Value Equity 3Q 2024

Markets Review

Given the ongoing progress toward target inflation and a softening labor market, the Federal Reserve lowered the target range of the federal funds rate by 50 basis points to 4.75% to 5.00%. Fed Chair Powell acknowledged that loosening policy restraint too quickly could undo progress on inflation, whereas moving too slowly could undermine economic activity and weaken employment. Therefore, Powell stressed the importance of monitoring economic data before making further adjustments to monetary policy.

Corporate earnings remained strong, with S&P 500 companies reporting earnings growth of 11.3%, the highest year-over-year improvement since 2021. Furthermore, only 67 S&P 500 companies issued negative EPS guidance, and about 80% exceeded estimates. Reflecting the general trend of disinflation and a resilient domestic economy, fewer companies mentioned topics like “inflation” and “recession” during earnings calls.

In political news, President Biden announced he would not seek re-election. Vice President Kamala Harris was subsequently named the official Democratic presidential nominee for the 2024 election. In geopolitics, tensions in the Middle East escalated as clashes between Israeli forces and Hezbollah fighters intensified. In response, the U.S. announced the urgent deployment of additional troops to the region in case of a wider regional conflict, while simultaneously mediating a potential ceasefire between the groups.

Performance and Attribution Summary

For the third quarter of 2024, Aristotle Capital’s Value Equity Composite posted a total return of 6.47% gross of fees (6.39% net of fees), underperforming the 9.43% return of the Russell 1000 Value Index and outperforming the 5.89% return of the S&P 500 Index. Please refer to the table for detailed performance.

Performance (%)	3Q24	YTD	1 Year	3 Years	5 Years	10 Years
Value Equity Composite (gross)	6.47	12.82	29.10	7.82	12.90	12.37
Value Equity Composite (net)	6.39	12.59	28.75	7.55	12.61	12.03
Russell 1000 Value Index	9.43	16.68	27.76	9.03	10.69	9.23
S&P 500 Index	5.89	22.08	36.35	11.91	15.98	13.38

Microchip Technology, the microcontroller (MCU) and analog semiconductor producer, was a primary detractor for the period. The company reported results in line with guidance, but its short-term outlook remains challenged. Between 2021-2023, amid a global chip shortage, Microchip implemented a preferred supply program to meet the large demands of its clients, who overestimated their needs and are now working through their inventory levels. While management has started to see some positive signs pointing toward a recovery (e.g., higher expedited orders and fewer order cancelations), it is taking longer than anticipated. Longer term, Microchip has been able to generate 15+ years of robust FREE cash flow and margins, while lowering its debt and consistently returning money to shareholders. This, we believe, speaks to the company’s proven ability to manage the business through economic cycles, while taking advantage of its broad portfolio to continue gaining share in areas including IoT, 5G infrastructure, autonomous driving and data centers.

Blackstone, one of the world’s largest alternative asset managers, was a leading contributor for the period. Blackstone reported nearly $40 billion in inflows and deployed $34 billion during the quarter, its highest investment activity in two years. With over $180 billion in dry powder, the company possesses significant purchasing power to invest in attractive opportunities such as its recent $24 billion acquisition of data center platform AirTrunk, its largest investment in the Asia/Pacific region. Moreover, Blackstone continues to make progress in penetrating the retail and private wealth channels, as the company raised $7.5 billion overall during the quarter, with assets raised in perpetual vehicles over the first half of 2024 eclipsing full-year totals in 2023. BCRED (a private credit vehicle), BREIT (a private real estate vehicle) and the newly launched BXPE (a private equity vehicle) have all seen encouraging signs with new inflows. Despite BREIT’s challenges last year, all redemption requests since February have been fulfilled at 100%, and requests in June were down 85% from the peak of 2023. As the overall industry fundamentals improve, we believe Blackstone’s first-mover and distribution advantages in its retail initiatives and its overall reputation as a best-in-class operator will continue to create shareholder value.

Recent Portfolio Activity

During the quarter, we sold our position in Autodesk and invested in American International Group and Verizon Communications.

We first invested in Autodesk—the global industry standard for computer‐aided design in the architecture, engineering and construction industry (AEC)—during the second quarter of 2022. During our holding period, the company remained at the cutting edge of enabling improvement through innovation and promoting the use of open standards, or open building information modeling (BIM). The company also improved its profitability, supported by further adoption of its cloud offerings. We continue to believe the company is uniquely positioned to benefit, as the AEC industry has increasingly sought to resolve the inefficiencies that arise when many parties are needed to complete a building project. However, we decided Autodesk was the best candidate for sale to fund what we believe to be a more optimal investment in Verizon Communications.

Verizon Communications Inc.

Headquartered in New York, Verizon is one of the largest telecommunications companies in the U.S. The company was formed in 2000 with the combination of Bell Atlantic Corp. and GTE Corp., businesses with roots dating back to the late 19^th century and the beginning of the telephone business.

Over the years, Verizon has expanded through strategic acquisitions and innovations, particularly in wireless technology, which has become the cornerstone of its business. Unlike its competitor AT&T’s strategy of vertical integration through the acquisition of media and entertainment companies, which AT&T is now unwinding, Verizon has instead focused on expanding its fiber networks in major cities and acquiring wireless spectrum to increase network capacity and performance. Today, Verizon’s wireless services account for approximately 70% of its revenue (serving over 90 million postpaid and 20 million prepaid phone customers), making it the country’s largest wireless carrier. Verizon also offers fixed-line operations with local networks in the Northeastern U.S., serving over 30 million homes and businesses and nine million broadband customers. In early September, Verizon announced the $20 billion all-cash acquisition of Frontier, the largest pure-play fiber internet provider in the U.S. Upon closing (expected within 18 months), Verizon’s fiber network will expand to 31 states.

High-Quality Business

Some of the quality characteristics we have identified for Verizon include:

• Strong brand reputation for network reliability and speed, along with the broadest wireless coverage in the industry, supports premium pricing and customer loyalty in the form of low churn;
• Leading market share in wireless and economies of scale allow Verizon to generate high margins and returns on invested capital; and
• Verizon’s position at the forefront of 5G technology, combined with its spectrum licenses and the capital-intensive nature of building and maintaining network infrastructure, creates high barriers to entry.

Attractive Valutaion

Based on our estimates of normalized earnings, we believe Verizon’s current stock price is offered at a discount to the company’s intrinsic value. More specifically, we believe the company is trading at a CFRoEV greater than 10%, which translates to an attractive discount to intrinsic value.

Compelling Catalysts

Catalysts we have identified for Verizon, which we believe will cause its stock price to appreciate over our three- to five-year investment horizon, include:

• Higher FREE cash flow generation as prior large investments (e.g., 5G rollout and spectrum purchases) season, resulting in lower capital intensity;
• Enhanced revenue as more consumers upgrade to 5G-enabled devices, which should lead to increased data usage, higher-value service plans and an expanded customer base;
• Market share gains in broadband internet service as customers switch from traditional cable companies; and
• Increased connections per account and higher ARPU by way of Verizon’s ability to bundle services (like wireless, home internet and media content), which encourages adding more devices and drives higher overall spending.

American International Group, Inc.

Established in 1919 and headquartered in New York, American International Group (AIG) is one of the largest global insurance companies. AIG provides a comprehensive range of property and casualty (P&C) insurance to businesses and individuals in over 190 countries and jurisdictions around the world. The company also has a ~48% stake in Corebridge Financial (Corebridge), AIG’s old Life & Retirement segment.

AIG’s government bailout following the 2008 global financial crisis left the company on a 10+ year journey to transform its business (including five CEOs) by streamlining operations and attempting to improve its image with the public and investor community. Since taking over the General Insurance business in 2017 and assuming the role of CEO in 2021, Peter Zaffino has restructured underwriting and increased levels of reinsurance to reduce risk and control volatility, implemented a new structure for its High Net Worth business, divested non-core divisions such as crop risk and personal travel, and separated its Life & Retirement segment into the independently publicly traded company Corebridge. Following these actions, AIG will be a purely General Insurance focused business, with roughly 75% of its premiums tied to commercial and 25% to personal policies. We believe with Mr. Zaffino’s emphasis on risk-adjusted returns, AIG has become a stronger, more focused organization.

High-Quality Business

Some of the quality characteristics we have identified for AIG include:

• Robust brand, market position and client relationships give it scale, with over $160 billion in assets and over $25 billion in net written premiums[1];
• Well diversified across product lines, sectors and geographies; and
• Innovative management team led by Chairman and CEO Peter Zaffino, whose focus has shifted from remediation (e.g., enhancing the underwriting culture and improving the financial profile) to preparing the company for future growth.

Attractive Valuation

We believe AIG is poised to improve underwriting, reduce expenses and return greater capital to shareholders, resulting in higher normalized earnings that correspond to a CFRoEV of around 8%. Moreover, AIG is one of the uncommon (for Aristotle Capital) investments where the discount to intrinsic value we see is due to both improved earnings and multiple expansion.

Compelling Catalysts

Catalysts we have identified for AIG, which we believe will cause its stock price to appreciate over our three- to five-year investment horizon, include:

• Completion of Peter Zaffino’s business transformation (i.e., focus on General Insurance following divestitures, including the complete exit of Corebridge; improving underwriting culture; and disciplined capital management) should result in higher normalized earnings, cash flow and return on equity;
• Further expense management through operational initiatives (e.g., AIG Next) and tighter underwriting;
• Continued transformation of the firm’s High Net Worth business, utilizing a managing general agent model, should result in higher volumes and more efficiencies; and
• Enhanced financial flexibility following a reduction in leverage as well as excess capital, which we believe will continue to allow for greater returns of capital to shareholders (e.g., the ongoing $10 billion share repurchase program and consecutive years of 10% dividend growth).

Conclusion

With the evolving global macroeconomic landscape, increasing geopolitical tensions and the approaching U.S. elections, there are plenty of headlines to follow. At Aristotle Capital, our priority is determining whether these events provide valuable insights for long-term investors. Instead of repositioning our portfolios based on predictions of how the market may or may not respond to such events, we focus on identifying and owning companies that, we believe, can succeed in the face of global uncertainty. It is our belief and experience that well-managed, high-quality companies will take appropriate actions to respond to the ever-changing world.

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[1] These figures are estimated based on the run rate as of June 30^th after the deconsolidation of AIG’s Life & Retirement segment.