Commentary

Key Takeaways

• 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, health care and consumer companies.
• Despite recent weakness, we are encouraged by positive catalysts underpinning our health care and energy holdings.

Market Overview and Outlook

Equity markets maintained their linear rise in the first quarter, led by a rotation into higher beta growth stocks. The S&P 500 Index gained 6.07%, the Russell 3000 Index advanced 5.74% while the Russell Midcap Index added 5.15%. 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 solid economic numbers helped extend the post-election rally. The economy expanded 2.1% in the fourth quarter, based on the final reading of GDP growth. Hiring cooled in March with just 98,000 jobs created while February’s payroll total was revised downward by 19,000 jobs to 219,000. The unemployment rate edged down to a post financial crisis low of 4.5% even as more individuals entered the labor force looking for work. Wages grew 2.7% year-over-year in March 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 two additional rate increases in 2017 rather than adopting a more hawkish stance.

The extended rally 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. The acceleration of equity returns since the election is discounting a much more rapid pace of economic growth that has yet to materialize. Deep cyclical stocks most directly tied to GDP growth and U.S.-focused companies poised to see a bigger benefit from corporate tax reform than multinationals have done exceedingly well post-election.

"We believe a less correlated, high active share approach is a good complement or alternative to passive."

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, consumer discretionary and energy sectors that feature better growth rates with lower debt levels and cheaper valuations than the broad market.

The portfolio’s consumer discretionary and cyclical technology holdings were primary drivers of performance during the quarter. Continued solid execution in its retail e-commerce and enterprise cloud services businesses drove strong results for Amazon.com while Comcast was boosted by increasing subscriber growth and its NBCUniversal properties. Meanwhile, improving fundamentals and pricing power in memory, storage and software lifted shares of Western Digital and Seagate Technology. Communications chip maker Broadcom 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 rebounding from depressed levels on solid operating results and positive clinical readouts. Pricing pressure has held back these stocks for more than a year, but we believe our targeting of companies making scientific breakthroughs to serve unmet needs and offering innovative therapies for cancer and other conditions will ultimately be rewarded. Vertex Pharmaceuticals reported strong clinical results for a combination cystic fibrosis treatment while Biogen and Regeneron Pharmaceuticals recently won approval for treatments with multi-billion dollar potential. In addition, we are optimistic that changes at the FDA under the new administration will allow new compounds to get to market faster.   

Energy is another area experiencing near-term weakness, but where we see positive catalysts. The increase in U.S. shale production has created inflationary pressures in raw materials and drilling equipment, which should lead to margin expansion for oilfield services companies like Schlumberger and Weatherford International. New holding Pioneer is a vertically integrated exploration & production company that owns many of the services that other shale producers must hire out for, including its own sand mine and pressure pumping for fracking, shielding it from service inflation.

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 Microsoft will become more important in this increasingly uncertain environment.

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.

Portfolio Highlights

The All Cap Growth Strategy underperformed its Russell 3000 Growth Index benchmark during the first quarter. On an absolute basis, the greatest contributors to performance were the Portfolios’ holdings in the information technology (IT), health care and consumer discretionary sectors.

Relative to the benchmark, overall stock selection and sector allocation detracted from performance. In particular, an overweight to the energy sector as well as stock selection in the health care and industrials sectors hurt performance. On the positive side, stock selection in the energy and consumer discretionary sectors and an underweight to consumer staples had positive impacts on performance.

In terms of individual stocks, the greatest contributors to quarterly returns included positions in Amazon.com, Vertex Pharmaceuticals, Weatherford International, Comcast and Facebook. The greatest detractors from returns included positions in Anadarko Petroleum, Ionis Pharmaceuticals, Akamai Technologies, Schlumberger and Twitter.

During the first quarter, we initiated positions in Honeywell International in the industrials sector and Pioneer Natural Resources in the energy sector. The Portfolios received shares of Bioverativ in the health care sector following its spinoff from Biogen and shares of LogMeIn in the IT sector following its merger with GoTo Meeting, a spinoff from Citrix Systems. We also sold our positions in Aetna in the health care sector and General Electric in the industrials sector.