- Equities touched new highs, with performance broadening across the market to include more cyclical and undervalued areas.
- Two major acquisitions in the energy and health care sectors could be the catalysts to drive a change in market leadership away from mega cap momentum stocks.
- Our technology and health care exposures were performance headwinds but the long-term outlook for both groups remains encouraging.
Market Overview and Outlook
Equities endured a roller coaster ride during the second quarter, with mega cap growth stocks leading the U.S. market to new record highs. The S&P 500 Index gained 4.30% during the quarter and is up 18.54% year-to-date, its best first-half showing since 1997. Meanwhile, the Russell 3000 Index added 4.10% while the small cap Russell 2000 Index rose 2.10%. Growth once again outperformed value, with the benchmark Russell 3000 Growth Index advancing 4.50% for the quarter to post a first-half return of 21.41%, topping its value counterpart by 82 basis points for the quarter and 536 bps year-to-date.
The U.S. Federal Reserve jumpstarted the latest up leg for equity markets as June remarks by Fed Chairman Jerome Powell took a decidedly dovish tone that hinted at future interest rate cuts. Both stocks and bonds rallied on the news, with the 10-year U.S. Treasury yield retreating 40 basis points to finish the second quarter at 2.0%. A suddenly accommodative Fed helped offset volatility caused by heightened trade tensions between the U.S. and China and increasing signs of a slowing global economy.
The portfolio lagged the benchmark for the second quarter, hurt primarily by our exposures in the information technology (IT), health care and materials sectors. The market has become increasingly concentrated in mega cap IT stocks, namely the FAANGs and Microsoft, which constitute over 25% of the Russell 3000 Growth Index. Avoiding this momentum trade in favor of undervalued companies primarily in IT, health care, media and energy has detracted meaningfully from relative performance over the last several years.
We have been calling for a rotation in market leadership and have seen signs emerge over the last several quarters. As we wrote at the end of 2018:
“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.”
Cyclically oriented industrial and energy stocks were among the best performers in a first quarter that saw broader market participation while financials (+8.39%) and materials (+7.04%) both outperformed IT (+6.48%) in the second quarter. But the real evidence came with the announcement of two significant acquisitions of portfolio holdings this quarter in the energy and health care sectors that support our thesis that M&A will be a primary catalyst of leadership change (Exhibit 1).
Exhibit 1: Increased M&A Activity Could Broaden Market Leadership
In May, Anadarko Petroleum agreed to be acquired by Occidental Petroleum, which outbid Chevron for the exploration & production (E&P) company. Anadarko, which we have owned since 2003, is being acquired at a significant premium to where its shares were trading prior to the announcement of deal talks. Both companies were attracted to Anadarko’s disciplined execution which, in a period of accelerating U.S. shale production, has been focused on generating free cash flow, reducing debt through asset sales and returning capital to shareholders. Anadarko also maintains an attractive asset base in the shale-rich Permian Basin.
The Anadarko deal further consolidates the E&P sector, which demonstrates that during a period of range-bound commodity prices the industry needs to shrink to remain efficient. The stocks of energy companies have been disconnected from crude oil prices since 2016 (Exhibit 2), but we believe a leaner E&P industry has a greater chance of being valued in line with fundamentals. Oil services stocks have also lagged due to depressed capital spending on offshore and international production. The potential for consolidation here, as well as the likelihood of an equipment refresh cycle in the second half of the year, could help monetize the value of the services companies we own. Companies with strong balance sheets and business models stand to gain share in the downturn and emerge in a stronger competitive position on the other side of the cycle.
Exhibit 2: Energy Stocks and Oil Prices Remain Far Apart
Health care, which represents the portfolio’s largest overweight, has faced performance headwinds similar to energy over the last several years. The seemingly constant threat of prescription drug pricing reform as well as the potential for a major overhaul to the health care system has caused investors to largely stay away from the biopharmaceutical companies that constitute the bulk of our exposure. Innovative, mid cap biotechnology holding Ionis Pharmaceuticals bore the brunt of negative investor sentiment in the second quarter. The threat of generic competition for leading branded treatments has also weighed on valuations, causing companies generating billions of dollars of cash flow, developing breakthrough treatments and with compelling product pipelines to trade at historically low multiples. As we wrote in May:
“We remain convinced that Allergan maintains one of the most attractively priced businesses in the biopharmaceutical industry and that pipeline treatments nearing commercial approval are not being properly discounted by the market.”
We have stated repeatedly that such dislocations from fundamentals could not continue indefinitely and that investors would eventually find ways to extract value from these stocks.
The announcement of a proposed acquisition of Allergan by rival drug maker AbbVie late in the quarter is one such way this monetization will happen. Allergan shares climbed 40% following the news but are still trading at less than half their previous high. It will take some time, but we think the deal can be accretive to AbbVie and has the best chance of realizing the brand value of Botox and other leading treatment franchises of the combined company. The deal validates our approach as engaged long-term shareholders and the consistency of our process of identifying companies which we view as dramatically mispriced in the public markets and helping managements realize their value over time.
"Another encouraging sign of broadening leadership has been the media industry."
Another encouraging sign of broadening leadership has been the media industry. After being under a cloud of uncertainty over cord cutting and bidding wars for premium content assets, the media names we own have been strong performers year-to-date. Comcast continues to execute and is beginning to realize the synergies of its greater global scale from the acquisition of Sky. Discovery is also being more recognized for its earnings power and the value of its programming assets.
The portfolio’s IT holdings were a significant detractor during the quarter, hurt by trade restrictions placed on Chinese telecom equipment maker Huawei as well as a slowdown in cloud and storage demand. Broadcom, a major supplier of chips to Huawei and rival smartphone maker Apple, missed earnings forecasts and sharply reduced guidance due to the Huawei ban. Western Digital, meanwhile, suffered a power outage during the quarter that impacted production of NAND flash memory. While the outage will hamper near-term results, it should act to balance an oversupplied market and help stabilize pricing, a move that should help both Western and Seagate Technology. The Trump administration’s lifting of the ban on selling to Huawei in late June, meanwhile, has caused suppliers like Broadcom to rally. We continue to favor these companies, which have more of a focus on enterprise customers than the consumer-oriented FAANG stocks, and believe they possess valuable intellectual property similar to that enjoyed by our holdings in the biotechnology industry.
Our outlook remains favorable for undervalued growth companies with strong competitive positions and healthy free cash flow generation. We choose to own a select group of multicap companies with unique assets that have historically been monetized through operational execution or consolidation. In contrast, the leading positions in our benchmark trade in excess of $500 billion in market cap. While disappointed with our recent results relative to the benchmark, we have noted the historically attractive valuations we continue to see across the areas of the market we favor. We are confident that over the next three to five years, our emphasis on owning companies that are driving disruption, innovation and delivering durable growth will be amply rewarded.
The ClearBridge Multi Cap Growth Strategy underperformed its Russell 3000 Growth Index benchmark in the second quarter. On an absolute basis, the Strategy had gains across four of the seven sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the industrials and energy sectors.
Relative to the benchmark, overall stock selection contributed to performance but was offset by the negative impact of sector allocation. In particular, stock selection in the energy, industrials and communication services sectors aided performance. Conversely, stock selection in the IT, materials and health care sectors and overweight allocations to health care and energy hurt relative results.
On an individual stock basis, positions in Anadarko Petroleum, L3 Technologies, TE Connectivity, Allergan and Comcast and were the greatest contributors to absolute returns during the quarter. The largest detractors included Ionis Pharmaceuticals, Broadcom, Freeport-McMoRan, Qurate Retail and Weatherford International.
During the second quarter, we initiated a position in FireEye in the IT sector. FireEye is a leader in incident response and threat remediation, helping enterprises in the event of a major security breach, a risk that has become a CEO-level priority across most enterprises and one that is more immune from cyclicality than other technology spending. The company is cash flow positive and trades at a significant valuation discount to many of its cybersecurity peers. We believe FireEye’s early adoption of cloud, subscription and managed security as a way to offer security services, and focus on cash flow, give it a competitive advantage.
We also closed a position in Weatherford International in the energy sector after the company announced a restructuring of its business due to liquidity and financing constraints. New management led by CEO Mark McCollum had been pursuing a turnaround plan, selling non-core business units and other assets while working to reduce debt. Since the stock had traded down substantially, we believed this to be a high risk/reward situation. We stated previously that the probabilities of success through both improved operational execution and other restructuring options were not being properly discounted, but we underestimated the length and depth of the down cycle in the oil services business.