- During the recent equity drawdown, the market began to reward attractively-priced companies with solid cash flow profiles and defensible business models.
- The portfolio’s technology and media holdings drove relative performance.
- Increasing M&A activity, an innovation-friendly regulatory environment and the resetting of valuations in depressed areas of the market are encouraging signs for the year ahead.
Market Overview and Outlook
U.S. equities sold off sharply in December to end the fourth quarter and the year with losses. Disappointing results from several of the mega cap technology and Internet companies that have led the market for the last several years were a significant contributor as the S&P 500 Index suffered its second-worst December on record (-9.03%) to finish down 13.52% for the fourth quarter. The benchmark Russell 3000 Growth Index fell 16.33% for the quarter, underperforming its value counterpart by 409 basis points.
As the recent equity correction helps the market start to normalize in terms of volatility and valuations, we believe attractively priced companies with attributes like free cash flow and durable business models with high barriers to entry will once again be rewarded. We have always sought to target businesses with these fundamental characteristics. We believe conditions are setting up for our portfolio companies to monetize assets that have been depressed for some time, either through accretive M&A, increasing share buybacks or through the rerating higher of underowned and undervalued stocks and sectors.
We have been discussing the green shoots of leadership change in recent commentaries, a progression that gained strength late in the year and into 2019 as investors began to acknowledge the risks embedded in certain crowded areas of the market, including the FAANG stocks. Apple, for example, has started to see a slowdown in iPhone sales and issued its first ever profit warning in early January.
As high active share investors, we have constructed a portfolio that looks very different from our benchmark and the passive strategies that track it. That differentiation has been a headwind in the increasingly narrow, momentum-driven market of the last several years. But recent results are beginning to demonstrate the benefits of our contrarian approach to long-term growth investing. Communication services, for example, was a leading driver of relative performance during the quarter, led by Comcast – an out of benchmark holding trading at a single-digit multiple of cash flow.
"We are encouraged that the market climate has changed, and risk has started to be priced into stocks."
Our information technology (IT) holdings have also showed greater resilience than many of the widely-held tech stocks. Broadcom, which develops chips for Apple and software for a broad range of other industries including networking infrastructure, and Cree, which has successfully expanded beyond its core LED business with its Wolfspeed division that develops custom chips for power applications that figure prominently in electric vehicle development, both delivered gains in a quarter that saw 10 of the 11 sectors in the benchmark fall sharply. In addition, Broadcom followed through on a pledge to return cash to shareholders, raising its dividend 50%.
Recent results have been in-line with the market despite a significant performance headwind from our energy exposure. Crude oil prices plummeted more than 35% during the quarter due to oversupply from U.S. shale drillers, Saudi Arabia and Russia coupled with the perception of lower demand from slowing global growth. The energy sector (-31.05%) was by far the worst performer in the benchmark, with declines in the share prices of exploration & production and oil service companies exaggerated by year-end tax-loss selling and the liquidation of commodity-focused hedge funds. The portfolio’s overweight to energy as well as generally negative sentiment toward the sector failed to spare even companies with strong balance sheet discipline.
In these markets, price tends to cure price. The lower oil prices go, the more companies and countries will be forced to cut production. This dynamic could result in a quicker normalization of supply and demand and higher prices in a shorter period of time. Cash flow producing enterprises and assets have a clearing price and we expect to see both strategic and private equity purchases of high-quality assets trading at depressed valuations. Our largest exploration & production holdings own such assets and could be attractive targets for larger buyers. On the services side, while the decline in the spending cycle has been deeper and longer than we had forecast, equipment inventories remain incredibly low. We believe we are overdue for an equipment refresh cycle and that demand will pick up for next generation technologies. Additionally, the industry may consolidate to leave stronger companies with better products and technologies.
Innovation should also be a driver of improved performance in the biopharmaceutical industry. 2018 saw a record number of first-cycle treatment approvals from the FDA and regulators will continue to fast track therapeutics that serve unmet needs. These are the types of compounds in clinical development at portfolio companies Biogen and Vertex Pharmaceuticals. The year also witnessed
a record amount of capital markets activity, a trend that continued in early 2019 with Bristol-Myers Squibb’s $74 billion offer for Celgene (the portfolio does not hold either stock). We believe these clinical and consolidation trends could lead to a meaningful rerating of profitable health care stocks.
Volatility remains at elevated levels compared to the recent past and should settle into a more normalized range going forward. This is the type of environment that separates quality, competitively-advantaged companies from those lifted by easy financial conditions and broad market trends. We believe financial discipline and valuation will be key drivers of performance in the year ahead. Signs of a pickup in merger & acquisition activity, the outperformance of cash-rich companies across the market and the resetting of prices in distressed areas like energy all point to what we expect to be a productive year.
We are encouraged that the market climate has changed, and risk has started to be priced into stocks. Investor pessimism has risen to extreme levels and we feel the most optimistic about the broad market since making our call of a market bottom in early 2016. Market psychology tends to repeat and the sentiment surveys that we follow, which are contrarian indicators, suggest the declines of the fourth quarter along with a pull-back in interest rates could set up a meaningful leg up for equities in 2019. Importantly, as well, the portfolio valuation vis-à-vis the market is close to its biggest discount in nearly two decades.
The ClearBridge Multi Cap Growth Strategy outperformed the Russell 3000 Growth Index benchmark during the fourth quarter. On an absolute basis, the Strategy had losses across the seven sectors in which it was invested (out of 11 sectors total). The primary detractors from performance were the health care and IT sectors.
Relative to the benchmark, overall stock selection contributed to performance. In particular, stock selection in the IT and communication services sectors as well as an overweight to health care were the primary contributors to performance. On the negative side, an overweight to the energy sector and stock selection in the energy, industrials and materials sectors were the primary detractors from relative returns.
On an individual stock basis, positions in Broadcom, Cree and Ionis Pharmaceuticals were the leading contributors to absolute returns during the quarter. The largest detractors included Allergan, Anadarko Petroleum, L3 Technologies, Biogen and Autodesk.