- Pro-growth and pro-business policy appears to have re-awakened the animal spirits in the economy and generated optimism, which is reflected in the equity markets.
- We are seeing the fruits of global economic recovery in the results of the multinational companies in our portfolio.
- With the market trading at fairly robust multiples, we continue to be sensitive to valuation, with a keen eye on continuously improving the quality of the portfolio.
Market Overview and Outlook
U.S. stocks continued their positive performance in the fourth quarter of 2017, supported by solid economic data, including healthy projected holiday sales, and, importantly, the tax reform bill that passed in December. The S&P 500 Index returned 6.64% for the quarter and ended the year up 21.83%. During the quarter the consumer discretionary, information technology (IT), and financials sectors led the market, while utilities, health care and real estate lagged. For the year, the market experienced positive returns in all but two sectors and was led by a 38.83% gain in the IT sector. Telecommunications services and energy were the trailing sectors, declining 1.25% and 1.01%, respectively.
The most significant economic development in the quarter was the passage and signing of the tax reform bill in December. Its passage helped sustain investor optimism, which was supported as well by steady economic growth and historically low interest rates. Final third-quarter U.S. GDP growth was revised to an annualized 3.2%, largely in line with the second quarter’s 3.1%. U.S. manufacturing remained strong in the quarter, with the IHS Markit U.S. Manufacturing PMI at 55.1 in December, above November’s 53.9 and the highest since March 2015. Panelists in December’s survey cited favorable domestic demand conditions, while business confidence rose again, reaching a two-year high. Meanwhile, consumer sentiment as reported by the University of Michigan survey remained elevated, with respondents split on the economic impact of December’s tax reform bill. New home sales rose over 17% to a seasonally adjusted 733,000 in November, the highest since July 2007, while the economy added jobs at a healthy rate.
As expected, in December the Federal Reserve raised the Federal Funds rate by 0.25%; equity markets reacted calmly. Core PCE, the Federal Reserve’s preferred measure of inflation, rose slightly in November to 1.48% from October’s 1.45%, marking three consecutive months of growth.
Crude oil prices finished the year by rising above $60 per barrel (WTI), from $51.67 at the start of the quarter, helped by cuts in non-U.S. production and concern over unrest in Iran. Both the 10-year U.S. Treasury yield and the U.S. dollar remained largely flat during the quarter, with the 10-Year Treasury closing at 2.41%, and the dollar stabilizing after declining in the first three quarters of 2017.
"We expect the trend toward vertical integration in the health care industry to continue."
Notwithstanding a barrage of controversies, the current administration has generally supported a pro-growth and pro-business agenda that includes stimulative tax reform and broadly deregulatory policies. These actions appear to have re-awakened the animal spirits in the economy and, as outlined above, generated optimism, which is reflected in the equity markets. In addition, U.S. growth appears to be synchronized with many overseas economies, such as the EU, China and Japan. We are seeing the fruits of global economic recovery in the results of the multinational companies in our portfolio. Nevertheless, with the market trading at fairly robust multiples, we continue to be sensitive to valuation, with a keen eye on continuously improving the quality of the portfolio.
Industrials and health care stocks helped portfolio performance relative to the benchmark in the fourth quarter. In the industrials sector, portfolio holdings Illinois Tool Works and Honeywell International continue to execute well and are enjoying the benefits of synchronized global growth. In the health care sector, holding UnitedHealth Group has been at the vanguard of the sector’s M&A trend targeting the improved delivery of health care benefits through vertical integration. The company has been on this path for years, acquiring pharmacy benefit manager Catamaran in 2015 in addition to buying physician practices and surgery centers in order to provide more effective and integrated care.
The portfolio’s consumer discretionary and consumer staples exposures detracted from relative performance in the quarter. Within the consumer discretionary sector, long-term holding and top-10 position DISH Network was hurt by the environment of M&A uncertainty caused by the regulatory hurdles faced by AT&T’s proposed merger with Time Warner and the abandonment of Sprint and T-Mobile merger talks. Nevertheless, we are constructive on DISH’s capabilities: we feel its portfolio of 100 megahertz of nationwide wireless spectrum is not fully reflected in the stock price and continues to have tremendous value, which we expect will be realized over time.
Sticking to the media theme, Disney agreed to acquire general entertainment assets from Twenty-First Century Fox in an all-stock transaction currently worth about $66 billion. In an effort to gain more scale and expand globally, Disney is acquiring Fox’s film and TV studios, several domestic cable and regional sports networks, Fox’s 39% stake in European pay TV leader Sky, as well as Asian content and distribution assets of Star India. As Fox shareholders, we will receive 0.2745 Disney shares for each Fox share and continue to hold shares in Fox’s remaining assets, which include Fox news, Fox Broadcast Network and TV stations, and cable and regional sports channels. Fox’s assets being sold to Disney are worth about $30/share, while Fox’s remaining businesses are worth approximately $12–$15/share.
"Quality remains at the core of our investment philosophy."
Within the consumer staples sector, CVS hurt portfolio performance as the stock fell largely on concerns of execution risk in its deal to acquire Aetna. The market perceived the deal as a defensive move, which fully valued Aetna shares and at the same time increased the balance sheet leverage for CVS. This transaction is another example of the trend toward vertical integration in the health care industry, a trend we expect to continue. CVS is trying to leverage its pervasive local retail pharmacies footprint around the country in order to gain efficiency and lower the cost and improve the quality of health care delivery. The company has some experience in vertical integration and was somewhat of a pioneer in its acquisition of Caremark in 2007.
Quality remains at the core of our investment philosophy. With valuations fair to expensive and with an extra layer of uncertainty in the markets related to technological disruption, it is even more important to remain true to our style and be even more diligent in analyzing companies. We continue to focus on high-quality companies that have competitively advantaged business models and trade at attractive valuations. It remains our view that these types of equities are the best option for most investors over the long term.
The ClearBridge Large Cap Value Strategy underperformed its Russell 1000 Value Index benchmark during the fourth quarter.
On an absolute basis, the Strategy had gains in seven of the 10 sectors in which it was invested for the fourth quarter (out of 11 sectors total). The largest contributors to the Strategy’s performance were the financials, industrials and materials sectors. The main detractor from returns during the quarter was the consumer staples sector.
On a relative basis, the Strategy underperformed its benchmark impacted primarily by stock selection decisions. On the other hand, sector allocation added to overall performance during the quarter. The leading detractor from relative performance was stock selection in the consumer discretionary sector. The consumer staples and IT sectors also hindered relative performance driven by stock selection. On the positive side, stock selection in the industrials and health care sectors contributed to relative results, as did the Strategy’s underweight to the utilities sector.
On an individual stock basis, Time Warner, DISH Network, Merck, CVS and Charter Communications were the greatest detractors from absolute returns in the fourth quarter. Twenty-First Century Fox, JPMorgan Chase, Anthem, Freeport-McMoRan and Wells Fargo were the largest contributors to absolute performance.
During the quarter, we initiated a new position in Oracle and exited a position in Nuance Communications.
"Quality remains at the core of our investment philosophy."