- A continued broadening of leadership in information technology to enterprise software companies drove performance.
- We took advantage of increased volatility to increase our exposure to cyclical names that stand to thrive in a strengthening economy.
- As long-term investors, we remain confident that the fundamental strengths of undervalued companies in healthcare and energy – sectors that represent some of our largest active bets – will be recognized.
Market Overview and Outlook
Stocks endured their first period of elevated volatility in two years during the first quarter, sparked by fears of rising inflation, higher interest rates and trade tensions. The S&P 500 Index declined 0.76%, its first negative quarter since September 2015, while the Russell 1000 Index fell 0.69% and the Russell Midcap Index dropped 0.46%.
The FAANG stocks plus Microsoft, which comprise a quarter of the benchmark Russell 1000 Growth Index, were further pressured following disclosure of the unauthorized use of Facebook customer data in the 2016 election. This raised fears that greater regulatory scrutiny of Facebook and other Internet/social media companies with similar business models could crimp advertising revenue and hinder growth. Despite the late March sell-off in technology, growth stocks held up better than other parts of the market, with the benchmark Russell 1000 Growth Index gaining 1.42% for the quarter.
We are seeing a broadening of participation in the information technology (IT) sector, which accounts for 38.7% of the benchmark and 37.0% of the portfolio. From growth led by the FAANGs, which appeal to primarily consumer end markets (with the exception of Amazon’s AWS cloud business), a shift is underway to enterprise software companies dependent on corporate demand along with workloads and applications moving to the cloud. Steady GDP growth and greater confidence among corporate management teams is incentivizing more companies to ramp up investment in their businesses, driving strong results for portfolio companies Adobe Systems, Red Hat, Microsoft and Akamai Technologies. We are encouraged by this development as the return on investment for customers from technology spending and innovation is usually good. Tax reform is a material tailwind for most of our companies – especially the ability of companies to immediately write off capex expenses – and could extend this current cycle of strong spending on enterprise IT, as we feel there is pent-up demand as we have received clarity on the corporate tax situation.
"We are becoming more assured about the strength and duration of the current expansion."
Stronger spending on information security software is the latest example of renewed business optimism. Palo Alto Networks, a provider of next generation security platforms, endpoint and threat management services, is benefiting from an industrywide refresh to upgraded firewall technology and robust new customer additions. Palo Alto, along with Akamai, is also thriving due to its leading position in the burgeoning market for cloud security and greater demand from global clients racing to meet stricter EU requirements for the protection of consumer data. Splunk, whose software aggregates and analyzes machine data to provide real-time intelligence not only on security threats but also business operations and opportunities, is well positioned to support the explosion of data in the cloud. The company is looking to increase its share in a $60 billion data market that is growing volumes 30% per year with an offering that combines modern architecture and behavioral analytics.
Our allocation to enterprise software is an effective diversifier to the FAANG and related consumer IT companies in the portfolio. As long-term, price-conscious growth investors, we are being opportunistic in adjusting our IT allocations based on market action. Increased volatility during the quarter also enabled us to establish a new position in Equinix. While classified as a REIT, Equinix broadens our exposure to the secular migration to the cloud. The company owns and operates interconnected data centers that provide network and cloud platforms for enterprise customers across a growing number of industries. It is well positioned to participate in what we view as the early stages of a buildout in hybrid cloud services. The company maintains a mix of retail customers that provide higher current growth opportunities, and wholesale customers (hyperscale cloud providers such as Facebook, Microsoft, Amazon and Alphabet) that offer long-term exposure to public cloud growth. We believe Equinix has the global scale and reach to be a leader in the markets for interconnection and co-location services.
Beyond idiosyncratic and secular growth themes, the economic backdrop remains strong and supportive of equities. The U.S. created a better than expected 313,000 jobs in February, the biggest hiring gain since July 2016, while job growth for the previous two months was revised higher. The employment rate remained at a post-recession low of 4.1%, unemployment claims hit their lowest level in 45 years while wage growth remained steady. GDP growth has also been robust, with fourth-quarter annualized growth revised upward to a higher than forecast 2.9%. Consumer confidence readings, meanwhile, remain high. This data reinforces our view that the U.S. consumer is in good shape and the next leg of growth needs to be driven by industrial activity. The latest readings on manufacturing have been encouraging, with the IHS Markit Manufacturing PMI increasing to 55.7 in March, the fastest expansion in three years.
After initial skepticism over the trajectory of the economy under a new presidential administration, we are becoming more assured about the strength and duration of the current expansion. Capital spending driven by tax savings should be good for GDP growth while earnings growth, a key driver of stock price appreciation, is accelerating across the large cap market. Industrial activity and S&P 500 earnings tend to move in tandem and have both been trending upward since 2016 (Exhibit 1).
Exhibit 1: Earnings and Industrial Activity are Heading Higher: Manufacturing PMI and S&P 500 EPS
We have been opportunistically increasing the beta of the portfolio to better participate in these gains, adding to several of our newer names in the industrials and materials sectors and establishing a new position in heavy equipment maker Caterpillar. The company provides broad exposure to an improving global economy through its construction, energy, transportation and resource divisions. Caterpillar has been effectively taking costs out of its business over the last five years which should position it for a period of high incremental margins at this point in the cycle. It is intensely focused on balancing order rates with dealer inventory. Steel tariffs represent a near-term risk to the heavy consumer of raw materials, but do not affect our broader thesis.
Oilfield services provider Schlumberger should also benefit from a stronger global economy, specifically an uptick in spending among non-U.S. energy producers who have lagged their U.S. counterparts in bringing on new capacity. Late last year, Schlumberger consolidated U.S. pressure pumping assets from Weatherford International at advantaged pricing, making them the largest service company supporting unconventional drilling. The return of pricing power in general should also be accretive to results and the eventual re-rating of its shares and those of other fundamentally sound energy companies.
Health care was once again a detractor from results, with weakness in biotechnology spreading to other areas. We believe the sector – a long-time source of growth for the portfolio – is being weighed down by negative sentiment, causing investors to avoid health care in favor of areas with greater revenue and earnings visibility. While money flows are a concern, the regulatory backdrop for biotech and pharmaceutical companies is supportive as new leadership at the FDA has proven receptive to innovation when considering new drug approvals.
Several of our biotech holdings are suffering from a lack of near-term catalysts that could lift their stock prices. Biogen, for example, is in phase three clinical trials for a potential blockbuster treatment for Alzheimer’s disease but announced during the quarter that it was making changes to its study that will delay results until early 2020. Shares sold off on the news, overlooking solid fundamentals. Biogen is also successfully ramping up Spinraza which treats the rare disease spinal muscular atrophy – a condition which affects infants and early adolescents and is truly a disease modifying drug – and has ample cash to deploy for stock buybacks and M&A. The company said recently that it is looking at bigger deals to boost its pipeline, targeting treatments already generating revenue or close to commercialization. This gives us confidence in continuing to focus on similar companies in the mature stages of developing innovative treatments and we have added more of these stocks to our watch list of potential purchases. We are approaching the point where many of our large, platform-sized biotech companies are trading at zero pipeline value, which is a rarity.
We could be at an inflection point in this long-running bull market as the Fed steadily withdraws liquidity and volatility shows signs of normalizing. Below the surface of an otherwise robust expansion in economic growth and earnings, we note that retail sales have declined for three straight months, the savings rate is near all-time lows, and that nearing full employment could pressure wages and corporate margins. Political interference is also overshadowing the markets on many fronts.
This is the time when an active approach to stock selection, embracing controversy and being patient in waiting for attractive entry points into quality growth companies could have a greater impact on performance than maintaining exposure to the stocks and sectors with the strongest momentum. The balance we’re trying to strike in this environment is allowing our fundamentally sound growth franchises time to execute and earn the recognition of investors while also sourcing new ideas among particularly well positioned companies.
The ClearBridge Large Cap Growth Strategy outperformed its Russell 1000 Growth Index benchmark during the first quarter. On an absolute basis, the Strategy had gains in four of the nine sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the IT and consumer discretionary sectors.
On a relative basis, overall stock selection and sector allocation contributed to performance. Stock selection in the IT, materials, consumer discretionary and consumer staples sectors as well as an underweight to the real estate sector drove relative returns. On the negative side, stock selection in the health care sector and an overweight to the energy sector detracted from results.
On an individual stock basis, the biggest contributors to absolute returns in the first quarter included positions in Amazon.com, Adobe Systems, Red Hat, Palo Alto Networks and Zoetis. Dentsply Sirona, Celgene, Comcast, Biogen and Facebook were the largest detractors from absolute performance.
During the first quarter, we initiated positions in Caterpillar in the industrials sector and Equinix in the real estate sector and exited positions in Monsanto in the materials sector and Rockwell Collins in the industrials sector. Caterpillar provides broad exposure to an improving global economy through its construction, energy, transportation and resource divisions. The company has been effectively taking costs out of its business over the last five years which should position it for a period of high incremental margins at this point in the cycle. It is intensely focused on balancing order rates with dealer inventory.
We closed our position in Monsanto following the announcement that it was being acquired by Bayer while we completed the sale of Rockwell Collins ahead of the closure of its acquisition by United Technologies.