- Volatility spiked during the month with momentum and energy stocks bearing the largest losses.
- Solid execution is beginning to be rewarded in some undervalued areas of the market, particularly among media companies.
- We believe the midterm elections could be a clearing event that motivates companies to start putting cash to work in productive ways.
Volatility returned to the equity markets in force in October, with uncertainty ahead of the midterm elections, higher interest rates and ongoing trade concerns causing a broad decline in stock prices. The S&P 500 Index fell 6.83% over the month, the Russell 3000 Index dropped 7.36% while the small cap Russell 2000 Index tumbled 10.86%. The benchmark Russell 3000 Growth Index gave back 9.23% during October, trailing its value counterpart by 377 basis points as the momentum trade reversed.
A lot has changed in a few months. We have seen a broad correction in the Nasdaq Composite – down 13% from its all-time high in late August to a trough in late October – and an even deeper correction in several of the most crowded mega cap Internet stocks. Meanwhile, companies in underowned sectors including media, an area of focus for the portfolio, have been demonstrating resilience.
Comcast and Twitter, which now reside in the new communication services sector that includes media and Internet stocks, were positive contributors in a turbulent month that saw the CBOE Volatility Index trade well above average. Twitter delivered a beat and raise quarter with strength across most metrics, especially cash flow generation and earnings. Comcast maintained strong performance in the month following its successful bid for Sky, with good growth in its broadband and content divisions helping the company top earnings forecasts.
We believe the market could be entering an environment where strong earnings and free cash flow will be more important as the tailwinds of the momentum trade recede. Despite valuations being depressed across many areas of the market we target, our portfolio companies are delivering robust earnings growth in excess of our benchmark.
Health care has been another sector with strong operating results. However, stock prices are not yet reflecting the solid fundamentals and encouraging clinical trial data from portfolio companies Biogen, Amgen and Allergan as negative sentiment continues to cause multiples to contract. We believe an uptick in buybacks from these cash-rich businesses could help valuations begin to catch up.
"The market could be entering an environment where strong earnings and free cash flow will be more important."
Oil prices weakened with the equity market in October as the price for a barrel of crude (WTI) fell from $73.25 to $65.30. Concerns about the health of the Chinese economy and threats to demand growth from rising trade tensions have seen crude retrace much of its 2018 gains. Energy stocks have had difficulty in a period of rising commodity prices and things could get tougher as crude weakens. We still have confidence that E&P company Anadarko Petroleum is doing the right thing to be successful in this cycle. We are more disappointed, however, in the oil services names which have yet to realize the benefits of expected increases in capex among their drilling customers. Weatherford International is a services name we own that has been drawing increasing scrutiny over its financial position. We are closely monitoring its liquidity position and the progress of its cost-cutting initiatives.
We are starting to see the change in market leadership we have been discussing for some time and believe the midterm elections could be a clearing event. Companies have been letting cash build and we expect some of it will be put to work through increased stock buybacks as well as a rise in M&A activity and capex. In this environment, we believe defensive names with the steady earnings and strong balance sheets we favor are well positioned to outperform the broad market and passive strategies.
The ClearBridge Aggressive Growth Strategy underperformed its Russell 3000 Growth Index benchmark for the month of October. On an absolute basis, the Strategy had losses in the eight sectors in which it was invested (out of 11 sectors total). The primary detractors from performance were the health care, energy and information technology (IT) sectors.
Relative to the benchmark, overall stock selection contributed to performance but was offset by negative sector allocation effects. In particular, stock selection in the communication services sector was the primary contributor to performance. Stock selection in the health care sector and an underweight to the consumer discretionary sector also aided relative results. On the negative side, stock selection in the energy and IT sectors and an overweight to energy weighed the most on relative returns.
On an individual stock basis, positions in Comcast, Twitter, Cree, Discovery and Nuance Communications were the greatest contributors to absolute returns during the month. The largest detractors included Biogen, Core Labs, Anadarko Petroleum, Allergan and Seagate Technology.