- The first quarter saw the return of volatility to U.S. equity markets: while painful at the time, we believe we can take advantage of pricing anomalies when volatility runs hot and high.
- Energy and health care look to be two sectors where prices and values appear to be diverging meaningfully.
- We continue to apply our process broadly across the market, looking to diversify our portfolio with attractively valued companies.
Market Overview and Outlook
The Russell 2000 Index fell 0.08% in the first quarter, its first quarterly decline since the first quarter of 2016. Our portfolio underperformed for the third straight quarter. Again, our picks in health care, energy and materials accounted for most of the shortfall. As we’ll discuss later, we believe these trends are poised to reverse.
The first quarter saw the return of volatility to U.S. equity markets. For most of the last five years, the VIX Index has stayed in a very narrow range, with its 50-day moving average between 10 and 15. Only in late 2015 and early 2016 did the VIX spike, with the moving average climbing over 20, during which time the Russell 2000 Index fell more than 25%. In the first quarter of 2018, the VIX moved above 20 once again. While painful at the time, we believe we can take advantage of pricing anomalies when volatility (read: investors’ emotions) runs hot and high.
The complacency of a trend-following market, where investors have been happy to buy whatever passive index is working at the moment, makes it hard for active managers like us to differentiate ourselves through bottom-up, fundamental valuation work. As a result, after outperforming in 2016, we’ve trailed the index since the beginning of 2017. And it hasn’t just been we who have underperformed over that period — on average, Morningstar’s Small Blend category, excluding ETFs and index funds, trailed the index by 16 basis points more than we did.1 That’s a remarkable level of underperformance from a diversified group of active small cap managers, which hints at something systematic going on in the market, though it’s hard to say for sure what exactly it is. Still, the rubber band has been stretching over the past two years. At some point, it will have to snap back.
The recent volatility provides a welcome respite from this momentum market. The 2015–2016 volatility spike provided us with the opportunity to buy very good companies at excellent prices, which contributed to our Strategy’s strong relative returns in 2016. The current spike in volatility, which started in early February 2018, has coincided with only an 8% drop in the Russell 2000 Index — and that's after the Russell 2000 Index was up over 50% in the previous two years2 — so buying opportunities have not been as numerous. Nevertheless, there are two sectors where prices and values appear to be diverging meaningfully: energy and health care.
"The divergence of oil prices and energy stocks has grown more severe; the odds of a reversion have risen."
Energy is one of the primary anomalous areas of the market thathas hurt our performance. The sector has diverged strongly from oil futures contracts. While the forward-month contract is up 28% since March 2017, the Russell 2000 Energy Index is down 16%. The 24-month futures contract is only up 9%, but that’s still 25% outperformance versus the energy sector. Over the last 10 years, the monthly beta of the Russell 2000 Energy Index with the forward-month oil futures contract has been 0.84: oil and energy stocks have moved in sync. Since oil peaked in June 2014, however, the commodity is down about 38%, both one-month and 24-month contracts, while stocks are down 71%. That’s an unusual break.
Extraction Oil & Gas is emblematic of the disconnect. Over the course of 2017, Extraction increased the percentage of oil in its production mix from 40% to 50%, while reducing the average cost to produce each barrel of oil equivalent from $7/bbl to $6/bbl. Extraction’s total operating cost per barrel of production is lower than its Colorado peers’, with a breakeven cost in the $40s, according to management. With costs under control, if Extraction was earning $10 on a barrel of oil at $50, it is earning $20 with oil at $60 — double the profitability. Yet, while oil futures rose over the past 12 months, Extraction was down 38%, even underperforming other small cap E&P producers, despite lower operating costs. There are, of course, other factors that affect the company’s valuation, but it is remarkable that the stock has ignored commodity valuation to this degree.
We believe this divergence will reverse at some point and so have increased our exposure over the past year. The first quarter of 2018 remained bad, however, with the commodity up mid-single digits and energy stocks down 10%. That move cost us but it made the divergence more severe, so that the odds of a reversion have risen.
Health care was the other primary sector of difficulty for us, as it has been for the last year. Health care was the strongest-performing Russell 2000 Index sector over the last year, up 29%, compared to the 17% gain for the second-best sector, technology. Our performance in health care in 2017 and the first quarter of 2018 was positive, but only about market average; not the soaring return of the sector. The good news is that we saw very few adverse developments in our holdings, such as weak trial data. We simply weren’t in the handful of go-go biotechnology stocks that really soared. We still think our holdings can generate good returns, but whether they will outperform their highly idiosyncratic peers depends a lot on momentum, which is not the way we invest. Again, the longer this divergence continues, the higher the odds become that it will revert.
We continue to apply our process broadly across the market, looking to diversify our portfolio with attractively valued companies, but it remains challenging to find good investment opportunities. Consensus earnings estimates have risen dramatically, largely from tax cut benefits that may or may not fall to the bottom line. If that earnings growth doesn’t materialize, valuations are very stretched. We know it’s very difficult to time the market, however; our intention is to build a portfolio that can outperform in both up and down markets.
The ClearBridge Small Cap Strategy underperformed the Russell 2000 Index, the Strategy’s benchmark, during the quarter.
On an absolute basis, the Strategy had gains in three of the sectors in which it was invested for the first quarter (out of 11 sectors total). The primary contributors to the Strategy’s performance were the information technology (IT), financials and health care sectors. The main detractors from returns during the quarter were the energy and consumer discretionary sectors.
On a relative basis, the Strategy underperformed its benchmark impacted primarily by stock selection. Stock selection in the energy, health care and consumer discretionary sectors detracted the most from relative returns. On the positive side, stock selection in the financials and IT sectors contributed most to relative results.
On an individual stock basis, Gray Television, Smart Sand, REV Group, Amarin and Web.com Group were the greatest detractors from absolute returns in the first quarter. 2U, HealthEquity, Aaron’s, OneMain Holdings and RingCentral were the largest contributors to absolute performance.
During the quarter we initiated positions in Liberty Oilfield Services, Rapid7, ORBCOMM, Prothena and Hudson. We closed our position in Ligand Pharmaceuticals.