- Rising levels of uncertainty and volatility sparked the beginning of a rotation out of the momentum leadership of the last several years into undervalued areas of the market.
- Health care and energy were areas of weakness, hurt by political rhetoric over changes to the health care system and fears over global oil demand.
- Broadening market participation, coming on the heels of increasing M&A activity, are encouraging signs that investors are beginning to recognize companies with strong competitive positions and free cash flow profiles.
Investors’ affinity for the largest growth and momentum stocks waned during the third quarter as trade and geopolitical tensions sparked a rotation into more undervalued parts of the market. The S&P 500 Index rebounded from a late summer selloff to finish the quarter in the plus column with a gain of 1.70%. The Russell 3000 Index rose 1.16% while the small cap Russell 2000 Index declined 2.40%. Value stocks snapped a long run of dominance by growth, with the Russell 3000 Value Index outperforming the benchmark Russell 3000 Growth Index by over 350 basis points in September to finish the quarter up 1.23% compared to a gain of 1.10% for its growth counterpart.
The higher-yielding utilities, real estate and consumer staples sectors – areas where the Strategy has no exposure – were the best-performing sectors of the market, while the energy and health care sectors – two areas the Strategy is overweight – fell the most. In sectors where the pull of passive momentum buying is strongest, information technology (IT) topped the benchmark while communication services and consumer discretionary both lagged.
The strong performance of the FAANG stocks over the last several years, driving major indexes to near all-time highs, has masked a meaningful correction or bear market in many other areas of U.S. equities. While this mega cap dominance has pushed the market multiple to above-average levels, the majority of stocks in our growth universe still trade at depressed valuations. Shifts in leadership like we saw during the quarter are early and encouraging signs that should pave the way for the fundamentally sound but under-owned companies we hold in the portfolio to be monetized.
One sign of evidence of the rotation and mean reversion is in the media space, which today falls into the communication services sector. We commented last summer that streaming media service Netflix traded at an exceedingly high multiple of cash flow while running a free cash flow deficit. At the time, Netflix had a higher market cap than diversified media and content provider Comcast, which generates north of $10 billion in free cash flow per year while trading at a single digit multiple of EBITDA. Since then, a handful of media companies have jumped into the streaming market, forcing Netflix to keep spending aggressively to develop new content. Over a volatile third quarter, Netflix — which we do not hold — endured a correction as the risks of its business model became evident to investors, while Comcast outperformed the market. The performance gap has widened even more over the last year with Comcast, the portfolio’s largest holding, now worth about $80 billion more than Netflix.
In short, we are long-term business owners who don’t chase prices. We would rather own a business that has valuation support and diversity. The same applies in IT, where we have avoided the highly valued and increasingly crowded mega cap companies and instead target earlier-stage growth companies in areas where they hold a strong competitive advantage, like Seagate Technology and Western Digital in storage and Cree, whose technologies serve the fast-growing opportunity for silicon carbide–based power chips used in electric vehicles. Cree has struggled through several quarters of volatile results as it transitions out of the LED component and lighting markets into power and radio-frequency chips and we have added to our position on price weakness.
"In IT, we have avoided the highly valued mega caps and instead target earlier-stage growth companies where they hold a strong competitive advantage."
While the picture is improving for the companies we favor, the Strategy underperformed for the quarter, due primarily to our overweight exposure to health care, and to a lesser extent, energy. Health care sentiment has remained poor as political rhetoric heats up over potential changes to the U.S. health care system. The 2020 presidential election is an overhang for the sector and the improving poll numbers for Democratic candidates pushing a “Medicare for All” system specifically hurt UnitedHealth Group (UNH), the nation’s largest managed care provider. While UNH would be hurt by such an overhaul, we believe such a scenario is unlikely. The service innovations the company has put in place are part of the solution to managing health care costs. In fact, government agencies lack the expertise and infrastructure to implement significant changes to health care and would be reliant on providers like UNH to do so. In addition, the company has successfully diversified its business and now generates nearly half of its operating income from non-managed care services. Biotechnology companies have also been pressured by the risk of prescription drug pricing controls. This too is sentiment driven and we maintain confidence that the scientific breakthroughs our holdings are developing in areas like rare diseases will be less susceptible to pricing competition.
Oil prices endured a volatile quarter that saw WTI crude spike as high as $63 per barrel after drone attacks on the Abqaiq oil processing plant in Saudi Arabia removed 5.7 million barrels a day, or roughly 5%, of oil output from world supply. The oil price rally proved to be short-lived, however, as signs of slowing global growth and the continuing uncertainty surrounding U.S.-China trade tensions still point to lower demand conditions. A barrel of WTI crude ended the quarter down 7% at $54. In the recent past, such a supply disruption would have driven U.S. exploration & production companies to ramp up production. But today, companies are exhibiting greater capital discipline and focusing on generating free cash flow over production growth. This approach will eventually be appreciated by investors, who have mostly avoided the sector, which should cause the wide gap between oil prices and energy stock valuations to narrow.
We have always constructed the portfolio to target undervalued growth franchises with strong competitive positions and healthy free cash flow generation. This causes us to look quite different from the benchmark and has historically provided a good source of less correlated returns compared to passive and low active share growth strategies. Over the last several years, market momentum has kept investors committed to technology and Internet companies with the highest degree of ownership, but in 2019, we have written about the signs that give us confidence that such crowding is beginning to dissipate. Earlier in the year, merger & acquisition activity in energy, health care and media began the process of monetizing assets in these areas that had been trading at unsustainably low valuations. The sector rotation we experienced this past quarter is the latest indication of a broadening of market leadership.
The ClearBridge Aggressive Growth Strategy underperformed its Russell 3000 Growth Index benchmark for the third quarter. On an absolute basis, the Strategy had gains across five of the eight sectors in which it was invested (out of 11 sectors total). The primary contributors came from the IT and industrials sectors, while the primary detractor was the health care sector.
Relative to the benchmark, overall stock selection and sector allocation detracted from performance. In particular, overweight allocations to the energy and health care sectors as well as stock selection in health care and IT hurt relative results the most. On the positive side, stock selection in energy and an underweight to the consumer discretionary sector aided performance.
On an individual stock basis, positions in Seagate Technology, Comcast, Twitter, Western Digital and L3Harris Technologies were the greatest contributors to absolute returns during the quarter. The largest detractors included UnitedHealth Group, Discovery, Autodesk, Cree and Vertex Pharmaceuticals.
During the quarter, we closed a number of minimal positions in the health care sector, including Aduro BioTech, ProQR Therapeutics and Wright Medical Group, and the communication services sector, including Liberty TripAdvisor and Liberty Latin America. The Strategy also received shares of L3Harris Technologies following the merger of portfolio holding L3 Technologies and Harris Corp as well as shares of Occidental Petroleum following the closure of its acquisition of portfolio holding Anadarko Petroleum.