Sustainability Leaders Strategy

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1 Sustainability Leaders Strategy Derek Deutsch, CFA Managing Director, Portfolio Manager Key Takeaways ffactively favoring renewable energy over carbon-based fuel sources was a positive contributor to performance. ffour integrated approach to ESG research leads our sector analysts to engage with companies on topics most relevant to their industry, such as data privacy in technology. fffor companies that rely on raw materials and/or labor from less regulated markets, the treatment of workers in the supply chain is an increasingly important issue. Mary Jane McQuillen Managing Director, Portfolio Manager Market Overview and Outlook U.S. stock markets continued to make all-time highs in the second quarter, with the Russell 3000 Index advancing 3.02% for the quarter and 8.93% for the first half of the year. Growth stocks maintained market leadership, with the Russell 3000 Growth Index stretching its performance advantage to more than nine percentage points year-to-date. Equities were propelled higher by a combination of solid earnings growth, a steady economy and a benign interest rate environment. Stocks in the S&P 500 Index turned in their best earnings growth in four years. Continued health in the economy was also supportive as first quarter GDP growth was revised higher for the second time to a final reading of 1.4% while hiring picked up in June with 222,000 new jobs created. The unemployment rate finished the quarter near a decade low at 4.4%, indicating the economy is nearing full employment. Consumer spending rose a solid 2.8% in June while manufacturing activity and loan growth were also robust. Companies ability to push for improvements through their purchasing power could reform many industries and protect workers across multiple sectors. These solid improvements led the Federal Reserve to raise shortterm interest rates 25 basis points in June and disclose plans to start paring down its balance sheet of government bonds. Financial stocks received a boost from the rise in rates as well as positive results from the Fed s latest stress tests (CCAR) in which every bank passed for the first time since the financial crisis. Following the positive results, many banks announced ambitious plans to return capital to shareholders through buybacks and dividend increases. The health care sector was the best performer in the benchmark, with a gain of 4.55%. Drug makers, hospitals and insurers were lifted by the introduction of a Senate plan to replace the Affordable Care Act that is viewed as more moderate than the proposed House legislation. UnitedHealth Group was the biggest beneficiary in the portfolio as the managed care provider has a diversified enough business that any health care reform should have limited impact.

2 CLEARBRIDGE SUSTAINABILITY LEADERS STRATEGY Addressing climate change is one of the primary environmental challenges our society faces. We seek to help investors limit carbon emissions by investing in companies developing clean energy sources such as Brookfield Renewable Partners rather than companies engaged in the production of fossil fuels. Brookfield generates power from hydroelectric resources in the United States, Canada and Brazil. The company recently initiated an engagement with ClearBridge to help them conduct an assessment of sustainability issues most relevant to their business including climate change, environmental regulations and water scarcity. The portfolio s lack of exposure to carbon-based energy sources was a meaningful contributor to results during the quarter as the energy sector was the worst performer in the benchmark due to a 9% decline in crude oil prices. Promoting healthy lifestyles through the production of natural and organic foods free from pesticides and other chemicals is another important way we can have a positive influence from both a social and environmental standpoint. Whole Foods Market, the U.S. grocery chain offering the largest selection of natural and organic foods, was the portfolio s leading performer following a $13.7 billion takeover offer from Amazon.com. We believe the deal validates the demand for healthier foods, and through Amazon s vast distribution infrastructure, could increase the online delivery of such products. Companies across different sectors of the economy have different challenges and priorities with regard to environmental, social and governance practices. Unlike other investment managers that may have an ESG team that follows these issues across the broad marketplace, ClearBridge sector analysts integrate ESG considerations into their fundamental research. This specialization enables each analyst to engage with portfolio companies on issues most relevant to their business. Information technology is a good example. Over the last year, our technology analysts have been engaging with companies on the topic of data privacy and data security. These are important business issues as a breach of customer trust can lower usage of a company s internet platform or online products, resulting in reduced revenues. ClearBridge has had a long-running dialogue with Microsoft on a number of ESG issues and in 2016, we spoke with the company s Director of Corporate Citizenship specifically about data privacy and security. Data security has been a barrier to adoption of cloud services for many organizations, so Microsoft s reputation as a trusted partner is essential to the success of its cloud and Azure businesses. Microsoft has 2 significantly enhanced its own security, both within its own products and its cloud offerings, to the point that it now gets plaudits from industry experts for offering among the most secure products in the industry. The company has laid out key privacy principles that form the foundation of its approach to privacy. It was also the first company to adhere to the international standard for privacy protections for the processing of personal information by cloud service providers. A key priority for Microsoft is giving its customers control over their own data, allowing them to manage their own privacy settings. Microsoft is also instrumental in helping its customers understand and adhere to the increasing number of privacy laws globally, and to anticipate changing requirements in advance. During the second quarter, we established a position in Jones Lang LaSalle, a global real estate broker, leasing agent, investor, real estate fund manager and facilities manager. The company s leadership position in commercial real estate and its long-term service contracts provide predictable revenue streams. The company has a best in class ESG record in its industry, has terrific financial and accounting disclosure and a well-established governance disclosure 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. We expect individual stock selection, driven by our process of integrating ESG factors into fundamental company research, will be the primary determinant of our relative returns going forward. At the same time, our portfolio management team and supporting sector and portfolio analysts will carefully monitor external factors such as public policy developments and Federal Reserve actions that could impact the performance of the stocks where we are share owners. We remain committed to investing in high-quality companies that are well positioned to perform and make a positive societal impact. Portfolio Highlights The ClearBridge Sustainability Leaders Strategy outperformed its Russell 3000 Index benchmark during the second quarter. On an absolute basis, the Fund had gains in eight of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the information technology (IT), financials and consumer staples sectors. On a relative basis, sector allocation decisions contributed to performance but were partially offset by

3 stock selection. An underweight position in the energy sector was the leading contributor to relative returns (no holdings in the energy sector). Stock selection in the consumer staples and real estate sectors and a lack of exposure in telecommunication services (no holdings) further contributed to returns. On the negative side, stock selection in the health care, consumer discretionary and industrials sectors detracted the most from relative performance. On an individual stock basis, Whole Foods Market, UnitedHealth Group, Autodesk, Alphabet and BlackRock were the largest contributors to absolute performance in the second quarter. The biggest detractors from absolute returns included positions in W.W. Grainger, Lowe s, MEDNAX, Discover Financial Services and Walt Disney. During the second quarter, we initiated a new position in Jones Lang LaSalle in the real estate sector and closed positions in W.W. Grainger in the industrials sector and CVS Health in the consumer staples sector. The pricing environment for industrial distribution and retail has been increasingly competitive, and as a result, Grainger has had a difficult time supporting gross margin, coupled with the uncertainty around the new management s ability to execute on proposed initiatives to offset pricing pressure with volume. While CVS has one of the best management teams in the health care sector and has been a leader in ESG practices, the company s growth has been challenged due to the slowdown in generics. In addition, the competitive benefits from its unique business model have been greatly reduced. ESG Highlights This quarter we examine the challenges our portfolio companies face in promoting fair pay and safe workplace conditions in a period of heightened attention on immigration, migrant workers and in some cases, refugees. Our engagements and analysis of these social practices extends well beyond the home offices of the companies we own. For companies that contract with many suppliers, the integrity of the supply chain is an important component in building and maintaining sustainable business models. For parts of the retail and information technology industries that rely on raw materials and/or labor from less regulated markets, the treatment of workers at the bottom of the supply chain is an increasingly important issue. Migrant workers are a significant and growing component of the global workforce, with more than 200 million migrants around the world. Mexican immigration to the U.S. is currently the largest corridor of migration globally. Migrants, also known as contract workers in some industries, are employed primarily in the food/agriculture, textile and electronics industries and are often not offered or eligible for basic workplace rights such as a minimum wage or a guarantee of safe working conditions. In some countries with less developed labor laws that supply raw materials or goods to multinational companies, workers can endure forced or slave labor. Meanwhile, civil wars in Syria and parts of Africa have led to an exodus of refugees to countries where local employers often take advantage of their undocumented status in exposing them to substandard working conditions. In agriculture, migrant workers in California harvest the bulk of U.S. produce that is purchased by portfolio companies such as Whole Foods Market and Costco. Through our engagements, we have discussed how both of these companies have proactively implemented policies related to ethical recruitment and auditing of their supply chains to promote fair treatment of migrants. These efforts are intended to curb unlawful recruiting practices along the Mexican border and the use of child labor among illegal or undocumented immigrants. For example, The Coalition of Immokalee works with Whole Foods Market, Costco as well as Wal-Mart, McDonalds and Burger King to improve pay and conditions of their 30,000 tomato growers in Florida. Farms that supply onions to Costco and other fresh producers are getting certified by the Equitable Food Initiative, which provides substantial training on food safety, coupled with higher pay to motivate workers and reduce turnover. Despite efforts to improve these areas, low wages remain a challenge for migrant workers. While wages for farm workers have been going up, average wages for non-supervisory employees are about $11 per hour, well below the living wage which is estimated at $15.84 per hour, 1 and below the Federal poverty line. Companies Increasing Scrutiny of Global Supply Chains Other consumer companies are also aware of the social risks in their supply chains and have implemented policies and requirements to promote fair working conditions and protect worker s rights. Coca-Cola, for example, was one of the first companies to establish an ethical recruitment policy. Coke s policy requires that workers do not pay recruitment fees; employment contracts must be in a language that employees can easily understand and be provided prior to their arrival in the host country and workers have access to personal identity documents. These policies are intended to counteract practices where employment agencies force immigrant workers to pay exorbitant fees to secure work, fees that often become a form of servitude until 3

4 CLEARBRIDGE SUSTAINABILITY LEADERS STRATEGY they are paid off, or refuse to surrender documents necessary for workers to find employment elsewhere. Thailand is another country where Western companies are taking action to monitor and curb not only labor abuses but also environmental issues. Forced migrant labor has been uncovered in the Thai seafood industry as Thailand attracts migrant workers from surrounding countries such as Myanmar and Cambodia that suffer from economic and demographic inequality. Illegal and unregulated fishing operations in the region have been cited for human trafficking, forced labor and child labor as well as the depletion of fish stocks from overfishing, according to the Seafood Task Force. The task force, a group formed and led by global corporations, aims to identify and remedy labor and environmental abuses by closely monitoring seafood supply chains. Our consumer discretionary analyst engaged Costco on how the company played a lead role in development of the task force, while Nestle recently announced an action plan to address labor and human rights abuses in the seafood supply chain. From what we understand, Nestle is the first company to release a report that discloses findings from an investigation into its own supply chain, lays out a comprehensive set of actions, and commits to annual reporting on progress. Among the highlights of its plan, Nestle is creating training programs and awareness campaigns of recruitment and labor practices for fishing boat owners and captains and funding an emergency response team to provide assistance to migrant workers. Turkey, a key supplier to several apparel makers owned across ClearBridge portfolios, has come under recent scrutiny over employment and treatment of Syrian refugees in the garment industry. Our International Growth team has discussed the issue in meetings with Inditex, the Spanish retailer known for its Zara brand, and ASOS, a UK-based online fashion retailer that primarily sells to the under 30 population. Estimates by the Business and Human Rights Resource Centre have 250,000 to 400,000 refugees working without legal documentation in Turkey. ASOS told us that they discovered undocumented Syrian adults working in suppliers factories, but rather than firing these workers, the company recognized the need for them to work and wanted to provide them with a safe working environment and proper wages. The company also found that a subcontractor breached its terms of trade by employing three Syrian adolescents. ASOS chose to place the adolescents back into Turkish school and are paying the family the equivalent of national living wage. The company told us it will collaborate with the other big players that use Turkish suppliers to curb abuses, relying on the power of the purchase order to pressure suppliers to change their behavior. 4 Inditex is also working with industrial and other nongovernment organizations to ensure that refugees are not exploited and to crack down on the use of child labor. Inditex has 100 people on the ground in Turkey and systems in place to approve and monitor subcontractors. The company s policy is to remedy workplace issues rather than exit a supplier relationship. While the refugee issue in Turkey is complex and nuanced, we are encouraged by the company s proactive approach and adherence to high standards for outsourced labor. The information technology sector relies on raw materials extracted and components produced by contract workers in many countries with less developed labor laws and has taken action to address shortcomings. A U.S.-government-funded study in 2015 found that one in three migrant workers in Malaysia s electronics industry was working in conditions of forced labor. Seagate Technology is a leading proponent of workers rights that directly pays recruitment fees, prohibits the retention of worker documents and does not use contract workers obtained via labor agents. Intel and Apple were also among the first technology companies to implement ethical recruitment policies to specifically address recruitment fees, written contracts and document retention. In its 2017 Supplier Responsibility Report, Apple disclosed that it reimbursed $2.6 million to over 1,000 workers in 2016 to cover recruitment fees paid to employment agencies. Apple has recently raised its requirements for suppliers to pay recruitment fees directly to employment agencies, which help workers avoid falling into debt to such agencies. Intel, meanwhile, requires suppliers to reimburse employees that are found to have been charged more than one month s wages in fees. Apple, Intel and Seagate are members of the Electronic Industry Citizenship Coalition (EICC), a group of over 100 companies formed in 2004 to protect the rights of workers in the global electronics supply chain. The EICC maintains and regularly updates a code of conduct for the treatment of workers and also addresses such issues as forced labor, working hours and conflict minerals, the mining of metals such as gold and tungsten in areas of armed conflict. U.S. securities law requires that companies seek to certify their minerals are not supplied by mines controlled by armed militias. Earlier this year, Apple temporarily stopped buying cobalt from mines in the Congo that use child labor. Cobalt is a key component of the lithium-ion batteries that power its devices. Apple realizes the importance of mining income to Congolese workers and is working on a program to identify and work with cobalt mines that meet their labor standards. 2

5 ClearBridge has been working with portfolio companies on workplace conditions for many years, initially with the apparel manufacturing industry. Supply chain labor practices were a key engagement theme for ClearBridge in 2015, while earlier this year, we hosted a workshop on business and human rights with Ceres, an organization of investors and companies that addresses sustainability issues. The workshop, which was attended by a dozen of the largest public companies in the U.S., focused on building capacity to monitor and enforce worker s rights, sharing best practices and developing new approaches to implement the UN Guiding Principles on Business and Human Rights. Participants also discussed the importance of having a human rights policy which sets the tone at the top of the company and signals intent to work on the issue education programs on human rights issues as well as supplier training. While the risks around exploitation and abuse of workers in the global supply chain will not be resolved in the immediate future, we believe that the corporate sector, with support from investors focused on sustainable business practices, wields significant influence. The ability of companies to push for improvements through their purchasing power and supplier standards exist at a scale that could reform many industries and protect workers across multiple sectors. ClearBridge is committed to continuing to engage our portfolio companies on this critical labor component on behalf of our clients and as long-term shareowners. By advocating for the protection and fair treatment of workers in its supply chains, companies have the potential to improve performance by lowering reputational and legal risks related to labor conditions. 1 Living Wage Calculator, 2 Washington Post, Apple cracks down further on cobalt supplier in Congo as child labor persists. March 3, ClearBridge Investments 620 Eighth Avenue, New York, NY ClearBridge.com Past performance is no guarantee of future results. Copyright 2017 ClearBridge Investments. All opinions and data included in this commentary are as of June 30, 2017 and are subject to change. The opinions and views expressed herein are of the portfolio management team named above 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 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. 5