2020 Product Commentary CLEARBRIDGE VALUE TRUST · ultimately burn itself out as we attain herd...
Transcript of 2020 Product Commentary CLEARBRIDGE VALUE TRUST · ultimately burn itself out as we attain herd...
1Q 2020 Product Commentary
CLEARBRIDGE VALUE TRUST
INVESTMENT PRODUCTS: NOT FDIC INSURED • NO BANK GUARANTEE • MAY LOSE VALUE
Sam Peters, CFA, and Jean Yu, CFA Portfolio Managers Average annual total returns and fund expenses (%)
as of March 31, 2020
Since Incept. Expenses
Class A 3-mo 1-yr 5-yr 10-yr (02/02/09) Gross Net
Excluding sales charges
-30.45 -23.57 -0.98 5.56 9.59 1.08 1.08
Including effects of maximum sales charges
-34.45 -27.97 -2.15 4.94 9.01 1.08 1.08
S&P 500 Index -19.60 -6.98 6.73 10.53 N/A - -
Performance shown represents past performance and is no guarantee of future results. Current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than the original cost. Class A shares have a maximum front-end sales charge of 5.75%. Total returns assume the reinvestment of all distributions at net asset value and the deduction of all Fund expenses. Total return figures are based on the NAV per share applied to shareholder subscriptions and redemptions, which may differ from the NAV per share disclosed in Fund shareholder reports. Performance would have been lower if fees had not been waived in various periods. Returns for less than one year are cumulative. For the most recent month-end information, please visit www.leggmason.com.
Gross expenses are the Fund's total annual operating expenses for the share class(es) shown. Net expenses are the Fund's total annual operating expenses for the share classes indicated and would reflect contractual fee waivers and/or reimbursements, where these reductions reduce the Fund's gross expenses. These arrangements cannot be terminated prior to December 31, 2021 without the Board’s consent. In periods of market volatility, assets may decline significantly, causing total annual Fund operating expenses to become higher than the numbers shown in the table above. The Gross and Net Expenses listed include 0.01 of Acquired Fund Fees and Expenses (AFFE) that are required to be shown in the Fund’s prospectus. AFFE reflects the Fund’s pro rata share of fees and expenses relating to its investments in acquired funds; however, AFFE are not incurred directly by the Fund. Therefore, AFFE are not reflected in the Fund’s audited financial statements or financial highlights. S&P 500 Index is a market capitalization-weighted index of 500 widely held common stocks. Investors cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.
Key takeaways
• Given the policy response to COVID-19 and the reversal of globalization as a major deflationary force, there is potential for a major change in economic and market dynamics.
• During episodes of such market stress, we tend to get very active as we look to take advantage of the price volatility and resulting dislocations between price and underlying value.
• Even after the recent compression in valuation spreads, from current levels the forward 12-month relative performance opportunity in favor of value has averaged almost 30% historically.
Market overview
The COVID-19 crisis will almost certainly be one of the most
dramatic events we will experience in our lives, if not the most
dramatic. What makes a global pandemic so frightening and
challenging is that pandemics are not linear, but rather
exponential, enemies. The continuous compounding of
COVID-19 resulted in cases doubling almost every two days in
the early stages of the crisis, and even now cases are still
doubling roughly every nine days in the U.S. Tackling an
enemy that doubles every few days has quickly altered the
world as we knew it, as the scale of many things — virus
outbreak, economic slowdown, market selling, policy response
— has blown up well beyond all past experience. The physicist
Albert Bartlett argued that “the greatest shortcoming of the
human race is our inability to understand the exponential
function.” To tackle this natural shortcoming, we will explore
how the virus has exploded the scale of recent economic and
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market events, and how we are adapting as long-term
valuation-disciplined investors.
We will spare our readers any real math, but the proper way to
handle data that varies widely, which is almost always the case
with exponential growth, is to use a logarithmic or log scale on
all charts. A log is the inverse function of an exponential, and
its basic power is its ability to reverse the effects of
exponential growth so that you can more easily compare data
across time. In almost all cases a log scale will squeeze the
drama out of a long-term chart by flattening a curve and
making it look linear. Unfortunately, the scale of the ongoing
fight against our exponential enemy has not been tamed in
any way by a log scale.
Despite the intensity of the Global Financial Crisis (GFC) in
2008, in which jobless claims rose almost threefold (Exhibit 1),
scarring most investors and profoundly affecting behavior and
policy over the ensuing market cycle, it did not prepare us for
the scale of what we have experienced over the past few
weeks. By contrast, the thirty-fold increase in claims in April
2020 turns the intense job stress of the GFC into a noticeable
but modest foothill by comparison.
Exhibit 1: Initial Jobless Claims Soar in 2020
As of April 11, 2020. Source: ClearBridge Investments, Bloomberg.
When 20 years of experience gets amplified by a ten-fold
multiplier, it quickly becomes clear we need a new map. The
real challenge is that we are still somewhat early in this
process, and we are facing many unknowns around the
ultimate duration and magnitude of the crisis. Clearly,
however, we are witnessing the largest decline in global
economic activity ever over such a brief period, as the virus’s
exponential nature has been dictating the pace of the crisis.
Left to run its course, this pace would quickly run the global
economy into a depression.
Fortunately, the economic fallout of the crisis is being met by a
fiscal and monetary response that is also historic in its scale
and speed. The key objective for policy is to fill the historic gap
in economic activity, and, with the combination of monetary
and fiscal policy now adding up to 35% of the U.S. economy,
the response has been massive. The other objective of policy is
to buy time to fight the virus. As a natural system, the virus
has the advantage of continuous compounding, but natural
systems have the disadvantage of organic limiters. We may
face several COVID-19 infection waves, but the virus will
ultimately burn itself out as we attain herd immunity with
time and, ultimately, the aid of a vaccine. In addition, with
each wave we will have more diagnostic information to isolate
outbreaks and balance the economic response.
As importantly, policy has the advantage of being a man-made
system, which has no organic limits — at least over the short
to intermediate term. Money supply historically used the gold
standard as a natural limiter, but money is now free to follow
its own exponential path. This freedom has allowed the
Federal Reserve (“Fed”) to grow the money supply over this
crisis at an unprecedented rate. The following chart shows the
M2 broad money supply over the last 20 years. This chart may
not look as dramatic as the previous chart, but that vertical line
at the far right is truly shocking on a long-term log chart of
this scale. Over the past 20 years the Fed has grown the money
supply at roughly 6% annually. Over the past two weeks the
Fed has increased the money supply by roughly $1.2 trillion, or
7.5%, which is almost 200% annualized. More importantly, the
Fed has pledged to provide whatever it takes and has followed
up with its continuously expanding interventions across asset
classes to ensure ample liquidity. We expect the exponential
battle between the economic fallout of the virus and the policy
response to swing back and forth over the coming months, but
ultimately policy and time will win out over the virus. We are
certainly not gold bugs, but we do think the long-term cost of
the policy response is an unknown that will linger long beyond
COVID-19.
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Exhibit 2: Money Supply Growth Is Unprecedented
As of April 11, 2020. Source: ClearBridge Investments, Bloomberg.
Despite the terrible nature of this economic crisis, new market
cycles always emerge from the pain and fear of downturns.
However, in the early stages of this crisis, pre-existing market
trends in favor of growth and against value accelerated. Value
as a broad category has been suffering mightily since 2017
(Exhibit 3), but this suffering accelerated into a value collapse
in March that was arguably the worst period for value on
record. However, as the battle between policy and the virus
ensued, value started to bottom and fight back (Exhibit 4).
Fortunately, our relative performance started to rebound
materially with the better performance of value, but we still
have a long way to go to restore long-term relative
performance after facing such intense headwinds over this
market cycle and the recent crisis. The key question is, how to
dimension the potential for a value cycle?
Exhibit 3: Value Stocks Have Suffered Since 2017
As of April 11, 2020. Source: ClearBridge Investments, Bloomberg.
Exhibit 4: Value Vs. Growth Trend Accelerated
As of April 11, 2020. Source: ClearBridge Investments, Bloomberg.
To measure value cycles, we have long used the following
valuation spread chart from Empirical Research Partners
(Exhibit 5). The chart tracks the cheapest 20% of the market
over time. When the line is rising, value is underperforming
materially, but it sets up major opportunities for value
outperformance when the spread compresses. Value cycles are
violent in nature, characterized by sharp peaks and reversals.
The nature of value cycles requires the discipline and
temperament to stick with value when it is at its most painful
moments. As valuation spreads rise, the math becomes easier
while the emotional stress intensifies. Therefore, most people
understandably lose confidence in value and value managers
at exactly the wrong time, and this behavioral response is,
ironically, one of the critical ingredients powering a value
cycle.
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Exhibit 5: Valuation Spreads Peaked at Third-Highest Ever
As of April 1, 2020. Source: National Bureau of Economic Research, Empirical Research
Partners Analysis. Measures U.S. large-cap valuation spreads, top quintile compared to the average.
Valuation spreads peaked in mid-March at their third-highest
level ever and have recently compressed to just over three
standard deviations. Even after the recent compression in
valuation spreads, from current levels the forward 12-month
relative performance opportunity in favor of value has
averaged almost 30% historically.
However, if there is one clear message here, it is that we are
dealing with a scale of events that we have never witnessed.
When you see the exponential moves in log scale highlighted
in the charts above, you are clearly dealing with some very fat
tails, and the range of possible outcomes is incredibly wide.
With such ongoing uncertainty we cannot be sure that the
equity market has truly bottomed and that valuation spreads
will not widen again before a new market cycle begins.
Especially with so much economic pain and dislocation headed
our way.
What we do know is that ultimately there will be a very big
tactical move in favor of value strategies like ours, as policy
and time win the battle over the virus. There is also the
distinct possibility that the next cycle could favor value
strategically if the historic merging of fiscal and monetary
policy at an unprecedented scale gives birth to a higher level of
inflation (although stagflation is a possibility). To be clear, as
we navigate this deflationary collapse in the economy, there is
zero evidence of inflation, and technology and demographics
will continue to be structurally deflationary. However, given
the emerging policy response and the reversal of globalization
as a major deflationary force, there is potential for a major
change in economic and market dynamics. For now, our goal is
to survive this cycle in order to take full advantage of a tactical
value cycle, while gauging if the current uncertainty gives rise
to a longer-lasting opportunity for value down the road. How
are we doing this?
As the crisis steamrolled through financial markets, daily
volatility rose to historic levels and valuation spreads exploded
higher at a record pace. During episodes of such market stress,
we tend to get very active as we look to take advantage of the
price volatility and resulting dislocations between price and
underlying value. Given the magnitude and pace of this crisis,
our portfolio turnover rose to the highest level in our tenure,
as we established 15 new positions and sold 14.
In the very early stages of the crisis our focus was on
minimizing direct risk to the most virus-exposed market areas,
and we sold our travel-related positions and reduced auto,
financial and energy exposure. These were prudent moves, but
with hindsight we wish we had done even more.
A primary process transition in every crisis is that equity
analysts quickly become credit analysts. Accordingly, we had
the team stress test every position in the portfolio. The simple
goal is to make sure that each company can survive this
historic collapse in economic activity, as price and value
cannot converge if a company cannot survive. The added
challenge of this crisis is that stress tests had never included
multiple cases of company revenues collapsing toward zero. In
the few cases where we thought balance sheets would become
too stressed, we exited or reduced positions, especially in
certain energy and credit-sensitive companies. To be clear, as
the wave of economic pain is still cresting, stress testing will
be iterative and ongoing. Our goal is simply to maintain a
healthy gap between the price and value of portfolio positions,
but while continually reducing liquidity and solvency risk.
Given the high level of uncertainty and such an incredibly
wide range of future outcomes, we are well-diversified, while
staying true to our valuation discipline. The portfolio now has
roughly 10% in international equities, and we added three
international companies: Melco Resorts, Sony and Unilever.
We also added to our greater than 4% position in gold by
adding Newmont Corporation and Wheaton Precious Metals.
As we commented previously, we are not gold bugs by any
means, but if there was ever a time to own gold, we think this
is it. We also added to dominant U.S. “platform companies” as
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their prices fell, with new positions in Amazon, Comcast and
UnitedHealth Group. These companies should navigate the
ongoing crisis well and will also do well over the long term if
deflation intensifies.
Despite the intense focus on managing risk by stress testing
companies and adding diversification to an already diversified
portfolio, the portfolio’s valuation potential remains extremely
high and fully reflects our valuation-driven investment
process. As a result, we should do well in a wide range of
future scenarios, and we are certainly positioned to navigate
the crisis and enjoy an eventual compression in valuation
spreads. The biggest risk to relative performance remains
continued headwinds to value, which were historically intense
until very late in the quarter.
Dimensioning the historic scale of this crisis is critical context
for investors, but we remain intensely aware of the stress and
toll this crisis is having at the individual level. We will,
however, beat this exponential enemy with an exponential
policy response, time, and the greatest strength of humans:
our ability to organize at a global scale to tackle our collective
challenges. As this crisis fades, we hope our global efforts are
energized to tackle the other great challenges we face. At a
smaller scale, we also hope for a restoration of value.
Fund highlights
During the first quarter of 2020, the ClearBridge Value Trust –
Class A shares generated a total return of -30.45%, excluding
sales charges. In comparison, the Fund’s unmanaged
benchmark, the S&P 500 Index, returned -19.60%.
On an absolute basis, the Fund had losses in all 11 sectors in
which it was invested during the quarter. The least negative
contributions to the Fund’s performance were the real estate,
materials and consumer staples sectors. The financials and
energy sectors were the main laggards.
In relative terms, the Fund underperformed its benchmark
during the quarter due to stock selection and sector allocation
decisions. In particular, stock selections in the financials,
consumer discretionary and energy sectors were detrimental,
as were overweights to the energy and financials sectors.
Conversely, stock selection in the materials sector and an
underweight to the industrials sector proved beneficial.
On an individual stock basis, the greatest contributors to
absolute returns during the quarter included positions in
Amazon.com, Arista Networks, McKesson, Newmont and
Expedia. The largest detractors from absolute performance
were positions in American International Group, Energy
Transfer LP, Synchrony Financial, Wells Fargo and Capri
Holdings.
Besides the new positions discussed above, portfolio activity
for the period included initiation of positions in Western
Digital, in the information technology (IT) sector, McKesson,
in the health care sector, Vail Resorts, in the consumer
discretionary sector, Uber, in the industrials sector, and Valero
Energy, in the energy sector. Meanwhile, larger positions
closed during the quarter included Royal Gold, in the materials
sector, Delta Air Lines, in the industrials sector, Anheuser-
Busch InBev, in the consumer staples sector, Voya Financial, in
the financials sector, and Advance Auto Parts, in the consumer
discretionary sector.
Top contributors
Amazon.com (AMZN), in the consumer discretionary sector,
is a leading retail e-commerce site and provider of web hosting
and related cloud services that continues to benefit from the
migration of commerce from offline to online. The company is
well-positioned in the current “stay at home” environment,
given its dominant e-commerce platform and rapidly growing
Amazon Web Services cloud platform.
Expedia (EXPE) announced broad plans to improve efficiency
across its business on the fourth-quarter earnings call. Digging
further into details regarding the achievability of Expedia’s
cost reduction efforts, investors felt more comfortable with
Expedia now that the business is in the hands of an operator
willing to take decisive action for change.
Arista Networks (ANET) reported an EPS beat driven by better gross margins in February but guided margins down worse than expected, which led to some selling. With the stock trading near trough levels on what we believed were trough EPS, we saw the opportunity for both significant EPS growth and multiple re-rating when hyperscale spending resumes (and 400G deploys), likely in 2H20/1H21. The stock performed well in March as it benefited from the virus driving internet demand for cloud titans such as Facebook and Microsoft, to which Arista supplies network equipment.
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Top detractors
American International Group (AIG) shares traded lower,
along with the financial services sector, as investors grappled
with the reality of low interest rates for an extended period of
time and the economic fallout of COVID-19. While concerns
over credit losses in the investment portfolio are real and there
are many unknowns with respect to insurance coverage during
a pandemic, AIG trades at a considerable discount to book
value, suggesting many risks are already incorporated in the
stock price.
Synchrony Financial (SYF) is embedding a huge credit cycle,
given the spike in unemployment. Directionally this is right, of
course, and unsecured credit card lenders have among the
highest frequency and severity of loss. However, unlike past
bad unemployment cycles, the government is providing
absolutely massive stimulus directly to the consumer. Loan
losses per unit of unemployment this cycle should be less than
it has been in past recessions, as resulting consumer liquidity
is substantially better this go-round. Furthermore, the market
continues to underestimate the counterbalance in Synchrony’s
model that is different from other lenders. It shares economics
with its retail partners and pays them less when loan losses
spike. This has the potential to be a multiyear and multibillion
dollar offset to higher loan losses. Wall street analysts and the
market mis-frame this dynamic.
Wells Fargo (WFC) reported disappointing fourth-quarter
earnings in January. Fees were slightly below estimates and
expenses were slightly higher than expected, which was at
least in part a reflection of the fact that Q4 was something of a
“clean-up” quarter for new CEO Charles Scharf. Credit remains
fine and Wells is still well-capitalized. Wells’ exposure to the
pandemic is the impact from the broad economic drawdown;
the narrative is that Wells has a comparatively fixed cost base
and as such could see more discontinuous earnings downside
as revenues decline in a recession and as loan losses increase.
This is true to a point, but Wells also has meaningfully de-
risked over the past few years as the company has shifted its
balance sheet due to the asset cap, and it has a lower consumer
credit mix, which will likely see the biggest absolute increase
in loan losses.
Outlook Value stocks have underperformed materially of late, although value cycles are violent in nature, characterized by sharp peaks and reversals. The nature of value cycles requires the discipline and temperament to stick with value when it is at its most painful moments. As valuation spreads rise, the potential reversal is larger, while the emotional stress intensifies. Therefore, most people understandably lose confidence in value and value managers at exactly the wrong time, and this behavioral response is, ironically, one of the critical ingredients powering a value cycle.
Even after the compression in valuation spreads in late March 2020, the forward 12-month relative opportunity in favor of value has averaged between 30% and 40% from current levels. We cannot know if valuation spreads will widen again or continue to compress, but the current math is very much in favor of value as the painful uncertainty of the COVID-19 crisis slowly gives way to risks that we can model and price.
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Top 10 equity holdings (%)
Microsoft Corp 7.5
Alphabet Inc 7.4
Alexion Pharmaceuticals Inc 3.9
Amazon.com Inc 3.9
American International Group Inc 3.1
Oracle Corp 3.1
Wells Fargo & Co 3.0
Bristol-Myers Squibb Co 2.9
AbbVie Inc 2.8
Facebook Inc 2.7
Sector allocation (%)
Information Technology 19.2
Financials 14.9
Health Care 14.3
Communication Services 12.3
Consumer Discretionary 12.1
Energy 6.8
Utilities 5.3
Materials 4.7
Consumer Staples 4.5
Industrials 2.0
Real Estate 1.1
Cash/Other 3.0
Percentages are based on total portfolio as of quarter end and are subject to change at any time. For informational purposes only and not to be considered a recommendation to purchase or sell any security.
Definitions and additional terms:
Please note that an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.
Coronavirus disease (COVID-19) was discovered in 2019 and has not been previously identified in humans.
Deflation is a general decline in prices, often caused by a reduction in the supply of money or credit.
Earnings per share (EPS) is a company's profit divided by its number of common outstanding shares. If a company earning $2 million in one year had 2 million common shares of stock outstanding, its EPS would be $1 per share. The Global Financial Crisis (GFC) was the recessionary period between December 2007 and June 2009, which was caused primarily by the U.S. housing market bubble collapsing.
The Federal Reserve Board ("Fed") is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
M2 is a calculation of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds, and other time deposits.
S&P 500 Index is an unmanaged index of roughly 500 stocks that is generally representative of the performance of larger companies in the U.S.
Stagflation is a seemingly contradictory condition described by slow economic growth and relatively high unemployment, or economic stagnation, which is at the same time accompanied by rising prices (i.e. inflation).
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Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional. Portfolio holdings and sector allocations may not be representative of the portfolio manager's current or future investment and are subject to change at any time. Percentages are based on total portfolio as of quarter end and are subject to change at any time. For informational purposes only and not to be considered a recommendation to purchase or sell any security. ClearBridge Investments, LLC and Legg Mason Investor Services, LLC are subsidiaries of Legg Mason, Inc. © 2020 Legg Mason Investor Services, LLC. Member FINRA, SIPC. CBAX107131 D7407 04/20
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What should I know before investing? Equity securities are subject to price fluctuation and possible loss of principal. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. The manager’s investment style may become out of favor and/or the manager’s selection process may prove incorrect, which may have a negative impact on the Fund’s performance. Because this Fund expects to hold a concentrated portfolio of securities, and invests in certain regions or industries, it has increased vulnerability to market volatility. Diversification does not guarantee a profit or protect against a loss.
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