- We believe active stock selection and sector allocation is critical to identifying attractively priced growth companies in the current environment.
- A renewed focus on fundamentals was recognized in the performance of our technology and health care companies.
- With commodity prices range bound, we continue to favor high-quality E&P stocks with low drilling costs and oilfield service providers.
Market Overview and Outlook
Equity markets maintained their positive momentum in the first quarter, led by a rotation into growth stocks. The S&P 500 Index gained 6.07%, the Russell 3000 Index advanced 5.74% while the Russell 2000 Index added 2.47%. The benchmark Russell 3000 Growth Index (+8.63%) outperformed its value counterpart by 564 basis points for the quarter.
Optimism surrounding President Trump’s pro-growth agenda and signs of strength in the economy helped extend the post-election rally. The economy expanded 2.1% in the fourth quarter, based on the final reading of GDP growth. Hiring remained solid as well, with an average of 236,500 new jobs created in each of the first two months of the year, while the unemployment rate edged down to 4.7%. Wages grew a robust 2.8% year-over-year in February and core inflation increased 1.8%, close to the Federal Reserve’s 2.0% target. These data supported the Fed’s decision to raise short-term interest rates 25 basis points in March. The central bank stuck with its plan for three rates increases in 2017 rather than adopting a more hawkish stance. Longer term, we believe higher interest rates could become a headwind for the broad market.
The extended bull run has lifted most major indexes to new highs, inflating valuations and growth expectations in some parts of the market and causing us to become more selective in assessing opportunities. Investor psychology has improved meaningfully since the sharp correction in early 2016 during which time we grew more constructive on the overall market. In the current environment, we believe active stock selection and sector allocation is critical to identifying attractively priced growth companies. Our long-term orientation as business owners continues to lead us to stocks across parts of the information technology, health care, media and energy sectors that feature better growth rates with lower debt levels and cheaper valuations than the broad market.
The portfolio’s cyclical technology holdings were a primary driver of performance during the quarter. Improving fundamentals and pricing power in memory, storage and software lifted shares of Seagate Technology, Western Digital and Citrix Systems, while the positive effects of a restructuring and a shift toward subscriptions boosted design software maker Autodesk. Communications chip maker Broadcom, the portfolio’s largest technology holding, also continued to be a strong contributor on the heels of better than expected quarterly results.
The removal of monetary accommodation has caused correlations among stocks to begin to recede, placing a greater emphasis on individual company characteristics. The portfolio’s health care holdings benefited from this renewed focus on fundamentals, with therapeutics companies Amgen, Vertex Pharmaceuticals and Allergan rebounding from depressed levels on solid operating results and positive clinical readouts. The failure of Trump and the Republican Congress to pass a replacement to the Affordable Care Act highlights the execution risks with attempting to handicap political outcomes that have been overlooked by many investors. We believe owning companies with healthy free cash flow generation and broadly diversified business models such as UnitedHealth Group and Comcast will become more important in this increasingly uncertain environment.
"Our long-term orientation continues to lead us to stocks that feature better growth with lower debt and cheaper valuations than the market."
Crude oil prices fell about 6% during the quarter driven by increases in crude inventories, dampening the near-term performance of certain energy stocks. Due to the competing forces of OPEC production cuts and increased U.S. drilling/production, we expect commodity prices will remain range bound in the near term. We continue to favor well-capitalized exploration & production companies with quality assets and low drilling costs as well as oilfield service providers with market leading positions that should soon benefit from better pricing power.
Consolidation is another catalyst that has enhanced long-term portfolio results and has the potential to drive performance going forward. Technology and health care companies hold some of the largest overseas cash positions and repatriation would allow them to tap that capital to finance growth through M&A. Parts of the sectors we favor, including media and health care, could benefit from the increased scale resulting from merger activity as well as government deregulation. Several of our portfolio companies have recently completed transactions that better position their businesses as acquisition targets.
Strong inflows into passive strategies have been another support to the current rally. We have picked up on the perception that some investors equate passive strategies with less risk. The risk of owning the largest stocks in an index is easily overlooked when the direction of stock prices is higher; however with pockets of overvaluation growing, and crowded trades building in certain areas of the market, we believe a less correlated, high active share approach is a good complement or alternative to passive. As long-term business owners, we seek to invest in companies with the defensible business models to weather changing market conditions and use volatility to either build or pare positions.
The Aggressive Growth Strategy outperformed its Russell 3000 Growth Index benchmark during the first quarter. On an absolute basis, the Strategy had gains in six of the eight sectors in which it was invested during the quarter (out of 11 sectors total). The primary contributors to performance were the information technology (IT) and health care sectors while the primary detractor was the energy sector.
In relative terms, overall stock selection contributed to performance but was partially offset by the negative impact of sector allocation. In particular, stock selection in the energy, IT and consumer discretionary sectors and a lack of exposure to the consumer staples sector drove relative returns. On the negative side, an overweight to the energy sector and an underweight to the IT sector detracted the most from relative performance.
On an individual stock basis, the largest contributors to absolute returns during the first quarter included Broadcom and Seagate Technology in the IT sector as well as Amgen, Vertex Pharmaceuticals and Allergan in the health care sector. The greatest detractors from absolute returns included positions in Anadarko Petroleum, Newfield Exploration and Core Laboratories in the energy sector, Ionis Pharmaceuticals in the health care sector and Twitter in the IT sector.
During the first quarter, we received shares of Bioverativ in the health care sector following its spinoff from portfolio holding Biogen and shares of LogMeIn in the IT sector following its merger with GoTo Meeting, a spinoff from portfolio holding Citrix Systems.