- Growth stocks outperformed during the quarter, but leadership started to shift from mega cap technology to health care.
- The portfolio’s biopharmaceutical and media holdings re-rated higher on better results and a more conducive M&A environment.
- Recent relative performance has not altered our long-term approach of targeting undervalued growth companies with consistent cash flow generation and well defended businesses.
Large cap U.S. equities delivered their best quarterly performance since 2013 in the third quarter. The S&P 500 advanced 7.71%, the Russell 2000 Index returned 3.58% while the Russell 3000 Index added 7.12%. The benchmark Russell 3000 Growth Index was up 8.88% for the quarter, outperforming its value counterpart by 349 basis points.
Against a mixed and often volatile geopolitical backdrop, the U.S. bull run continued, led by inflows into ETFs and other passive vehicles. September U.S. equity fund inflows were the highest since March as investors continued to participate in the powerful momentum trade. While bullishness is not at the extremes we have seen in the past, complacency, particularly apropos to passive vehicles, is rising, which bears watching. The selloff in Facebook during the quarter on the threat of greater regulatory scrutiny and the underperformance of certain FAANGs vs. the S&P 500 illustrate the risks being overlooked in the largest names in the market.
While information technology (IT, +13.5%) again led benchmark performance, health care was a close second (+12.1%), boosted by strong results for several pharmaceutical and biotechnology stocks. The Nasdaq Biotechnology Index rose 11% during the quarter, following up a solid increase in the second quarter. The improving results from the sector are indicative of undervalued stocks and industries starting to be recognized by investors. Overlooked by the recent dominance of the FAANGs, 44% of the stocks in the Russell 3000 Growth Index are in the red year to date.
Portfolio holding Biogen reported a positive trial for an Alzheimer’s treatment named BAN2401, which it is developing with Japan’s Eisai, a result that could also bode well for a separate Alzheimer’s treatment with a similar mechanism of action in the company’s pipeline. Amgen profits beat expectations and the company raised guidance for the year on strength in its bone cancer franchise. These improvements suggest the market is beginning to appreciate the fundamentally strong businesses of these companies and assign value to their pipelines of innovative treatments for unmet needs. Expectations are so low for biopharmaceuticals that any good news has the potential to meaningfully boost stock prices.
Weakness in the portfolio’s IT holdings weighed the most on relative results. Seagate Technology and Western Digital, which maintain a virtual duopoly in data storage devices, were hurt by declining prices for flash memory and worries that capital spending on cloud services is slowing. We believe the bearish case for the cloud is overblown and see demand continuing to increase for some time as more enterprises embrace the cloud for their computing and data needs. Meanwhile, both Seagate, with a forward P/E of 7.5 and Western, at a forward P/E of 5, trade at depressed valuations that fail to capture the free cash flow generation and long-term value of their businesses. On a price/cash flow basis, the overall portfolio is trading close to its lowest level compared to the benchmark in over a decade.
Exhibit 1: Aggressive Growth Strategy Price/Cash Flow Ratio vs Russell 3000 Growth Index
Energy was another headwind as announcements of increased capital spending by drillers was viewed negatively by the market. The firming of crude oil prices stalled during the quarter, with WTI down 1.2%. Longer-term, however, we remain constructive on exploration & production and oil services companies as OPEC’s September decision to keep production levels intact, combined with a series of supply disruptions around the globe, should cause commodity prices to rise. As U.S. producers work through supply bottlenecks in Texas and Oklahoma and inventories decline, the call on the U.S. to step up production should resume, boosting demand for drilling equipment and infrastructure. While still up on the year, stocks of companies like Anadarko Petroleum sold off on fears of higher capex, despite remaining disciplined in their spending plans. This should allow more cash to continue to be directed to shareholder-friendly actions.
Share buybacks in particular are expected to increase as we approach year end, which could provide a boost to portfolio holdings across sectors (Exhibit 2). In addition to Anadarko, biopharmaceutical makers Allergan, Amgen and Biogen are repurchasing a significant number of shares at an accelerating rate, signaling their boards feel their shares are undervalued. We expect the buyback trend could expand to our storage names. The ability to repurchase shares as well as reduce debt and fund acquisitions are functions of strong balance sheets and sturdy free cash flow generation, primary characteristics we seek in companies. The flexibility afforded by such cash should help the portfolio as U.S. financial conditions tighten and volatility normalizes.
Exhibit 2: Buybacks Should Drive Performance into Year End
We have always pointed to merger & acquisition activity as a bellwether of value creation and the media industry continued to be a beneficiary in the third quarter. Top-five portfolio holding Comcast won a bidding war with Twenty-First Century Fox for UK pay TV provider Sky, giving it an immediate presence in Europe and adding to the scale we believe is critical in today’s rapidly changing media landscape. As this comes on the heels of the AT&T/Time Warner merger, our thesis of consolidation among programmers and distributors is beginning to play out. Discovery also benefited from a more constructive backdrop for media. We could see more M&A activity in the space as strong earnings growth and the benefits of tax reform leave corporate coffers flush with cash for deal making.
September marked the 10-year anniversary of the collapse of Lehman Brothers which ushered in the last bear market. Since then, U.S. equities have moved meaningfully higher with little sustained volatility and few corrections. With mega caps leading, simply owning the market or the passive benchmark has been a good strategy for the last few years as the bar for high active share managers like ourselves has been raised. While recent relative results have been challenging, we have remained consistent to an approach that has created significant value for shareholders for nearly 35 years. The portfolio continues to look very different from our benchmark, owning companies across the market cap spectrum and seeking to deliver returns with a low correlation to those offered by passive vehicles. Entering into a period where volatility may be higher and driven more by M&A activity than money flows to ETFs, we believe the large valuation discount gap afforded our companies vis-à-vis the market will continue to close. By acting as long-term business owners and seeking out growth opportunities in underowned and underinvested stocks and sectors, we are well positioned for periods when free cash flow and valuations are once again recognized.
The ClearBridge Aggressive Growth Strategy underperformed its Russell 3000 Growth Index benchmark during the third quarter. On an absolute basis, the Strategy had gains in four of the eight sectors in which it was invested (out of 11 sectors total). The main contributor to performance was the health care sector while the main detractor was the energy sector.
In relative terms, stock selection and sector allocation detracted from performance. Stock selection in the IT sector and overweights to the energy and newly created communication services sector, which is a reconstituted and renamed telecommunication services sector now including select stocks from the consumer discretionary and IT sectors, hurt results the most. On the positive side, stock selection in the communication services and health care sectors and an overweight to health care supported performance.
On an individual stock basis, the largest contributors to absolute returns included Biogen, UnitedHealth Group, Allergan, Autodesk and Comcast. The greatest detractors from absolute returns during the third quarter included positions in Twitter, Seagate Technology, Western Digital, Anadarko Petroleum and Core Laboratories.