PORTFOLIO MANAGER COMMENTARY

Second Quarter 2015

Market Commentary
Markets are constantly in a state of uncertainty and flux
and money is made by discounting the obvious and betting
on the unexpected.
George Soros
Im extremely fortunate to have the rewarding challenge of raising
two boys. From an early age we have played all kinds of games
Managing Director
to spend quality time together, and games have also served as a
Portfolio Manager
great medium to teach them lessons about life. In particular, we
have played a lot of poker together as an effective way to gain
appreciation of probability and the complex dynamics
Fortunately, as active of interactive games. If you ask either one of my boys
managers we have the luxury whose cards they are playing they will immediately
and the discipline not to buy answer: the other guys!
Sam Peters, CFA

What my boys do not yet realize, is that understanding

how people interact is something I must give a lot
of thought to as an investor. After all, one of the key
dynamics of markets, and in fact all of economics, is
the interaction of people (economic agents) as they
react to various incentives and to each others actions.
One of the great contributors to understanding this
interactive dance was John Nash, who helped develop game theory
and specifically the theory of non-cooperative games through his
Nash equilibrium. With the recent death of Dr. Nash, I was compelled
to review the core premise of game theory: end-game outcomes
are often extremely difficult to predict, and often not intended by
ANY of the player agents. I believe this vexing takeaway is one of the
reasons markets are typically impossible to predict. However, you can
derive some insight by studying how different investors actually make
decisions, and thus trying to understand the different games that
often drive markets in parallel.

most stocks, and we are still

finding exploitable pockets of
absolute value in financials,
legacy tech and in the broad
power generation sector.

To help crystallize competing decision-making frameworks, I will use

an example from Richard Thalers excellent new book on behavioral
economics, Misbehaving. In the book, Thaler provides many examples
of how economic theory says decisions should be made, and contrasts
them with how decisions are actually made in the messy real world.
In one example, two railroad tracks are laid down end to end, nailed
down at the end points and meet in the middle. Each track is one mile
long (5,280 feet) and expands to one mile plus one inch (5,280.08 feet)
when it gets hot. Assuming the tracks maintain their linear shape,
Thaler asks how high the expanded track is in the middle. The right
way to answer this question is to realize that the expanded tracks
form an isosceles triangle, where each half is a right triangle with a
base of 5,280 feet and a hypotenuse of approximately 5,280.08 feet.

MARKET COMMENTARY

You can then simply plug this into the Pythagorean

Theorem: a2 + b2 = c2 where you are solving for b. The
correct answer is almost 30 feet. The problem is that
most peoples answer is around two inches. Whats
a gap of almost 360 inches or an error of over 99%
among friends?

a probability-weighted expected value for a given

stock, explicitly detailing the scenario that the market
weights most highly and visualizing the magnitude of
our variant perception. In many ways, our subjective
probabilities reflect our knowledge of a given stock, but
they also help quantify our ignorance.

What this example, and several other fantastic examples

in the book, illustrates is that we often frame the
financial market as a well-ordered machine, where
people converge on some concrete truth as they assess
a set of objective probabilities. The reality is that people
rely heavily on intuition and a subjective set of rules
or heuristics when making decisions. This process is
further complicated by the interplay and feedback of
each decision on other competing decisions. This is why
markets are a complex adaptive system, and we reflect
this framing into our investment process. How so?

This probability framework also beautifully reflects

the time-driven dynamic of financial markets and
uncertainty: as events occur through time, different
scenarios get pruned away as the cone of uncertainty
ultimately narrows to a single outcome. A big part of
our job is to observe these events and stay ahead of
the updating process by continuing to ask the critical
question: are we right or is the market? This nearly
mathematical nature of markets is inherently humbling
if you are paying attention, as it highlights mistakes
and compels you to change your mind. Our process
forces us to pay attention, and we are constantly
learning and adjusting.

First of all, as fiduciaries and long-term valuation

investors, we are consistently trying to solve for
business value using a disciplined process: typically by
discounting the future free cash flows that we think a
business will generate over time. This gets to the heart
of our process, which is trying to find stocks where
price is well below business value, and we generate
returns from price-to-value convergence. In the spirit
of the example, we are trying to find opportunities
where other investors are pricing something at two
inches, while our business-value math suggests 30
feet is the right answer. In most cases, the market gets
pretty close to our illustrative 30 feet. In these cases, we
have no differentiated view and we naturally dont bet.
However, the market sometimes gets it wrong, at times
by a large margin, and we always stand ready to take
advantage of such opportunities.

These are the basic process rules and the probability

framework we utilize as long-term investors playing
a very serious game. Aside from knowing the
expectations of the other players in the market and
identifying which of those we are betting against,
another critical factor is to understand that the financial
markets have several games with different rules being
played in parallel. Each of these games has an impact
on price, which further influences decisions. Thus, it is
impossible for an investor to operate in isolation, and
it is typically a worthwhile advantage if an investor
understands the different decision-making frameworks
at play in competitive markets.

The key here is that doing simple valuation math is

critical, but it is not enough to ensure a long-term
opportunity. Ultimately, we are in the judgment
business, and given the zero-sum competitive nature of
stock picking, we must try and solidify what the person
on the other side of a given transaction is getting
wrong. Essentially, why are our expectations for a given
business different than what the market has priced into
the stock?

Probably the most dramatic and long-standing

divide is between active and passive investing.
Active investors, like us, pick individual stocks we
deem attractive, and create portfolios that are highly
differentiated from an index. Passive investors simply
try to mimic an index. Increasingly, and certainly during
this market cycle, the tide of capital has been shifting
to passive. The general argument is that stock picking
is futile, making it impossible to beat an index, and
now ETFs can provide passive exposure and the same
liquidity as stocks.

To provide some rigor to our judgment and to reflect

the inherent uncertainty of looking into the future, we
rely on subjective probabilities of what might happen
to a given business over several quarters and years.
Basically, we create a probability tree that assigns
different business values to a whole range of scenarios,
varying from the nightmare to the best-of-all dreams.
This range of potential outcomes allows us to calculate

Although we welcome the continued shift to passive,

as it means less competition for our active valuation
strategies, the increasing influence of passive money
on the price action of stocks affects both the timing of
the price-value convergence of our holdings, as well as
the path toward such convergence. Every investment
strategy has some Achilles heels and passive is certainly
no exception:

PORTFOLIO MANAGER COMMENTARY

Second Quarter 2015
Diversity Breakdown: The whole goal of passive
is to harvest the markets long-term return at a
low cost. With equity indexing you are technically
trying to capture an equity-risk-premium (ERP),
typically with a market coefficient or beta of one,
plus an underlying risk-free-rate. The key to this
approach is that you assume there are enough
active investors like us around to do the math and
price the underlying assets efficiently, or as close
to 30 feet in our Pythagorean example as possible.
Essentially, passive treats stocks like a commodity,
but a commodity that gets priced approximately
right as supply and demand for stocks gets sorted
out by a diverse set of players. The problem arises
when passive overwhelms active as holder of a given
stock, resulting in a nasty feedback loop where past
price moves determine future price moves. In these
situations, if price is going up passive managers must
buy more stock, which further increases the price.
Taken to extremes, this pricing diversity breakdown
can push a stock a long way from its fundamental
underpinnings. The most dramatic example was in
the 1999 tech and U.S. mega-cap stock bubble that
pushed equity valuations to absurd levels. Using the
historic ERP chart below, U.S. stocks got priced to a
2% ERP (Exhibit 1), and the best strategy was simply
to own anything but the index.

Herding and Liquidity Risk: Increasingly, passive is

getting exploited in an expensive active wrapper, in
the guise of dynamic asset allocation. The problem
is that much of this activity simply amplifies an
underlying bias of human nature to buy an asset
class that has performed well, with resulting high
realized returns but low expected returns, coupled
with a simple and sexy story. The explosion of
ETFs has encouraged this price-and-story activity,
resulting in lots of short-term activity that consumes
liquidity in often relatively illiquid underlying stocks.
The underlying price distortions are growing as the
industry grows, and we agree with many market
observers that we risk a future bear market in
liquidity that will severely test this new approach to
passive investing.
In fairness, much of the asset allocation industry
understands the pitfalls of the price-and-story
approach, and is indexing on return-drivers or smartbeta factors other than price, such as valuation and
quality. The problem is that these approaches are
designed to harvest factor-driven returns over very
long periods of time, and too often people are now
simply chasing factors on a short-term basis. This led to
a great crowding in quant strategies that broke down
dramatically in the fall of 2007. In just a few weeks, the
models turned upside down, and several years worth

Exhibit 1: Equity Risk Premium U.S. (Jan. 1960 June 2015)

Credit Crisis
Peak: 7.68% in
March 2009

8%

7%

Equity Risk Premium

6%

5%

4%

7.64% in
Sept. 2011

+1 Standard Deviation

5.74%
June 1, 2015

Average

-1 Standard Deviation

3%

2%

1%
1960

2.05% in
Dec. 1999
1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Source: Aswath Damodoran (http://pages.stern.nyu.edu/~adamodar/), ClearBridge Investments.

Equity Risk Premium: Excess return above the risk-free rate that compensates investors for taking on the relatively higher risk of investing in equities. Data calculates implied equity risk
premium by using free cash flow to equity (FCFE) for the S&P 500 Index. Treasury rate used is the constant-maturity U.S. 10 year bond including coupon and price appreciation.

MARKET COMMENTARY

of returns melted away in just a few short weeks. Again,

every strategy has its Achilles heel, and popularity and
illiquidity are typically the culprits, as you end up with
assets priced for all risk and no return.
The rising popularity of passive clearly does create
opportunity for us, as it is coupled with risk controls
on many active managers that dont allow them to buy
stocks that are going down or not sell stocks that are
going up. This one-sided and pro-cyclical behavior is
likely creating even bigger gaps between price-andvalue. However, this also makes the risk of our strategy
abundantly clear, which can be framed in a much
modified version of Newtons First Law of Motion: a
stock in motion will remain in motion until acted on
by an outside force. That outside force is typically a
valuation manager, but the crowd and emotion can
take a stock a long way from fair value, and you may
not have any capital left for the return trip to fair value.
This is why we enforce quantified humility through our
probability-driven process: we always leave room for
being wrong and accordingly never bet the portfolio on
a narrow set of outcomes.
Despite the diminishing influence of active, this cycle
has featured a dominant active stock picker in the guise
of the companies themselves. In many ways, companies

have acted as managers of single-stock portfolios and in

aggregate have aggressively bought back $1.7 trillion of
their own stock since 2009. As animal spirits have risen,
boards have become increasingly comfortable with
an uncertain future and have started to acquire other
companies. The financial engineering logic behind these
deals speaks for itself, given the ability to buy existing
cash flow streams with cheap debt, and remarkably
roughly 2/3 of buying companies are seeing their stocks
increase along with the selling companies. Nothing like
2 + 2 = 5 corporate alchemy can fan the flames of deal
activity, and we are not surprisingly seeing historically high
deal activity at historically high valuation levels (Exhibit 2).
Increasingly, deal activity is coming to dominate the
returns in U.S. stocks, especially against the backdrop
of flattish equity returns year-to-date. We have
benefitted directly from deal activity, both as owners
of acquiring companies that went up a lot, such as
NXP Semiconductors (NXPI) and Expedia (EXPE), but
also as owners of targeted companies Perrigo (PRGO)
and Broadcom (BRCM). In the case of the two targets,
the offer price was very close to our assessment of
business value, which suggests good valuation work on
our part and provided a welcome catalyst for priceand-value convergence.

Exhibit 2: U.S. M&A Volume and Median Total Value/EBITDA Valuation (H1 Data Only From 1996 2015)
$1,200

17x
16x
15x
14x

$800

13x
$600

12x
11x

$400

10x
9x

$200

8x
$0

7x
H1 2015

H1 2014

H1 2013

H1 2012

H1 2011

H1 2010

H1 2009

Median TV/EBITDA (Right Axis)

Source: Bloomberg Finance, L.P., ClearBridge Investments.

Data includes M&A deals involving private and public U.S. target companies with deal value above $50M.
Data set includes completed, pending and proposed M&A deals as of June 30, 2015.

H1 2008

H1 2007

H1 2006

H1 2005

H1 2004

H1 2003

H1 2002

H1 2001

H1 2000

H1 1999

H1 1998

H1 1997

H1 1996

Deal Volume (Left Axis)

Total Value (TV)/EBITDA

Deal Volume ($ Billions)

$1,000

PORTFOLIO MANAGER COMMENTARY

Second Quarter 2015
The challenge for long-term investors is that if stocks
got pushed to 2 inches during the great financial crisis,
deals are now pushing price towards fair value at 30
feet and beyond. Not surprisingly, at this point, we
find many U.S. stocks broadly uninteresting, and yet
we expect pro-cyclical deal activity to likely push price
well above business value for many stocks. Besides
this rising valuation risk, we also expect that many
deals will fail to meet current investor and boardroom
expectations, and some of the popular current roll-up
companies will inevitably blow up on poorly executed
integration and mismanaged complexity. As in all
market cycles, as the perception of future uncertainty
fades, valuation and risk rise, and our jobs as valuation
managers gets tougher.
Fortunately, as active managers we have the luxury
and the discipline not to buy most stocks, and we
are still finding exploitable pockets of absolute value
in financials, legacy tech and in the broad power
generation sector.
Our financial stocks have recently performed well as
interest rates have moved up, and indeed some of
our holdings are closing in on fair value. However, the
majority of our financial holdings are still just climbing
out of the valuation basement of the housing crisis,
persistently low interest rates and crushing regulatory
costs. As a result, our core financial holdings, including
Citigroup (C) and American International Group (AIG),
are currently enjoy improving fundamentals and
capital return profiles, which we think are still not fully
reflected in price.
The legacy tech names we own, such as Microsoft
(MSFT) and Cisco Systems (CSCO), continue to generate
massive free-cash-flow (FCF) streams, which are valued
at narrowing, but still substantial discounts from the
overall market. The valuation discount of legacy tech
reflects the ever-present risk of disruption, especially
from the accelerating and dramatic transition to the
cloud. Our goal is to find tech stocks that reflect the
disruption risk of cloud, but have durable cash flow
streams that will allow them to transition and in some
cases thrive in a cloud-based world.
The power generation, natural gas and coal sectors are
all in various states of recession to depression. Power
prices are depressed from weak demand, natural gas

remains over-supplied thanks to massive productivity

gains from shale drilling, and the coal industry needs
to cut supply by almost 40% to balance the market.
Supply and demand fundamentals will improve with
time, but we expect a rash of coal bankruptcies, further
gas supply cuts and the retirement of many coal-fired
power generation plants in the meantime. Fortunately,
the lack of any current fundamental tailwinds and the
time required to improve these fundamentals over
the next several quarters is allowing us to buy trough
fundamentals at trough valuation levels. In particular,
AES (AES) and Calpine (CPN) continue to generate very
strong free-cash-flow streams, are valued at doubledigit FCF yields, and will benefit from any improvements
in power pricing. In the even more depressed gas
and coal sector, CONSOL Energy (CNX) is one of the
few well-capitalized coal and natural gas companies,
with low-cost production assets in both segments.
Fortunately, CNX saw the writing on the wall for coal
during the China-induced coal boom of last decade,
and wisely diversified into gas. CNX is now proactively
separating its coal and gas assets, and we think we are
getting very cheap high-quality gas assets due to the
coal overhang.
Even with the continued convergence of price and
value in most U.S. stocks, our focus on absolute value
has allowed us to maintain attractive potential riskadjusted upside in the portfolio. We track this potential
on a daily basis, and the current potential return profile
of the portfolio is similar to levels achieved during
the deflationary-driven correction that occurred last
October. This upside potential is not at the homerun
levels we enjoyed a few years ago, but it is still
absolutely attractive, and extremely attractive relative to
most fixed-income alternatives.
In closing, we are in the judgment business, and
our job is to execute an investment process that
exploits expectation-driven gaps between price and
underlying business value. Our judgment of these
valuation opportunities is constantly evaluated by a
probability-driven framework, which reinforces humility
and constant learning. We could not execute this
process without the long-term culture of ClearBridge
that encourages investors to truly invest, and more
importantly, without the quality and long-term
orientation of our shareholders.

MARKET COMMENTARY

Year To Date
10%

Broad U.S. Market Indices

S&P 500 Index

Dow Jones Industrial Average
Nasdaq Composite Index

8%

Returns

6%
4%
2%
0%
-2%
-4%
January 2015

March 2015

Index Name

June

QTD

YTD

S&P 500 Index

-1.9%

0.3%

1.2%

Dow Industrials

-2.1%

-0.3%

0.0%

Nasdaq Composite Index

-1.6%

2.1%

6.0%

S&P 100 Index

-1.8%

1.3%

1.1%

Russell 1000 Index

-1.9%

0.1%

1.7%

S&P Mid-Cap 400 Index

-1.3%

-1.1%

4.2%

Russell 2000 Index

0.7%

0.4%

4.8%

Russell 1000 Growth Index

-1.8%

0.1%

4.0%

Russell 1000 Value Index

-2.0%

0.1%

-0.6%

July 2015

May 2015

S&P 500 Sector Indices

Broad Foreign Market Indices (USD)

Index Name

June

QTD

YTD

Index Name

June

QTD

YTD

S&P 500 Consumer Discretionary

0.6%

1.9%

6.8%

FTSE 100 Index (UK)

-3.6%

3.1%

2.4%

S&P 500 Consumer Staples

-1.8%

-1.7%

-0.8%

DAX Index (Germany)

-2.5%

-4.9%

2.4%

S&P 500 Energy

-3.4%

-1.9%

-4.7%

CAC 40 Index (France)

-2.2%

1.2%

6.0%

S&P 500 Financials

-0.3%

1.7%

-0.4%

MICEX Index (Russia)

-2.0%

8.2%

20.7%

S&P 500 Health Care

-0.3%

2.8%

9.6%

NIKKEI 225 (Japan)

0.1%

3.6%

14.4%

S&P 500 Industrials

-2.5%

-2.2%

-3.1%

Hang Seng Index (Hong Kong)

-3.0%

7.2%

13.7%

S&P 500 Information Technology

-4.3%

0.2%

0.8%

Kospi Index (South Korea)

-2.3%

0.8%

6.2%

S&P 500 Materials

-3.9%

-0.5%

0.5%

Shanghai SE Composite (China)

-7.0%

14.8%

33.1%

S&P 500 Telecomm Services

-2.3%

1.6%

3.2%

BSE Sensex 30 Index (India)

0.4%

-2.1%

1.2%

S&P 500 Utilities

-6.0%

-5.8%

-10.7%

Brazil Bovespa Index

3.0%

7.0%

-9.5%

Source: Bloomberg (through June 30, 2015).

Past performance is no guarantee of future results.
All returns are in U.S. dollars.

ClearBridge Investments
100 International Drive, Baltimore, MD 21202 | 800 691 6960
ClearBridge.com
Past performance is no guarantee of future results.
Copyright 2015 ClearBridge Investments.
All opinions and data included in this commentary are as
of June 30, 2015 and are subject to change. The opinions
and views expressed herein are of Sam Peters and may

differ from other managers, 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 Investments nor its
information providers are responsible for any damages or
losses arising from any use of this information.