- We are actively managing our information technology and Internet exposures to benefit from strong fundamental performance while balancing crowding concerns.
- Recent strength in biotechnology shares is an encouraging sign that innovation is beginning to be appreciated by the market.
- The threat of tariffs poses additional risks for multinational growth companies and is one of several conflicting signals we are evaluating heading into the second half of the year.
Market Overview and Outlook
U.S. equities generated broad gains in the second quarter, with the best contributions coming from growth stocks. The Russell 1000 Index advanced 3.57%, the S&P 500 Index added 3.43% while the Russell Midcap Index rose 2.82%. The benchmark Russell 1000 Growth Index was up 5.76% for the quarter, outperforming its value counterpart by 458 basis points.
The momentum trade, bolstered by inflows into passive vehicles, resumed its position as a primary driver of stock performance. While energy was the top performer in the benchmark (+9.64%), boosted by a 14.2% rise in crude oil prices, consumer discretionary (+9.63%) and information technology (+8.60%) were also strong contributors. The FAANGs are well represented in both sectors and maintain significant weights in the Russell 1000 Growth Index. In fact, as of June 30th, the top five stocks — Apple, Microsoft, Amazon.com, Facebook and Google (Alphabet Class C — now account for the highest weight in the index (24.4%) since the aftermath of the Internet bubble in 2001 (Exhibit 1).
Exhibit 1: Weighting of Top 5 Stocks in Russell 1000 Growth Index
The portfolio has exposure to each of these five names, with Amazon.com, Microsoft and Alphabet among our top five holdings. As high active share managers, we have chosen to own these growth companies not based on their index inclusion but due to strong business fundamentals and market leadership positions that promote long-term compounding of earnings and cash flows. We are cognizant of the risks posed by their significant weighting in the benchmark and high ownership among passive investors and actively manage position sizes. We have trimmed our position in Amazon, for instance, four times in the last 24 months. We are also gravitating toward information technology (IT)-related companies with a mix of offense and defense like recent addition Equinix, a manager of data centers which supports the movement toward a connected home and connected society, that can withstand greater volatility and the withdrawal of liquidity from the market.
Our FAANG exposure had a mostly positive impact on second-quarter performance, with Amazon, Microsoft, Alphabet and Facebook among the top five contributors. The portfolio has also received meaningful contributions from lower cap technology names including Adobe Systems and Akamai Technologies, which are benefiting from gathering strength in enterprise IT spending.
The strength of the larger IT and Internet names, however, overshadows an equity market where we would argue the majority of companies are in bear market territory. Removing the 10 largest names from the Russell 1000 Growth Index, the benchmark’s year-to-date performance through July 5 drops from 8.16% to 4.32%. Doing the same in the S&P 500 Index drops performance from 3.38% to 1.77%.
The bifurcation of market performance creates opportunities in overlooked areas. In an ongoing effort to diversify our growth exposures, we added a bit more cyclicality to the portfolio during the quarter with the addition of chip maker Qualcomm. We believe the company’s earnings are cyclically depressed —shares are down roughly 12% year-to-date —and should improve as it settles a legal dispute with Apple, a core customer for its communications chips that has been withholding royalty payments. Greater pressure on management to control spending should also help profitability. Qualcomm is also well positioned to benefit from the 5G wireless technology cycle that should begin to ramp up early next year. We also added to Oracle, a database software provider that adds more optionality to the portfolio as it is earlier in the transformation of its business to the cloud than many of its software rivals.
While many IT and Internet stocks are fully valued, health care offers compelling opportunities from an affordable growth perspective. Health care in general and biotechnology in particular has been a drag on performance for the last 18 months and was again in the second quarter. Yet we continue to like the dynamics of the biotech industry as the new commissioner at the FDA seeks to control drug costs through competition and is rewarding innovation by speeding breakthrough treatments to market.
One company developing such treatments is BioMarin Pharmaceutical, a new addition to the portfolio which targets its research on rare and orphan diseases. BioMarin has a portfolio of approved drugs with strong growth potential, and gained FDA approval in May for a new treatment for a rare blood disease. The company also has an underappreciated pipeline of new treatments in the areas of hemophilia and dwarfism. The Nasdaq Biotechnology Index gained 7.1% in the second quarter, further evidence that investors are beginning to recognize the value in the space. To make room for more attractive growth companies in health care and across the portfolio, we closed a position in CVS Health. While the company is making sound moves for the long term, it faces several near-term headwinds that have weighed on the stock – pricing pressure in its PBM unit, increased competition within the pharmacy space as well as uncertainty over its planned acquisition of Aetna.
"Health care offers compelling opportunities from an affordable growth perspective."
Beyond company-specific catalysts, we have been monitoring the global trade and tariff discussions that have an impact on the many multinational companies in the portfolio. We are less worried about the tariffs implemented so far than the risk of escalation into a full-blown trade war and the potentially deleterious effects on U.S. GDP growth. The economy advanced a solid 2.0% in the typically weak first quarter and inflation is edging toward the Fed’s target of 2.0%. The implementation of further tariffs could push inflation higher. Steel tariffs raise the cost of doing business for industrial companies like Caterpillar, but does so for its global competitors as well. Caterpillar shares finished the second quarter unchanged while our industrials exposure was a contributor to performance, boosted by strength in industrial parts distributor Grainger.
As we enter the second half of the year, we are evaluating several crosswinds in the equity market and the economy. Given the boost from tax reform, earnings growth has been as good as advertised and the economy remains on strong footing. Yet the commentary we are hearing from some companies is instructive as some industries are not nearly as healthy as GDP numbers would suggest. We are not yet concerned about a broad recession but with the Fed having removed the backstop of abundant liquidity, we could be at the point of peak corporate earnings. Valuations in areas of the market and the portfolio that have done well, such as large cap software trading at 42 times earnings, suggests that broad-based multiple expansion in traditional growth areas like tech are no longer a given. These are the signals we are trying to dissect and evaluate what they mean for our portfolio companies.
The ClearBridge Large Cap Growth Strategy underperformed its Russell 1000 Growth Index benchmark during the second quarter. On an absolute basis, the Strategy had gains in eight 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 detracted from performance but was partially offset by positive sector allocation. Stock selection in the health care, IT and financials sectors as well as an overweight to financials hurt relative returns. On the positive side, stock selection in the industrials and consumer staples sectors and an underweight to industrials contributed to results.
On an individual stock basis, the biggest contributors to absolute returns in the second quarter included positions in Amazon.com, Facebook, Adobe Systems, UnitedHealth Group and Visa. Celgene, Red Hat, Dentsply Sirona, BlackRock and Yum China were the largest detractors from absolute performance.
During the second quarter, we initiated positions in BioMarin Pharmaceutical in the health care sector and Qualcomm in the IT sector and closed positions in CVS Health in the health care sector and eBay in the IT sector.