- Cyclical stocks drove portfolio performance as the U.S. economy continued to strengthen.
- Positive clinical news among our biotech holdings and resolution of several mergers in the media industry were encouraging signs for the future.
- We are closely monitoring the impact of trade tensions and U.S. dollar strength on demand in emerging markets.
Market Overview and Outlook
Strength of the momentum trade drove large cap U.S. equities to their best quarterly showing in five years. The Russell 1000 Index advanced 7.42%, the S&P 500 Index added 7.71%, while the Russell Midcap Index rose 5.00%. The benchmark Russell 1000 Growth Index was up 9.17% for the quarter, outperforming its value counterpart by 347 basis points.
Information technology (IT, +13.79%) resumed its place as the top performer in the benchmark while we were pleased to see health care (+12.82%) among the better performing areas.
From a relative performance standpoint, recent results have trailed the benchmark as we have been in a high-beta environment most rewarding to riskier growth companies. The short-term character of the market does not influence portfolio construction as we remain focused on generating consistent returns with attention to risk management. This is supported by owning stocks we consider cyclical growth stories like Qualcomm, a communications chipmaker and owner of a number of wireless technology patents that has been a strong performer as it shores up its management team and moves closer to resolution of intellectual property litigation.
Our diversified approach to growth, which includes owning stable growth companies and well as faster-growing select growth stocks, supports risk-adjusted returns and enables us to deliver consistency through varying market environments. In a momentum market like the current one, we would expect our select bucket of companies to do well. Facebook pulled down the select bucket and was the primary detractor for the quarter as the social and advertising platform delivered disappointing earnings and remained under the scrutiny of regulators over user privacy, a point exacerbated in late September by the disclosure of its largest ever data breach. The company understands the issues related to user data and is taking all available steps to protect that trust through significantly enhanced compliance and oversight. In addition, Facebook is cutting out data aggregators, forcing corporate brands to become more creative with their marketing approach. In the meantime, it continues to innovate, with Facebook Watch and Instagram Stories generating significant traction.
"With the U.S. economy accelerating, the portfolio’s cyclical exposure has also been a boon to results."
Energy was also a detractor as stabilizing crude oil prices – WTI was down 1.2% for the quarter but is up 20% year-to-date – failed to lift oilfield services provider Schlumberger and exploration & production company Pioneer Natural Resources. Supply bottlenecks in the Permian Basin of Texas and Oklahoma, a key market for both companies, have been a short-term headwind but given OPEC’s decision to maintain production levels and global supply disruptions, we believe the path of least resistance for oil prices is higher. Schlumberger has been hurt by execution issues but should benefit as capital spending by producers picks up, especially outside the U.S.
The portfolio’s biotechnology holdings benefited from positive clinical news during the quarter, providing a boost to a health care sector that has struggled for much of the last year and represents the portfolio’s largest overweight (+245 basis points). Biogen reported positive trial results on an Alzheimer’s treatment it is developing with Japan’s Eisai named BAN2401. The trial furthered the premise that targeting the buildup of plaque in the brain can improve cognition, which is consistent with the mechanism of action for Biogen’s other Alzheimer’s treatment in the pipeline, aducanumab. Regeneron Pharmaceuticals, meanwhile, reported positive sales trends for its Dupixent atopic dermatitis treatment, positive initial clinical data for a new treatment for severe chronic pain and a new dosage option for its Eylea treatment for macular degeneration.
Media was another bright spot during the quarter as bidding wars for two major content providers, Twenty-First Century Fox and Sky, were settled. Portfolio holding Disney won the right to acquire the film and non-broadcast TV assets of Fox, further expanding their library of entertainment programming. Portfolio holding Comcast, meanwhile, will acquire British pay TV provider Sky, expanding its reach into international markets. With clarity achieved, we believe both deals will become accretive to earnings and give the companies the increased programming and distribution scale critical in today’s media industry. Our media holdings are now part of an expanded telecom sector that has been renamed communication services and now includes select stocks from both the consumer discretionary and IT sectors. Top 10 holdings Alphabet and Facebook are the other major names new to communication services. We expect the sector transition will have limited impact on portfolio construction.
While most large cap U.S. Internet stocks have been hitting new highs this year, we were able to add Alibaba to the portfolio at a relative discount. China’s dominant Internet and e-commerce provider has traded down recently on U.S.-China trade tensions, a weakening currency and the threat of domestic regulation. We see Alibaba expanding its franchise into nearly every facet of China’s emerging middle class, much like long-time holding Amazon.com is doing in the U.S., as well as increasing its presence in markets outside China.
With the U.S. economy accelerating, the portfolio’s cyclical exposure has also been a boon to results. Second-quarter GDP grew at a 4.2% pace, the fastest rate since 2014, while industrial activity remains solidly in expansion territory and unemployment sits at a historically low 3.9%. Industrial equipment distributor Grainger has been a strong performer as it rolls out a new pricing approach while industrial conglomerate Honeywell is benefiting from margin expansion and free cash flow growth across its defense and commercial businesses. Ecolab, a provider of sanitation and hygiene services across multiple industries, has also been a solid contributor.
As we enter the fourth quarter and look toward 2019, trade tensions and the impact of a strong U.S. dollar (USD) on the many multinational companies we own top our list of concerns. Portfolio companies generate approximately 40% of their revenues outside the U.S. and we estimate the portfolio has about the same foreign exchange exposure as the benchmark. China represents our largest EM exposure, led by Yum China, but many companies there like Caterpillar have joint ventures that limit direct exposure. Company managements have not yet seen meaningful impacts from tariffs but that could change if trade rhetoric heats up. Dollar strength is having more immediate impacts as sales for Anheuser-Busch InBev in Brazil and other Latin America markets are worth less when translated back into USD.
The ClearBridge Large Cap Growth Strategy underperformed its Russell 1000 Growth Index benchmark during the third quarter. On an absolute basis, the Strategy had gains in eight of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the IT and health care sectors.
On a relative basis, overall stock selection and sector allocation detracted from performance. Stock selection in the IT, financials and consumer staples sectors as well as an overweight to energy hurt relative returns. On the positive side, stock selection in the communication services, industrials and materials sectors contributed to results.
On an individual stock basis, the biggest detractors from absolute returns in the third quarter were Facebook, Anheuser-Busch InBev, Schlumberger, Yum China and Dentsply Sirona. Leading individual contributors included positions in Amazon.com, Microsoft, Apple, Visa and Qualcomm.
During the third quarter, we initiated a position in Alibaba in the IT sector and closed a position in Dentsply Sirona in the health care sector. Dentsply Sirona is a global provider of dental supplies and technologies including instruments, appliances and software. We no longer have visibility on when to expect benefits from the merger of Dentsply International and Sirona Dental Systems. As a result, our thesis of significant margin expansion for the company and confidence in management no longer apply.