- Strong performance from cyclical stocks in the fourth quarter marked a broadening of the market that we view as encouraging.
- Technology stocks were the primary driver of portfolio returns, led by solid results from software names.
- We are positioning for continued strength in the economy, but remain mindful of consumer spending patterns.
Market Overview and Outlook
Stocks capped off a strong year with a flourish as large growth stocks continued to dominate market performance. The S&P 500 Index gained 6.64% for the quarter, the Russell 1000 Index advanced 6.59% while the Russell Midcap Index added 6.07%. The benchmark Russell 1000 Growth Index gained 7.86% for the quarter to finish 30.21% higher for the year.
The information technology (IT) sector gained 41.50% for the year but was not the top performer in a fourth quarter that saw a broadening of contributions across the market. We have constructed the portfolio to thrive in such an environment by owning a diversified set of growth companies that provide exposure not only to mega cap IT and Internet names but also leading consumer, health care and financial stocks as well. While Amazon.com, one of our largest holdings, was the top individual performer during the quarter, we also received notable contributions from less widely-owned names including software makers Akamai Technologies, Adobe Systems and Splunk.
Health care, meanwhile, was a headwind during the quarter as several of our biotechnology holdings sold off on disappointing clinical trial results and sluggish product launches. Celgene was hurt by weak sales of its Otezla treatment for psoriasis and the clinical failure of a treatment for Crohn’s disease. We added to our position as we believe Celgene is an inexpensive stock with a path to replenish the cash flows from the Revlimid patent expiration in the middle of the next decade. The company should have 19 late-stage clinical readouts in 2019 and cash continues to build, which we expect will lead to new business development opportunities or acquisitions to further bolster its clinical pipeline. Alexion Pharmaceuticals traded lower on a potential competitive threat to Soliris, a treatment for several ultra-rare genetic diseases, but we believe that a real competitor is still several years away and were encouraged that Alexion received additional approvals for its lead compound. Alexion recently installed new management, which we believe will refocus its research and development profile.
The portfolio’s biotechnology holdings fall into our select bucket of growth companies, which have the potential to deliver above-average earnings and revenue growth but also carry higher risk. We balance our select bucket by holding a core group of industry-leading growers in our stable bucket. These are companies that compound earnings and cash flows at or slightly above the market, maintain healthy balance sheets and have wide moats around their businesses that promote consistent results. UnitedHealth Group, Microsoft and Home Depot are three stable growth companies that were major contributors during the fourth quarter and throughout 2017. Companies in the stable bucket also tend to be less reliant on broad macro trends to support their growth.
That said, the U.S. economy again did its part to support equities in the fourth quarter. Economic activity was consistently strong, with GDP growth likely to exceed 3%, unemployment sustainable in the low 4% range and industrial production expanding. The U.S. consumer is doing well in terms of confidence measures and spending while housing showed steady gains throughout the year. Improvements in the emerging market economies that are a major source of demand for many of the multinational companies in the portfolio, like Coca-Cola and Visa, has also been encouraging.
"We expect the valuations of energy stocks to catch up to commodity prices as spending on oil production picks up."
Cyclical stocks in the consumer discretionary and industrials sectors were the best performing sectors in the benchmark in the fourth quarter, lifted by recently passed tax legislation that will lower corporate tax rates to 21% and allow companies to accelerate expensing of capital expenditures. The portfolio was hurt slightly in the fourth quarter by its underweight to industrials, but we have been taking advantage of price opportunities to increase our cyclical exposure. During the quarter, we initiated a new position in industrial gas producer Praxair that provides a good link to industrial activity in a recovering global economy. Praxair is the largest player in a gas production and delivery business with high barriers to entry and long-term contracts that feature attractive margins and promote stable returns on invested capital. Its proposed acquisition of Linde also has the potential to improve earnings more than currently forecast.
Slow but steady improvement in the energy sector is also encouraging. Crude oil prices continue to rebound from their mid-year lows, with WTI up 15.7% in the fourth quarter, however energy stock prices have lagged. We expect the valuations of energy companies like Schlumberger to catch up to commodity prices in 2018 as rising prices lead to increased spending on oil production internationally, where Schlumberger’s business activity remains depressed. Schlumberger is by far the largest global oil services company in a consolidating industry with many wounded competitors. After four years of giving price to integrated oil and national oil companies, service companies are reversing that trend and raising prices. Schlumberger currently generates incremental margins of 60% plus (the highest in its history) and is the only global service company that is using its balance sheet to invest alongside its customers.
We are keeping an eye on oil and gas prices and how that could impact the consumer going into 2018. GDP growth is likely to continue on its positive uptrend for the first half of the year and consumer spending will be an important component. While more optimistic on the economy than we were a year ago, we remain cognizant of the risks faced by the Trump administration in pushing forward with its remaining fiscal agenda as well as the extended valuations now present in parts of the large cap market. Against this backdrop, we will continue to take a diversified, opportunistic approach to owning quality growth companies.
The ClearBridge Large Cap Growth Strategy underperformed its Russell 1000 Growth Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in six of the sectors in which it was invested (out of eight sectors total). The primary contributors to performance were the information technology (IT), consumer discretionary, and financials sectors.
On a relative basis, overall stock selection contributed to performance but was offset by the negative impacts of sector allocation. Stock selection in the health care and consumer staples sectors as well as an overweight to health care negatively impacted relative returns. On the positive side, stock selection in the IT sector was the largest contributor to relative results. Stock selection in both the consumer discretionary and financials sectors helped relative performance.
On an individual stock basis, the biggest detractors from absolute returns in the fourth quarter included positions in Celgene, Alexion Pharmaceuticals, Regeneron Pharmaceuticals, CVS Health, and Anheuser-Busch InBev. Amazon.com, Akamai Technologies, Microsoft, W.W. Grainger and Adobe Systems were the largest contributors to absolute performance.
During the fourth quarter, we initiated positions in Costco Wholesale in the consumer staples sector, Oracle in the IT sector and Praxair in the materials sector and closed positions in Nasdaq in the financials sector and Twenty-First Century Fox in the consumer discretionary sector.
Costco possesses unique attributes – stable, high renewal membership model; narrow assortment that supports high productivity; growing services revenues – that provide a level of protection against online competition and the risk of an economic downturn. The retailer is attracting millennials as members and is eyeing expansion into higher margin international markets. The main risk to our thesis is the need for additional investment to maintain market share. Oracle has underperformed its large cap software peers over the last several years, presenting an attractive value as its core database offering reaches an inflection point. Database is a wide-moat business that provides predictable revenues. The company is also establishing a significant presence in the high margin, fast growing market for hybrid cloud infrastructure where we believe its software will appeal to customers with complex data needs.
Nasdaq was held in the portfolio for nearly 11 years and we exited after a strong run that drove shares to what we viewed as fair value. We closed our position in Twenty-First Century Fox after portfolio holding Walt Disney announced it was purchasing most of Fox’s entertainment assets.