All Cap Growth Strategy

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1 First Quarter 2018 All Cap Growth Strategy Key Takeaways Evan Bauman Peter Bourbeau Richard Freeman Margaret Vitrano The return of volatility after an unusually subdued 2017 should increase opportunities for active managers to take advantage of mispricings. A continued broadening of leadership in information technology to enterprise software companies drove performance. As long-term investors, we remain confident that the fundamental strengths of undervalued companies in health care and energy sectors that represent some of our largest active bets will be recognized. Market Overview Stocks endured their first period of elevated volatility in two years during the first quarter, sparked by fears of rising inflation, higher interest rates and trade tensions. The S&P 500 Index declined 0.76%, its first negative quarter since September 2015, while the Russell 1000 Index fell 0.69% and the Russell Midcap Index dropped 0.46%. The VIX spiked to its highest level in more than five years in early February as bond yields surged on signs of higher inflation. The fear gauge remained elevated for the remainder of the quarter as the Trump administration announced tariffs on imported steel and aluminum, and preliminary Section 301 tariffs on China, stoking fears of retaliation from trade partners. In late March, shares of Facebook sold off amid news that a political data firm gained access to private information of over 50 million users. Investors fear tougher regulation resulting from this incident could crimp Facebook s advertising revenue and hinder the growth of other tech giants with similar business models. The initial spike in volatility was sparked by the unwinding of short volatility derivative instruments rather than fundamental weakness. Instead, we continue to own well-managed companies with balance sheet strength, primarily in the IT, health care, media, industrials and energy sectors. In technology, the negative sentiment around Facebook and the other FAANG stocks could lead to a rotation out of this crowded area into underowned segments of the sector and other parts of the market. Seagate Technology, for instance, was a top contributor during the first quarter, boosted by accelerating 620 Eighth Avenue, New York, NY ClearBridge.com

2 CLEARBRIDGE ALL CAP GROWTH STRATEGY Stronger spending on information security software is the latest example of renewed business optimism. demand for storage in the cloud provided by its hard disk drives. The company is generating free cash flow that it is returning to shareholders through share buybacks and dividend payments. We are seeing a broadening of participation in the information technology (IT) sector, which accounts for 37.6% of the benchmark and 38.7% of the portfolio. From growth led by the FAANGs, which appeal to primarily consumer end markets (with the exception of Amazon s AWS cloud business), a shift is underway to enterprise software companies dependent on corporate demand along with workloads and applications moving to the cloud. Steady GDP growth and greater confidence among corporate management teams is incentivizing more companies to ramp up investment in their businesses, driving strong results for portfolio companies Adobe Systems, Red Hat, Autodesk and Microsoft. We are encouraged by this development as the return on investment for customers from technology spending and innovation is usually good. Tax reform is a material tailwind for most of our companies especially the ability of companies to immediately write off capex expenses and could extend this current cycle of strong spending on enterprise IT, as we feel there is pent-up demand as we have received clarity on the corporate tax situation. Stronger spending on information security software is the latest example of renewed business optimism. Palo Alto Networks, a provider of next generation security platforms, endpoint and threat management services, is benefiting from an industrywide refresh to upgraded firewall technology and robust new customer additions. Palo Alto is also thriving due to its leading position in the burgeoning market for cloud security and greater demand from global clients racing to meet stricter EU requirements for the protection of consumer data. Splunk, whose software aggregates and analyzes machine data to provide realtime intelligence not only on security threats but also business operations and opportunities, is well positioned to support the explosion of data in the cloud. The company is looking to increase its share in a $60 billion data market that is growing volumes 30% per year with an offering that combines modern architecture and behavioral analytics. Increased volatility during the quarter also enabled us to establish a new position in Equinix. While classified as a REIT, Equinix broadens our exposure to the secular migration to the cloud. The company owns and operates interconnected data centers that provide network and cloud platforms for enterprise customers across a growing number of industries. It is well positioned to participate in what we view as the early stages of a buildout in hybrid cloud services. The company maintains a mix of retail customers that provide higher current growth opportunities, and wholesale customers (hyperscale cloud providers such as Facebook, Microsoft, Amazon and Alphabet) that offer long-term

3 exposure to public cloud growth. We believe Equinix has the global scale and reach to be a leader in the markets for interconnection and co-location services. Beyond idiosyncratic and secular growth themes, the economic backdrop remains strong and supportive of equities. The U.S. created a better than expected 313,000 jobs in February, the biggest hiring gain since July 2016, while job growth for the previous two months was revised higher. The employment rate remained at a post-recession low of 4.1%, unemployment claims hit their lowest level in 45 years while wage growth remained steady. GDP growth has also been robust, with fourth-quarter annualized growth revised upward to a higher than forecast 2.9%. Consumer confidence readings, meanwhile, remain high. This data reinforces our view that the U.S. consumer is in good shape and the next leg of growth needs to be driven by industrial activity. The latest readings on manufacturing have been encouraging, with the IHS Markit Manufacturing PMI increasing to 55.7 in March, the fastest expansion in three years. After initial skepticism over the trajectory of the economy under a new presidential administration, we are becoming more assured about the strength and duration of the current expansion. Capital spending driven by tax savings should be good for GDP growth while earnings growth, a key driver of stock price appreciation, is accelerating across the large cap market. Industrial activity and S&P 500 earnings tend to move in tandem and have both been trending upward since Health care was once again a detractor from results, with weakness in biotechnology spreading to other areas. We believe the sector a long-time source of growth for the portfolio is being weighed down by negative sentiment, causing investors to avoid health care in favor of areas with greater revenue and earnings visibility. While money flows are a concern, the regulatory backdrop for biotech and pharmaceutical companies is supportive as new leadership at the FDA has proven receptive to innovation when considering new drug approvals. Several of our biotech holdings are suffering from a lack of nearterm catalysts that could lift their stock prices. Biogen, for example, is in phase three clinical trials for a potential blockbuster treatment for Alzheimer s disease but announced during the quarter that it was making changes to its study that will delay results until early Shares sold off on the news, overlooking solid fundamentals. Biogen is also successfully ramping up Spinraza which treats the rare disease spinal muscular atrophy a condition which affects infants and early adolescents and is truly a disease modifying drug and has ample cash to deploy for stock buybacks and M&A. The company said recently that it is looking at bigger deals to boost its pipeline, targeting treatments already generating revenue or

4 ($) CLEARBRIDGE ALL CAP GROWTH STRATEGY close to commercialization. This gives us confidence in continuing to focus on similar companies in the mature stages of developing innovative treatments and we have added more of these stocks to our watch list of potential purchases. We are approaching the point where many of our large, platform-sized biotech companies are trading at zero pipeline value, which is a rarity. Crude oil prices rose 7.7% during the first quarter yet energy stocks also continued to lag the market. We believe this disconnect between company fundamentals and oil prices (Exhibit 1), which has been extended by tax-loss and short selling in the sector, will close over time, either through consolidation or a rotation back into the sector. Some E&P stocks are nearing valuations where it would be cheaper for the major oil companies to acquire them than drill on their own. In this environment, more companies are choosing to cut back production in favor of financial discipline. Exhibit 1: Correlation of Oil and Energy Stocks Breaking Down WTI Crude Oil (Left) As of March 20, Source: Strategas Outlook We are bullish on the U.S. equity market due to the fear and skepticism that remains prevalent despite stocks touching all-time highs. Markets rarely top out when investors are nervous and growth stocks have done very well without a lot of the euphoria we saw during the technology-led market of Fundamentals are solid with companies holding high levels of cash. Completed tax legislation will now allow companies to budget and spend that cash, which we believe will lead to increased capital spending and M&A. GDP growth is likely to continue its positive uptrend for the first half of the year and consumer spending will be an important component. While more optimistic on the economy than we were a year ago, we remain cognizant of the risks faced by the Trump administration in pushing forward with its remaining fiscal agenda. While interest rates remain historically low, and a tailwind to the market, valuations remain more mixed with certain sectors and

5 subsectors extended and others cheap versus historical standards. This sets up an environment where we believe investors will be better off focusing on individual companies and feel sector selection is at a premium rather than simply owning the market. Conditions are becoming conducive to a leadership change from the crowded areas of the market to those that are underappreciated. Potential catalysts for this change could be undervalued companies re-rating higher or increased M&A activity that monetized these mispriced assets. Portfolio Highlights For the first quarter, the ClearBridge All Cap Growth Strategy outperformed its Russell 3000 Growth Index benchmark. On an absolute basis, the Strategy had gains in four of the nine sectors in which it was invested for the first quarter (out of 11 sectors total). The main contributor to performance was the IT sector while the health care sector was the primary detractor. On a relative basis, overall stock selection contributed to performance for the quarter. In particular, stock selection in the IT sector had the greatest positive impact on results. Stock selection in the materials sector as well as underweights to the real estate and consumer staples sectors also helped. On the negative side, stock selection in the health care and consumer discretionary sectors and an overweight to energy detracted from relative returns. On an individual stock basis, Amazon.com, Seagate Technology, Red Hat, Twitter and Adobe Systems were the largest contributors to absolute returns. Meanwhile, Comcast, Biogen, Weatherford International, Dentsply Sirona and Celgene were the greatest detractors from returns. During the first quarter, we initiated positions in Equinix in the real estate sector, Caterpillar in the industrials sector and Praxair in the materials sector and closed positions in Bioverativ in the health care sector, Monsanto in the materials sector and Rockwell Collins in the industrials sector. Past performance is no guarantee of future results. Copyright 2018 ClearBridge Investments. All opinions and data included in this commentary are as of March 31, 2018 and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other investment professionals, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge nor its information providers are responsible for any damages or losses arising from any use of this information. Performance source: Internal. Benchmark source: Russell Investments. Frank Russell Company ( Russell ) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell s express written consent. Russell does not promote, sponsor or endorse the content of this communication.