- Negative clinical news from a large biotechnology holding hurt results but we remain confident innovation in the health care sector will be rewarded.
- Mega cap technology stocks continued to outperform in a market that saw a broadening of leadership.
- The current environment remains favorable for undervalued growth companies with strong competitive positions and healthy free cash flow generation.
Market Overview and Outlook
U.S. equities rebounded strongly in the first quarter, with the market producing its best start to a year since 1998. The S&P 500 Index advanced 13.65%, the small cap Russell 2000 Index added 14.58% while the Russell 3000 Index rose 14.04%. Growth stocks maintained an advantage over their value counterparts with the benchmark Russell 3000 Growth Index gaining 16.18%, outperforming the Russell 3000 Value Index by 425 basis points.
Stocks were boosted by signals that the U.S. Federal Reserve is winding down its tightening program, better than expected fourth-quarter corporate earnings results and a positive outlook on the resolution of U.S.-China trade tensions. These factors led to a return in risk taking and a dampening of volatility from recent highs in December.
Returns in January and February were reminiscent of market trends over the last several years, with mega cap information technology (IT) and Internet stocks delivering strong results. Unlike the narrower market leadership in 2017 and most of 2018, however, that performance came within an environment of broader market participation with notable improvements in cyclical sectors like industrials. The NYSE advance-decline line, a popular measure of market breadth, hit new highs in the first quarter (Exhibit 1).
Exhibit 1: Market Breadth Continues to Improve
IT (+21.48%) and real estate (+18.93%) were the best-performing sectors in the benchmark while the cyclically oriented industrials (+16.00%), energy (+15.89%), consumer discretionary (+15.43%) and materials (+15.20%) sectors also delivered strong results.
We saw this broadening both across sectors and within IT, the largest sector in the benchmark by a factor of two. Mid cap tech stocks like portfolio holdings Seagate Technology and Western Digital delivered solid performance during the quarter in anticipation of better second-half demand and pricing for data storage. In addition, design software maker Autodesk, diversified chip maker Broadcom and Cree, a developer of LED products that is gaining share in the nascent market for power management chips for electric vehicles, continued their solid execution from the fourth quarter. What all these companies have in common are leading positions and intellectual property in industries with high barriers to entry. Despite strong returns, our IT holdings trailed the returns of the larger, more consumer-oriented FAANG stocks.
Health care was the main detractor during the quarter, due primarily to the sharp selloff in Biogen shares after it discontinued clinical trials for Alzheimer’s treatment aducanumab. As shareholders of Biogen and other biotechnology companies for decades, we look for long-term, innovative business models with disruptive science at the core while understanding the binary nature of clinical outcomes. We understood that Alzheimer’s is a high risk/high reward market (given the size of the unmet medical need) which made the aducanumab program one that, if successful, would have generated a substantial return on capital.
Without aducanumab, Biogen still maintains a solid base business in MS and rare diseases that in 2019 should generate over $8 billion in revenue and close to $5 billion in free cash flow from its diversified drug portfolio. This cash can be put to work to acquire new products or return cash to shareholders. In late March, after the Alzheimer’s program failure, the company announced a $5 billion stock buyback, a move we view as attractive given its low valuation on current earnings per share. Sales of Spinraza for the rare disease spinal muscular atrophy should reach $2 billion this year — a trajectory that helped co-developer and portfolio holding Ionis Pharmaceuticals rise 50% in the first quarter.
We also see promise in the company’s pipeline. Biogen has a number of development-stage assets for neurologic conditions and rare diseases and remains a leader in neurology R&D, which could lead to additional pipeline successes over time. Such characteristics could also make the company attractive to larger pharmaceutical companies in an environment where health care M&A activity has been picking up.
While the Alzheimer’s failure highlighted clinical risk, we feel that biotech companies today still offer tremendous opportunity. The stocks trade at historically low valuations relative to the markets for existing therapies and potential treatments in the pipeline. Many of these companies are more profitable than ever and are being supported by an FDA that is fostering innovation and the fast tracking of treatments for unmet needs earlier in disease progression when they can be most effective.
Media stocks also delivered mixed results to start the year. Comcast, the portfolio’s largest holding, was a leading contributor as diversified owners of both content and distribution rebounded from recent lows. Comcast is generating solid performance in its cable business, is already seeing a lift from its recent acquisition of Sky and is taking a prudent path toward expansion into the streaming video market. Tapping its consistent free cash flow growth, the company continued to return cash to shareholders during the quarter through a dividend increase. Pure play content programmers like AMC Networks and Discovery, however, underperformed due to ongoing uncertainty about the threats posed by growing competition from streaming providers. This is another part of the market where valuations remain compelling and the potential for further consolidation remains high.
Oil prices continued to rebound from their December trough, with WTI crude rising 32% during the quarter. Prices are recovering as an oversupply situation is being corrected by production cuts from Saudi Arabia and U.S. shale drillers, sanctions on Iranian exports and political unrest in Venezuela that has crimped operations.
Energy stocks have not kept pace with recovering commodity prices and their valuations remain compressed. We believe, however, that the exploration & production industry’s focus on financial discipline, returns, and free cash flow generation lines up closely with the objectives of our portfolio companies and should allow them to perform well in the current commodity price environment. In the oil services industry, meanwhile, demand for new drilling technologies and replacement of aging equipment should continue to recover after several years of depressed capital spending.
Ten years into the current bull market, stocks remain close to all-time highs, yet multiples look reasonable. We see no signs of a bubble in terms of valuations, investor sentiment or interest rates. In fact, the portfolio continues to trade at one of its widest ever valuation discounts to the market. This sets up a good backdrop for long-term business owners like us.
The Multi Cap Growth Strategy has never been managed to a benchmark and in periods where high-beta stocks with heavy passive ownership do well, our limited exposure to such companies can be a headwind. As we have discussed over the last several months, broader participation from companies in undervalued and underowned areas such as health care, cyclical technology and media bodes well in extending the bull market. From large sums of private equity on the sidelines ready to be put to work to compelling multiples across many areas of the market, we think there is a lot that can go right for the portfolio from current levels.
The ClearBridge Multi Cap Growth Strategy underperformed the benchmark Russell 3000 Growth Index during the first quarter. On an absolute basis, the Strategy had gains across six of the seven sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the IT and communication services sectors.
Relative to the benchmark, overall stock selection and sector allocation detracted from performance. In particular, stock selection and an overweight allocation in the health care sector were the primary detractors from performance. Stock selection in the IT, energy, consumer discretionary and communication services sectors also hurt results. On the positive side, stock selection in the industrials sector and a lack of exposure to the consumer staples sector contributed the most to relative returns.
On an individual stock basis, positions in Broadcom and Autodesk in the IT sector, Comcast in the communication services sector, Ionis Pharmaceuticals in the health care sector and L3 Technologies in the industrials sector were the greatest contributors to absolute returns. The largest detractors included Biogen, ImmunoGen and UnitedHealth Group in the health care sector, Qurate Retail in the consumer discretionary sector and Citrix Systems in the IT sector.