CLEARBRIDGE SUSTAINABILITY LEADERS FUND

Transcription

1 3Q 2018 Product Commentary CLEARBRIDGE SUSTAINABILITY LEADERS FUND Derek Deutsch, CFA, and Mary Jane McQuillen Portfolio Managers Average annual total returns and fund expenses (%) as of September 30, 2018 Class A 3-mo 1-yr 5-yr 10-yr Excluding sales charges Including effects of maximum sales charges Since Incept. (11/02/15) Gross Net N/A N/A N/A N/A Russell N/A N/A N/A - - Index Performance shown represents past performance and is no guarantee of future results. Current performance may be higher or lower than the performance shown. Class A shares have a maximum front-end sales charge of 5.75%. If sales charges were included, performance shown would be lower. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than the original cost. 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. Performance of less than one year is not annualized. All classes of shares may not be available to all investors or through all distribution channels. For the most recent month-end information, please visit 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, 2019 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. Russell 3000 Index is an unmanaged index of the 3,000 largest U.S. companies. Please note that an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges. Key takeaways Portfolio performance was led by IT and industrials stocks benefiting from economic strength and earnings growth. Broad-based health care sector resurgence was due to strong earnings, steady product approvals and good pipeline delivery. Industrial uses of water are global, large-scale and impactful, making efficient management of water resources critical to the bottom line of public equities. Market overview and outlook Equities delivered a strong third quarter, as investors shrugged off disruptions from escalating trade disputes between the U.S. and major trade partners, focusing instead on economic strength and earnings growth. The benchmark Russell 3000 Index gained 7.12%, while the S&P 500 Index added 7.71% for the period. Stocks in the health care sector led the benchmark, rising over 13% in the quarter. The sector s success was broad-based and it reflects affirmative sentiment, as investors rewarded a host of positive factors: strong earnings, steady product approvals, and for pharmaceuticals in particular, good pipeline delivery and more benign regulatory rhetoric around drug pricing. IT continued its strong performance, while industrials rebounded after a modest start to the year. Portfolio performance was led by recent IT stalwarts Apple and Microsoft. Apple shares rallied following its second- INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 quarter earnings beat, which helped the company reach $1 trillion in market cap. Apple, whose best-in-class environmental, social and governance (ESG) practices include renewable energy use, data privacy and workplace diversity, is successfully raising the average selling price of its iphone portfolio, while returns are also being driven by strong growth in its software and services division, which includes the App Store, itunes and cloud services. Microsoft whose leadership position in protecting customer data, reducing the digital divide, and increasing gender diversity has been an engagement theme with our IT software analyst delivered another quarter ahead of consensus expectations as it continues to see success with Office 365 and it remains on a strong cloud transition trajectory. Autodesk was another strong performer in the IT sector: Autodesk is a design software and services company with customers in the architecture, engineering and construction, manufacturing, and digital media and entertainment industries. Autodesk focuses on embedding sustainability considerations into the company s software tools, educating users on sustainable design, and increasing access to the tools. The stock surged higher following quarterly results that topped expectations on strength in billings and new subscribers and caused the company to raise its forward guidance. Positive market returns were driven primarily by a strong domestic economy: GDP growth reached 4.2% in the second quarter; early in September, jobless claims dropped to a near 49-year low, evidence of a steady labor market; and consumer and business confidence levels remain elevated. Secondquarter earnings were strong, as was guidance for future quarters. Industrials stocks in the portfolio, such as Trex and Acuity Brands, are benefiting from strong U.S. growth and consumer and business confidence, which has translated into healthy construction and home renovation trends. Trex manufactures and markets wood alternative decking products for residential and commercial customers. Trex s composite deck products are made from a blend of recycled wood fibers and discarded plastic film, and the production method eliminates the need for smokestacks, and leftover material is recycled back into the manufacturing process. Trex is one of the largest recyclers of plastic in the U.S., a position that grows in importance as China stops accepting scrap plastics. Use of Trex products also contributes to Leadership in Energy and Environmental Design (LEED) certification for builders, an added incentive. The company had a strong second quarter, led by a strong residential product segment. Acuity Brands had a good quarter as well. Acuity is a manufacturer of LED lighting and lighting systems for the commercial and residential construction and replacement markets. Increased competition and pricing pressures in the market for LED products led to revenue weakness in the first quarter, but Acuity rebounded with a consensus-beating second quarter. Input costs due to tariffs and wage inflation, meanwhile, still threaten the company. Health care returns in the portfolio were led by Biogen and UnitedHealth. Biogen is a biotechnology company and sustainability leader that produces therapies in the areas of oncology, neurology and immunology. Shares re-rated higher on positive clinical trials for one of its Alzheimer s treatments, delays of which had held down the stock earlier in the year. UnitedHealth, the largest high-quality managed care provider in the U.S., had another positive quarter as it expands health coverage to larger populations through its Medicare Advantage program. Yields on the 10-year U.S. Treasury climbed as investors gained confidence in the sustainability of a strong U.S. economy, overcame fears of slumps in emerging markets, and settled further in to a global monetary tightening cycle. Projecting steady growth in the U.S., the Federal Reserve raised the federal funds rate in June and again in September, making it three hikes so far in Rising rates pressured yield-oriented sectors such as real estate and utilities, including global real estate broker, leasing agent, investor, real estate fund manager and facilities manager Jones Lang Lasalle. The company has a best-in-class ESG record in its industry, has strong financial and accounting disclosure, and a well-established governance transparency practice. Jones is also a champion in promoting environmental and social sustainability, with a management focus on environmental protection through its consulting, property management and development programs, as well as its concerted effort to encourage diversity and equality initiatives at the company and subsidiary levels. Fund highlights For the quarter ended September 30, 2018, the ClearBridge Sustainability Leaders Fund Class A shares had a cumulative return of 8.49%, excluding the effects of sales charges. In comparison, the Fund s unmanaged benchmark, the Russell 3000 Index, gained 7.12%. 2

3 On an absolute basis, the Fund had gains in nine of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the information technology (IT) and industrials sectors. On a relative basis, both overall stock selection and sector allocation contributed positively to performance. Stock selection in the industrials and consumer discretionary sectors, as well as the newly created communication services sector (which expands the telecommunication services sector to include select companies from the consumer discretionary and IT sectors) helped relative results. A lack of exposure to the energy sector also boosted returns. Conversely, stock selection in the health care and real estate sectors was detrimental. On an individual stock basis, Apple, Microsoft, Lowe s, Trex and Biogen were the largest contributors to absolute performance in the third quarter. The biggest detractors from absolute returns included positions in Jones Lang LaSalle, SolarEdge Technologies, BlackRock, Lam Research and Charles Schwab. During the quarter, we established a new position in Lam Research, a leading technology hardware company that makes capital equipment used in the semiconductor manufacturing process. Lam is well positioned to benefit from the exponential increase in data being generated and the computing power required to store, process and analyze it. Lam s technologies are crucial to the miniaturization of semiconductor technology, which reduces device size and energy consumption for chips. This helps to offset the water intensity of the etch and deposition process used in creating semiconductors by Lam Research s customers in their production lines. We sold biotechnology company Shire following the announcement that Takeda had agreed to acquire the company at a significant premium. Top contributors In terms of individual stocks, the top contributors to Fund performance for the quarter included: Apple (AAPL), in the IT sector, designs, manufactures, and markets personal computers, smartphones and a variety of related software, services and devices. Shares rallied following its second-quarter earnings beat, helping the company reach $1 trillion in market cap. Apple is successfully raising the average selling price of its iphone portfolio, while returns are also being driven by strong growth in its software and services division, which includes the App Store, itunes and cloud services. Microsoft (MSFT), in the IT sector, is one of the largest software companies in the world. The company delivered another quarter ahead of consensus expectations and provided stronger-than-expected guidance. Microsoft continues to see success with Office 365, and it remains on a strong cloud transition trajectory. Trex (TREX), in the industrials sector, manufactures and markets wood alternative decking products for residential and commercial customers. The company had a strong second quarter, led by a strong residential product segment. Bottom contributors The bottom contributors to Fund performance for the quarter included: Jones Lang LaSalle (JLL), in the real estate sector, is a global real estate broker, leasing agent, investor, real estate fund manager and facilities manager. Shares edged down as rising rates pressured yield-oriented sectors. SolarEdge Technologies (SEDG), in the IT sector, is a solar energy company. Solar is a unique form of clean energy that is reaching cost parity in many parts of the world. While global electricity production has grown at 2% over the last five years, solar s share of global electricity production has grown over four times in just the last five years, with solar capacity additions growing at a 30% consolidated annual rate. SolarEdge is one of the best-positioned component suppliers to the solar industry, with a differentiated product, strong balance sheet and continuing market share gains. Component shortages and currency issues caused margin and earnings misses in the second quarter, resulting in some choppiness for this high-growth company. BlackRock (BLK), in the financial sector, is a global asset manager that benefits from significant scale and product and geographic diversification. BlackRock has been assessing its large investor ownership influence to engage companies on governance and ESG matters. BlackRock shares declined during the third quarter in part due to investors fears that Fidelity s fee reductions would hurt BlackRock s business. Fidelity s actions are actually positive for BlackRock, as Fidelity has significantly increased the number of BlackRock funds its customers can buy without trading commissions, a change which is already increasing demand for BlackRock ETFs. 3

4 Environmental, Social and Governance (ESG) Highlights Recently at World Water Week, a gathering of key stakeholders in Stockholm to discuss global water-related challenges, participants sized up the world s water challenges: water stress (occurring when demand exceeds supply or when poor quality restricts use) increased between 1996 and 2016 for most countries in the world, and it has more than doubled in 26 countries; only 59% of domestic wastewater is collected and safely treated; over 2 billion people lack access to safe drinking water; only one out of five countries is on track to achieve Sustainable Development Goal (SDG) 6 clean water and sanitation by 2030 for drinking water, and only one out of 10 for sanitation. Much of the world will be under high water stress in the next two decades (Exhibit 1). Exhibit 1: Water Stress by Country: 2040 guide our engagement efforts with companies in this case clean water and sanitation (goal 6) and life below water (goal 14). The mandate of SDG 6 is to ensure the availability and sustainable management of water and sanitation for everyone. Exhibit 2: Clean Water and Sanitation Source: Water Efficiency Can Make Waves Source: Luo, T., R. Young, and P. Reig "Aqueduct projected water stress rankings." Technical note. Washington, DC: World Resources Institute, August Available online at Water usage is ubiquitous. The average American has a water footprint of approximately 2,000 gallons of water per day not just flowing through the tap, but hidden behind the food we eat and products we buy. A single avocado needs 60 gallons to grow; a hamburger requires 660 gallons to be made; a cotton T-shirt 713 gallons. Statistics like these highlight the importance of water across industries. Industrial uses of water are numerous and impactful, making efficient management of water resources critical to the bottom line and reputation of public equities. Just as water usage is varied, there are many ways companies can improve water resources. Efforts to improve water resources illustrate how public companies are supporting the UN Sustainable Development Goals (SDGs), a set of milestones established in 2015 to solve some of the world s most significant social and environmental changes, goals which ClearBridge can reference to help frame our ESG research and Owning and engaging with companies that consume water offers ClearBridge meaningful opportunities to have an impact. In March 2018 ClearBridge analysts participated in a panel on water risks hosted by ClearBridge and Principles for Responsible Investment. There we discussed approaches to water conservation and challenges to beverage manufacturers water supply chains. The event followed closely upon ClearBridge s hosting of a water day for Coca-Cola and other investors to discuss water stewardship in December As a major consumer of water as an ingredient in its beverages ClearBridge s consumer staples analyst notes that this makes water a material business risk for the industry Coca-Cola prioritizes water quality and availability through efforts to improve water-use efficiency in its bottling plants and manage wastewater and water resources in the agricultural supply chain. It also replenishes over 100% of the water it uses in its finished beverages through nearly 300 water projects covering water sanitation, infrastructure and restoration of watersheds. In 2017 and 2018, Coca-Cola replenished almost 250 billion liters of water. Within technology, water is also a key input in the semiconductor manufacturing process, which uses water to rinse the semiconductor wafer between hundreds of manufacturing steps. Intel, the world s leading chipmaker, offers an illustrative case of steps that can be made toward improved water use in semiconductor manufacturing. ClearBridge regularly engages with Intel, and it has hosted Intel s annual sustainability day for over 10 years. Our 4

5 hardware sector analyst notes that such sustainability-focused business practices around the IT footprint have affirmed our view that Intel is investing for the long term. During our investor engagements, we have discussed how to reduce water use Intel has pursued internal recycling and efficiency initiatives (such as facility-based reuse of grey water) that recently conserved 3.5 billion gallons in a year. Using highly efficient reverse osmosis to purify water for wafer production, for instance, has also helped the company become over 90% more efficient in many operations. As described in an academic study on Intel, the company s focus on innovation, environment and efficiency have been a competitive advantage in terms of cost savings and environmental regulations. 1 We also have an impact by owning companies that make water treatment and efficiency their strategy, i.e., companies in the business of water. Xylem, for example, is the world s largest provider of water technology, and it demonstrates how addressing water-related challenges can also be an attractive business proposition. Xylem and the Water Industry A core element of Xylem s business proposition is improving resource efficiency in the water industry, as well as improving water quality and the resilience of water infrastructure. Many people don t think of energy use as an issue for the water utilities, but water is a heavy product to move. The wastewater industry is very energy-intensive energy is the second-largest operating expense for water utilities (behind labor). Xylem pumps and other products are helping reduce operating costs, energy use and associated Greenhouse Gas (GHG) emissions for its customers. In 2017 ClearBridge attended Xylem s Investor Day, to discuss one-on-one with CEO Patrick Decker the company s sustainability efforts and to understand use-cases for Xylem products. Xylem s own sustainability program prioritizes safety, employee engagement and better tracking of retention stats and engagement scores. We discussed with Decker the focus of Xylem s products on improving water efficiency and quality and reducing energy costs. Xylem s new Flygt Concertor, for example, is the world s first smart wastewater pump; it includes sensors that monitor operating conditions and automatically adapts the pump speed for optimal efficiency and cost savings. This can lead to energy savings of up to 70% versus conventional pumping systems. As Decker explained, Xylem is also having success in China with its ultra-violet (UV) treatment products, which offer more environmentally sustainable treatment solutions than chemical treatments. Xylem is looking to do the same in India, where water quality is a big focus. The country is pushing to clean up the Ganges River (the river passes through 50 cities in India), and Prime Minister Narendra Modi s Smart Cities Mission aims to improve infrastructure and provide connected technology to increase resilience to extreme weather and reduce resource consumption. Ecolab and Water Cost Reductions Ecolab sees water as the ultimate renewable resource and an area in which it can create value, either by helping reduce consumption, encouraging reuse or recycling water. In terms of water management, Ecolab has an incredible reach. Every year the company manages 1.1 trillion gallons of water, helping with water safety for 27% of the world s processed food and 42% of all processed milk supply. It supports 22% of the world s electricity production and 40% of all nuclear power production. Ecolab solutions are used in production of 45% of all petroleum products globally. For many years, Ecolab has reached out to ClearBridge for feedback on its environmental and governance practices. On a recent call with Ecolab s investor relations, legal and sustainability teams, we discussed new sustainability initiatives and trends in Ecolab estimates that in 2016, within the 20 largest countries by GDP, 75% of water was under either moderate or high water stress. This number is set to grow to 90% by The issue, according to Ecolab, is that water is underpriced, and they forecast water costs will have to go up as scarcity increases. The costs of Cape Town s water crisis, for example, are both social and economic. Recently, the crisis there required beverage companies to ship water in at $1,000 a truckload. Companies often lack the data on how much water they use and how much they can save, and this may explain why some are not prioritizing water more. Ecolab continues to build out technology that helps customers monitor and quantify their water usage. The Water Risk Monetizer is an app that helps companies calculate the returns that would come from waterrelated investments, making it much easier for companies to justify a water decision. Ecolab then sells other tools that monitor water use in water-sensitive applications like chemical plants. 1 Curry, Edward and Donnellan, Brian. Implementing Sustainable IT Strategy: The Case of Intel, March 4,

6 Companies are also not focusing on the regions with the highest risk for water scarcity. Ecolab helps customers identify severe-risk hotspots in places like Cape Town and Sao Paolo, which helps develop more context-based solutions and avoid blanket prescriptions. This is key because global statistics don t tell the complete story, as water is most often a local issue that needs to be addressed at the water basin level. The potential monetization of water creates both challenges and opportunities. On one hand, clean water is a universal human right, and there are risks to monetizing it. At the same time, because there is no pricing around water, much of the developed world takes the value of water for granted; it might not be pressured into conservation unless it becomes more economically necessary. Making the business of water sustainable therefore leads us to ask: Where can we as investors capitalize on making access to water possible? We ask similar questions about access to medicine and financial inclusion. We don t want those without the means to have to pay for water, but we do want everyone to value water and thus invest for the access to clean water. Such an approach could ensure that clean water will be available during droughts, and for future generations. While this conversation proceeds, as ESG investors and long-term shareholders, we can encourage better water management by both encouraging better corporate behavior toward water broadly and by owning water companies whose business is to make this better behavior possible. Top 10 equity holdings (%) Microsoft Corp 5.5 Alphabet Inc 4.7 Apple Inc 4.7 Lowe's Cos Inc 4.0 UnitedHealth Group Inc 3.9 US Bancorp 3.3 Automatic Data Processing Inc 3.3 Ecolab Inc 3.1 NIKE Inc 3.0 Costco Wholesale Corp 3.0 Sector allocation (%) Information Technology 20.4 Health Care 15.1 Industrials 14.5 Financials 14.0 Consumer Discretionary 8.7 Communication Services 7.4 Consumer Staples 7.2 Utilities 4.7 Real Estate 3.6 Materials 3.1 Energy 0.0 Cash/Other 1.5 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. Federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given period of time. The Russell 3000 Index is an unmanaged index of the 3,000 largest U.S. companies. The Sustainable Development Goals (SDGs) comprise 17 global goals created by the United Nations in U.S. Treasuries are backed by the full faith and credit of the United States government and offer return of principal value if held to maturity. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. 6

7 Brandywine Global ClearBridge Investments Martin Currie EnTrustPermal QS Investors RARE Infrastructure Royce & Associates Western Asset leggmasonfunds.com Youtube.com/leggmason Legg Mason is a leading global investment company committed to helping clients reach their financial goals through long-term, actively managed investment strategies. A broad mix of equities, fixed income, alternatives and cash strategies invested worldwide A diverse family of specialized investment managers, each with its own independent approach to research and analysis What should I know before investing? Over a century of experience in identifying opportunities and delivering astute investment solutions to clients The Fund is newly organized, with a limited history of operations. Equity securities are subject to price fluctuation and possible loss of principal. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks. 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. As a non-diversified fund, the Fund is permitted to invest a higher percentage of its assets in any one issuer than a diversified fund, which may magnify the Fund s losses from events affecting a particular issuer. 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, a 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. ClearBridge Investments, LLC and Legg Mason Investor Services, LLC are subsidiaries of Legg Mason, Inc Legg Mason Investor Services, LLC. Member FINRA, SIPC CBAX D /18 BEFORE INVESTING, CAREFULLY CONSIDER A FUND S INVESTMENT OBJECTIVES, RISKS, CHARGES AND EXPENSES. YOU CAN FIND THIS AND OTHER INFORMATION IN EACH PROSPECTUS, AND SUMMARY PROSPECTUS, IF AVAILABLE, AT PLEASE READ THE PROSPECTUS CAREFULLY. 7