Bottom-up research dominant for Clearbridge, prefers classic valuation metrics

Interview with Peter Bourbeau, portfolio manager Legg Mason Clearbridge Large Cap Growoth Fund

Peter Bourbeau

What is your view on the relationship between bottom-up and bottom down approaches, as markets become more international?

As a manager of large cap growth companies, we own many multinational businesses that generate a meaningful percentage of revenue outside the United States. We always start our process of stock selection by evaluating the bottom-up fundamentals of companies to ensure they have proven business models, leading market share, healthy balance sheets and the ability to grow earnings and revenues at or above the market. Part of our analysis will also entail looking at their global exposure and how macroeconomic trends like trade and FX could affect their businesses. Our companies operate in an environment where demand becomes more global every day so it’s critical to consider both bottom-up and top-down effects when building portfolios.

Do you have a preference for certain sectors?

Sector allocation is a byproduct of our individual stock selection process. We are currently overweight the health care sector as we believe large managed care companies like UnitedHealth Group and biotechnology companies developing innovative treatments for unmet or underserved needs like Biogen and BioMarin Pharmaceutical have attractive long-term growth profiles. We also favor technology as the return on investment from spending on software from companies like Adobe Systems and Microsoft is higher than most other uses of corporate cash and that migration to the cloud will led to step change in the growth of key players like Alphabet and Amazon.com. The latter two are now in the communication services and consumer discretionary sectors but are leveraging technologies like artificial intelligence to gain market share.

Which valuation variables do you prefer?

Our valuation work and metrics really depend on the sector that we are analyzing. That said, since we are big believers that free cash flow directionally determines stock prices over time, we use enterprise value-to-free cash flow ratios as a valuation metric across sectors.

How do you try to minimize the risk of your portfolio?

Diversification across three types of growth companies, what we call stable, select and cyclical, positions us to manage risk and generate consistent results regardless of market conditions. We seek to weather volatility with a bucket of steady compounders that we call our stable growers. We also own turnaround growth stories in the cyclical bucket whose performance is more tied to individual execution than market trends and we tend to purchase at valuations that provide more of a margin of safety. Over the last 12 to 18 months, we have been trimming exposure from our higher beta select growth names and re-investing into lower beta stable names to prepare for this volatility.

What are your tips for 2019?

We are in the later stages of the economic cycle but that doesn’t mean parts of the stock markets can’t march higher. We think technology stocks, for instance, look attractive after the selling we’ve seen late in the year. And we expect volatility to continue and think investors will be well served by staying diversified.

How many names do you normally hold in your portfolio?

We are high active share managers and limit our portfolios to 40 to 50 stocks in which we have the highest conviction. This focus allows our best ideas to generate the majority of performance.

How do you cover (hedge?) valuation risks?

As explained above, our three-growth bucket approach and being active in trimming winners and adding to underperformers at attractive entry points helps us lessen our valuation risk. We also maintain a watch list of companies where we have done the research and are interested in owning but will wait for the right price to initiate a position. We initiated a position in Chinese e-commerce company Alibaba, for instance, after Chinese technology stocks had sold off sharply.

Do you agree: benchmark thinking has become more important than absolute return?

While we acknowledge that passive investing has become very popular, the economic conditions since the global financial have been very conducive to stocks: ample liquidity, low interest rates and accommodative monetary and fiscal policies. It’s been a tide that has lifted all boats, both the high-quality growth companies we favor as well as low quality companies. But as volatility has normalized this year, you are beginning to see the benefits of an active management approach that seeks to generate strong absolute returns in all conditions rather than simply beating the benchmark.