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Commentary

Large Cap Value Strategy

First Quarter 2019

Key Takeaways
  • The U.S. equities market had a strong recovery in the first quarter of 2019 as fears of a slowing economy and rising interest rates abated.
  • The portfolio performed well in the first quarter and contributions were broad-based, including consumer staples and media companies.
  • Despite short- and medium-term market volatility, we expect investing in equities of quality
    businesses trading at attractive valuations to result in long-term value creation.
Market Overview and Outlook

The U.S. equities market had a strong recovery in the first quarter of 2019 as fears of a slowing economy and rising interest rates abated. Sentiment toward economic growth improved, driven by positive signs from U.S.-China trade negotiations and a more dovish stance from the Federal Reserve. The broader market, as measured by the S&P 500 Index, rose by 13.7%, its largest quarterly gain since 2009. Investors shrugged off a rough fourth quarter, a 35-day U.S. government shutdown and an inversion of the 3-month/10-year yield curve, which transpired after the March FOMC meeting, to push stocks higher. All the same, investors are wary of indicators that may suggest an economic slowdown.

The U.S. economy continued to expand at a healthy rate, albeit more slowly than the 4.2% it reached in the second quarter of 2018. U.S. GDP grew at an annualized 2.6% in the fourth quarter. The labor market showed mixed signs, adding a robust 311,000 jobs in January only to disappoint with 20,000 in February, while unemployment remained at historical lows and inflation just under the Fed’s target rate of 2%. The Fed held rates steady in January and again in March, while lowering its forecast for future hikes due to slower expected growth. Central banks grew more dovish internationally as well, with the European Central Bank lowering its inflation projection and growth forecast and China weighing more aggressive stimulus measures. Oil prices recovered after plummeting in the fourth quarter as the trade outlook improved and OPEC maintained previously announced temporary production cuts. Given a pause in short-term interest rate hikes, the yield on the U.S. 10-Year Treasury edged lower to finish the period at 2.41%, as some market participants interpreted the Fed’s “balanced” view of the economy as a possibility of a near-term rate cut.

The first quarter of 2019 was in many ways a mirror image of the previous quarter. The Russell 1000 Value Index turned from a 12% loss in December to a largely offsetting rise in the first quarter. In both cases, participation was broad across sectors. In the fourth quarter, cyclical industrials and energy stocks dragged the market lower; in the first quarter, they were among the leading sectors. The portfolio performed well in the first quarter and contributions were broad-based.

Our consumer staples holdings Philip Morris and Anheuser-Busch InBev did well during the quarter, recovering after a difficult 2018. Last year Philip Morris was hit by slower than expected, yet still healthy, adoption of next-generation reduced risk products in Japan and potential disruption from vaping products, while Anheuser-Busch InBev suffered from weaker emerging markets currencies, which negatively impacted cash flows and put the company’s relatively high balance sheet leverage in focus. During the period, Philip Morris reported solid fourth-quarter 2018 results and offered reassuring guidance for 2019 and beyond, which was well received by investors. Similarly, Anheuser-Busch InBev offered reassurance of stronger volume growth and solid expected profitability.

Our media holdings also enjoyed a good quarter, led by Charter Communications and Comcast. Amid an ever-changing media and telecom landscape in which fears over cord-cutting and competition from over-the-top streaming services have weighed on pay-TV providers, Charter has been able to grow revenue and cash flows by offering attractively priced broadband-centered bundles as it completes its multiyear integration of Time Warner Cable, which it acquired in 2016. Following the lead of Comcast, Charter is beginning to ramp up its mobile service, which over time should not only improve customer retention, but also layer in another profit stream to sustain and extend the overall company growth profile.

Meanwhile, less economically sensitive health care stocks generated positive returns but trailed the broader market partially due to political and regulatory concerns. Increasing pressure from the administration as well as the Senate’s drug pricing hearing, in which both pharmaceutical companies and pharmacy benefit managers (PBMs) such as CVS’s Caremark and UnitedHealth’s OptumRx came under pressure as the government pushed for lower drug inflation and greater drug price transparency. Managed care stocks were also negatively impacted by the resurgence of Medicare for All proposals that have re-entered the national conversation. Similar to media, health care is a sector in transition, as industry participants are trying to engineer a more efficient delivery of health care with better outcomes and lower costs. In addition to dealing with the industry-wide dynamics, CVS also has the added challenge of integrating its Aetna acquisition while at the same time experimenting with new store formats. Although, as with any large transaction such as the CVS/Aetna deal, there are execution and integration risks, we continue to think CVS has a unique set of assets and a strong management team that should be able to adapt to the new realities of the health care industry.

 

"The first quarter of 2019 was in many ways a mirror image of the previous quarter."

 

While financials generated about 9.7% absolute return during the period and attributed positively to the overall portfolio performance, the sector came under pressure late in the quarter as the market rapidly digested the Fed’s expectation of no additional rate hikes in 2019 and the possibility of future rates cut entered the conversation. Many financial services stocks remain economically sensitive; however, a decade after the Great Financial Crisis, it is our view that these companies have dramatically improved their risk profiles. Bank of America, for example, has significantly tightened its credit underwriting standards, increased capital and improved its risk management. Massive investments in technology have enabled the bank to gain a more accurate view of its credit risk exposures. As with our other financial holdings, we believe that Bank of America is well-positioned to generate strong returns for investors over the long term.

The market volatility experienced over the past two quarters is a healthy reminder of the short and medium-term risks inherent in equity investing. Nevertheless, we believe that a diversified portfolio of high-quality businesses at attractive valuations provides the best opportunity for long-term investors to compound wealth over time. As we mark the 10th anniversary of the current economic cycle, the U.S. economy remains strong. However, we recognize that the current expansion is one of the longest on record and will eventually come to an end. While not making macroeconomic predictions, and consistent with our investment philosophy, we continue to gradually reduce cyclicality and improve the quality of companies we own, while reducing leverage on the margin. We maintain a disciplined investment approach that focuses on competitively advantaged companies with strong business franchises capable of generating superior returns across cycles.

Portfolio Highlights

The ClearBridge Large Cap Value Strategy outperformed its Russell 1000 Value Index benchmark during the first quarter. On an absolute basis, the Strategy had gains in all 11 of the sectors in which it was invested for the quarter. The largest contributions came from the financials and information technology (IT) sectors. The consumer discretionary and utilities sectors contributed the least to Strategy performance.

On a relative basis, overall stock selection contributed to performance, partially offset by sector allocation. In particular, stock selection in the communication services, consumer staples and financials sectors contributed to relative results. The Strategy’s stock selection in the health care and industrials sectors, on the other hand, detracted. In terms of allocation, the Strategy’s cash position also detracted from relative returns.

On an individual stock basis, the largest contributors were Motorola, Honeywell, American Tower, Philip Morris and Comcast. Positions in CVS, Fox, Amgen, Berkshire Hathaway and Pfizer were the greatest detractors from absolute returns in the quarter.

During the quarter, we initiated a position in Berkshire Hathaway in the financials sector. In addition, Disney’s acquisition of certain assets of Fox, a portfolio holding, closed during the quarter; we received cash for those assets and retained the spinoff Fox entity (mostly comprising Fox’s sports and news assets) in the portfolio.

Robert Feitler

Portfolio Manager
25 Years experience
24 Years at ClearBridge

Dmitry Khaykin

Portfolio Manager
23 Years experience
16 Years at ClearBridge

Related Perspectives

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  • Large Cap Value Strategy
    4Q18 Commentary: Slowing global growth and rising short-term interest rates lowered valuations to more attractive levels.
  • Large Cap Value Strategy
    3Q18 Commentary: A broad-based catch-up trade in health care helped create a very strong quarter for equities.
  • Large Cap Value Strategy
    2Q18 Commentary: M&A activity took on an increasingly prominent role, while financials and health care stocks drove portfolio returns.

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  • Past performance is no guarantee of future results.

  • All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.
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