intermediate term and portfolio positioning.
- Perceived tail risk: We still put odds of a U.S. recession at less than 20%. U.S. growth will likely slow some due to Brexit, but not materially. In addition, lower rates would act as a direct tailwind to our consumer-led economy, manifested most directly in lower mortgage rates. This would continue to support a steadily improving housing market, while commodity prices remain subdued, and employment continues to improve. What would change these odds? The following: If credit spreads in the U.S. started to gap out, similar to what we saw in early 2016, which would act like shadow market-driven monetary tightening. So far, there is little evidence of that post-Brexit, and our recession probability is essentially unchanged.
- A continued muddle-through: We put 60% probability that the U.S. economy continues to muddle through, with slow but positive real growth of approximately 2%, and modest margin compression from higher unit labor costs. The combination would still allow many U.S. companies to generate ample free cash flow, which would support the market as share buybacks and deal activity offset a continued liquidation of equities by private investors. U.S. equity risk premiums and valuation spreads will probably stay elevated under this scenario, but these will likely not spike. Multiple expansion is unlikely, in our opinion, but with continued stability in oil prices and no major post-Brexit spike in the dollar, we could see an end to the current earnings recession. This could support mid-single-digit earnings growth and a commensurate return in equities over the next few quarters.
- Real tail risk: We think a rise in rates is the real risk to be concerned about, and our subjective probability is somewhere between 10% and 20%. We realize the current market narrative is completely counter to this view, but the potential for REAL surprise is what makes this scenario so dangerous. This outcome would likely trigger a spike in credit and valuation spreads, as the magnitude of mal-investment from an extremely low cost of capital would reverse and trigger forced selling. The silver lining in this scenario is that if it comes with fiscal policies that help reflate the U.S. economy, deep value assets that are tied to reflation could actually do well — especially on a relative basis. This possibility will make this scenario even harder for people to stomach, but the major risk comes from the challenge of selling crowded assets against limiting market liquidity. Assets tied to reflation are not crowded.
So where does this leave us on portfolio positioning? As always, our valuation-driven investment process is focused on buying stocks where a price-to-value gap suggests absolute value potential. Most importantly, we are focused on equities where absolute value is not driven by an artificially low cost of capital or unsustainably high cash flows and earnings. Broadly, we are finding absolute value opportunities where the stock price is volatile, and thus shunned by most investors, but where the underlying business model and cash flow is much less volatile than the price. The vast majority of the time, price is much more volatile than underlying business value, but these volatility-driven opportunities are even more prevalent in the current market environment, where low volatility is prized.
Our biggest challenge remains portfolio construction. The market has clustered assets into two correlating blocks: volatile “risk-on” assets that are deemed highly sensitive to economic risks, and low-volatility “risk-off” assets that correlate directly with bond yields. This binary state would be manageable, except that the trade-off between volatility and value has never been higher. This un-nuanced pricing behavior has driven the valuation gap between the equity risk premium and the risk-free rate to historic highs. Essentially, it has never been more expensive to hedge equity price volatility with bonds or bond-proxy stocks. The resulting valuation risk in the so-called risk-free rate leaves us uncomfortable and at odds with the asset allocation machine that is dominating the marginal pricing of assets. As we survey the widening gap between real and perceived risks, we think long-term investors must stay focused on absolute value and accept the price volatility that is an inherent part of harvesting a valuation-driven risk premium.
