- Improving performance of energy stocks is an encouraging signal of a broadening market.
- The FDA is embracing innovation and fast tracking to market treatments for unmet needs, which should be a catalyst for biopharmaceutical stocks.
Stocks snapped a two-month losing streak in April, with the S&P 500 Index and Russell 3000 Index both adding 0.38% while the small cap Russell 2000 Index gained 0.86%. Markets were more balanced in terms of leadership than we have seen in some time, with the Russell 3000 Value Index slightly outperforming the benchmark Russell 3000 Growth Index by 10 basis points.
Equity volatility has retreated from its recent highs but remains in a more normal range than markets experienced in 2017. We continue to believe that volatility is a necessary ingredient to remove the investor complacency that has caused crowding in mega cap technology and give way to a market with broader participation from different sectors. The outperformance of the energy and health care sectors during the month is an encouraging sign.
WTI crude oil prices rose 5.6% during the month and are up 14% in 2018. After a 15-month disconnect between crude and energy stock prices, the sector is now rising in line with higher commodity prices. We are finally seeing a rerating higher in some of the big independent E&P companies like portfolio holding Anadarko Petroleum, which has increased its already generous stock buyback program this year and raised its dividend five-fold early this year. It can do this because at $65 to $70 crude, Anadarko and other disciplined drillers are generating billions of dollars of free cash flow. They look extremely undervalued still, relative to where oil prices are trading. On the supply side, inventories are coming down, production disruptions are occurring around the world, OPEC is honoring its production cuts and U.S. shale drilling is not coming back as quickly as expected. On the demand side, global-coordinated growth is increasing consumption.
We believe the outlook for energy companies remains favorable. While oil services companies have lagged to this point, we think the setup remains favorable given the spending backlog and potential for consolidation activity. The sector represents a significant opportunity and is our second largest active overweight versus the benchmark (+1,045 bps).
"2018 is shaping up like past years where the popular trade begins to unwind."
Biopharmaceutical companies, which comprise a significant portion of our health care overweight (+1,912 bps), could also benefit from a catalyst that is being largely overlooked by the market: a supportive FDA. FDA Commissioner Scott Gottlieb has made it very clear that he wants to distinguish between innovators targeting rare diseases and unmet needs like ALS and Parkinson’s, and companies producing treatments in more competitive areas with generic options. We believe companies like Vertex Pharmaceuticals and Biogen should have pricing power as well as the ability to invest in R&D and bring drugs to market sooner where patient populations are in significant need of new therapeutics.
The FDA is modernizing the way it thinks about unmet needs such as Alzheimer’s, muscular dystrophy, and even migraines, and wants to bring drugs to market sooner in disease progression. This is a key point and a real positive for the sector as often drugs currently come to market for these unmet needs too late in disease progression after significant disability has occurred and where a reversal of this disability is difficult. Screening for at-risk populations and treating patients earlier could be a boon for the innovators.
2018 is shaping up like past years where the popular trade begins to unwind. Over the last several years, there was little volatility and a relatively narrow, top-heavy market. Not owning mega-cap technology made it tough to beat the market. So far this year, there has been a return of volatility and the potential for new leadership which could include energy, health care and undervalued segments in media. The S&P 500 is negative for the year through April and we would not be surprised to see choppiness continue. Generally, when we see a major shakeout in the market like the correction in February, when the next advance begins, it tends to be led by a different segment of the market. We think these are the very early days of seeing this leadership change.
The ClearBridge Aggressive Growth Strategy underperformed its Russell 3000 Growth Index benchmark for the month of April. On an absolute basis, the Strategy had gains in two of the eight sectors in which it was invested (out of 11 sectors total), energy and health care. The main detractors from performance were the consumer discretionary and information technology (IT) sectors.
Relative to the benchmark, overall stock selection detracted from performance but was partially offset by positive sector allocation effects. In particular, stock selection in the consumer discretionary and IT sectors hurt relative performance. Meanwhile, an overweight and stock selection in the energy sector contributed the most to relative returns.
On an individual stock basis, positions in UnitedHealth Group, Anadarko Petroleum, Core Labs, Newfield Exploration and Discovery were the greatest contributors to absolute returns during the month. The largest detractors included Comcast, Allergan, Western Digital, TE Connectivity and Liberty Broadband.
During April, the Strategy closed positions in Fitbit in the IT sector and Mallinckrodt in the health care sector.