- Equities declined in the fourth quarter as slowing global growth and rising short-term interest rates raised concerns about the sustainability of the U.S.’s robust domestic economy.
- As the market selloff continued during the quarter, we were able to deploy cash toward attractive investment opportunities.
- We continue to gradually reduce cyclicality of the portfolio while improving the quality of the companies we own, with a keen focus on sustainable cash flows.
Market Overview and Outlook
Equities declined sharply in the fourth quarter as slowing global growth, exacerbated by escalating trade tensions with China, and rising short-term interest rates raised concerns about the sustainability of the U.S.’s robust domestic economy. Meanwhile, in the face of lofty expectations and impressive stock performance during 2017 and the first nine months of 2018, the bellwether tech companies sold off even harder than the broader market, putting in doubt their market leadership going forward. While the market steadied somewhat in November when U.S. midterm elections produced a split Congress, viewed as more conducive to stable policy, this was short-lived. By year-end fears of slowing economic growth negatively impacted investor sentiment, resulting in further declines.
As the market selloff continued during the quarter, we were able to deploy cash toward attractive investment opportunities. In volatile markets, it becomes increasingly important to remain true to our investment style and diligent in actively analyzing companies, and we were able to increase position sizes in some holdings at prices we found attractive.
For the year, it was a tale of two markets. The S&P 500 Index generated a total return of more than 10% through September, led by the information technology (IT), consumer discretionary and health care sectors. Sentiment was positive: in September the University of Michigan Index of Consumer Sentiment topped 100 for only the third time since 2004. From its late-September peak, the S&P 500 then fell 14%, while the NASDAQ fell over 16%. Rising interest rates and suggestions that the Federal Reserve would continue unwinding its multi-trillion-dollar balance sheet pressured the stocks of many highly leveraged companies. While consumer sentiment remained strong, fears of an economic slowdown and higher interest rates negatively impacted markets.
"The portfolio benefited from strong performance in real estate and media holdings."
Despite fears, the U.S. economy continues to grow steadily while the labor market remains strong. The fourth-quarter market decline was broad based, with only the defensive utilities sector generating a positive return. Other defensive areas such as real estate and consumer staples were down, but performed relatively better, as long-term interest rates declined midway through the fourth quarter. The energy sector, meanwhile, was the hardest hit, as oil prices dropped to their lowest levels in a year. IT and consumer discretionary stocks also fell, largely on worries of global economic cooling.
The portfolio benefited from the strong performance of American Tower, a real estate investment trust that owns and operates wireless towers in the U.S. and internationally. American Tower capitalized on better-than-expected telephone carrier spending in the U.S. and finalized a settlement with consolidating wireless carriers in India, raising fiscal year 2018 guidance. The recent pullback in bond yields also boosted the stock.
Media names Fox and Comcast also helped performance. The media industry is transitioning from traditional linear viewing and big bundles to digital media consumption over the internet. Facing the meteoric rise of Netflix, Amazon Prime Video, YouTube TV and others, traditional media players are embarking on a consolidation spree to gain scale and improve their ability to compete globally. In the past we wrote about AT&T’s $88 billion acquisition of Time Warner. In a similar vein, after protracted bidding between Disney and Comcast, Fox’s general entertainment assets are being acquired by Disney for $70 billion or $38 per share in cash or stock, while Fox’s remaining legacy national sports and news assets will be spun off in a separately traded company. After more than a decade of Fox stock ownership, we are pleased the value of this unique global franchise is finally being recognized.
Comcast, meanwhile, is benefiting from a strong competitive position in broadband internet connectivity and aggressively investing in its Universal theme parks and resorts. After protracted bidding for Fox assets against Disney, Comcast emerged as the winning bidder for Sky, previously 40% owned by Fox. Recognizing the value and uniqueness of the Sky platform, Fox made multiple unsuccessful attempts to buy in the remaining 60%. While Comcast is paying a lofty $41.4 billion for Sky, the deal offers Comcast a leading pan-European content powerhouse and an expanding pay-TV distribution platform with a strong, if not dominant, presence in the U.K., Italy and Germany.
The energy sector broadly, along with our energy holdings such as Halliburton and Schlumberger, faced meaningful headwinds due to a more than 35% decline in oil prices during the quarter as well as pipeline bottlenecks in the Permian Basin. Suncor Energy, a Canadian-based company focused on oil sands development and refining and marketing under the Petro-Canada brand, faced its own set of challenges as pipeline constraints resulted in meaningfully wider than normal, albeit temporary, price differentials between Western Canada heavy and light crude and West Texas Intermediate (WTI), somewhat pressuring earnings in the interim. Nevertheless, Suncor has attractive long-term fundamentals with an abundant resource base that includes several decades of reserves located in a stable socio-economic environment, and we remain confident in the company’s long-term prospects.
In financials, fears of an economic slowdown or recession caused investors to pull back sharply from large banks. Notwithstanding near-term uncertainty, we remain positive on these stocks, as capital levels and risk profiles have improved considerably since the 2008 financial crisis and credit losses remain exceptionally low.
McCormick, the spices and seasoning giant, has been an exceptional performer since it acquired Reckitt Benckiser’s food division in 2017. We bought it opportunistically, participating in the equity offering at the time of the acquisition. As McCormick continued to buck the trend in packaged food and deliver strong earnings and sales growth, the stock appreciated considerably, reaching and exceeding our valuation target. We harvested our gains and sold our position in the fourth quarter.
There is no change to our disciplined investment approach that focuses on competitively well-positioned companies with strong business franchises capable of generating superior returns across cycles. Notwithstanding near-term uncertainty and market volatility, we think these companies should outperform over time. We continue to gradually reduce cyclicality of the portfolio while improving the quality of the companies we own, with a keen focus on sustainable cash flows.
The ClearBridge Large Cap Value Strategy outperformed its Russell 1000 Value Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in one of the sectors in which it was invested for the quarter (out of 11 sectors total): the real estate sector. The main detractors from Strategy performance came from the financial, energy and industrials sectors.
On a relative basis, overall stock selection contributed to performance, partially offset by sector allocation. In particular, stock selection in the industrials, real estate and health care sectors contributed to relative results. The Strategy’s stock selection in the consumer staples and consumer discretionary sectors, on the other hand, contributed negatively. In terms of allocation, the Strategy’s cash position added to relative returns, while its underweight to utilities was a detractor.
On an individual stock basis, the largest contributors were Merck, American Tower, McCormick, Twenty-First Century Fox and Charles Schwab. Positions in Halliburton, Suncor Energy, JPMorgan Chase, DISH Network and United Technologies were the greatest detractors from absolute returns in the quarter.
During the quarter, we initiated a position in Charles Schwab in the financials sector. We closed positions in Freeport-McMoRan in the materials sector, British American Tobacco and McCormick in the consumer staples sector and Citigroup in the financials sector.