- Momentum continued to dominate performance in a snapback rally, expanding the widest dispersion between growth and value investment styles since the bursting of the dot.com bubble in early 2000.
- We have made meaningful moves over the last year to concentrate the portfolio in our highest-conviction ideas and better participate in a number of secular growth trends.
- Communication services and health care were detractors for the quarter but are positioned to benefit long-term from changes caused by the COVID-19 pandemic and an increase in M&A activity.
Equities staged a vigorous rebound in the second quarter, boosted by abundant liquidity from aggressive stimulus measures that helped narrow most of the losses suffered in the COVID-19-induced downturn. The S&P 500 Index delivered its best 50-trading day performance in history from bear market lows in late March (+39.6%) and finished up 20.5% for the quarter, its strongest showing in 22 years. Momentum and growth once again led the way, with the benchmark Russell 3000 Growth Index soaring 28% during the quarter to finish the first half up 9%. The growth index outperformed its value counterpart by more than 1,300 basis points (bps) for the quarter and is ahead over 2,550 bps year to date. The market has not seen such dispersion between investment styles since the late 1990s into early 2000 (Exhibit 1).
Exhibit 1: Russell 3000 Growth vs. Value Over the Last 25 Years
The ongoing dominance of the mega cap and momentum trade has created challenges from a relative performance standpoint but it has not dissuaded us from an approach that has created long-term value for our shareholders over several decades. The Multi Cap Growth Strategy underperformed in the second quarter because, with an active share above 90%, the portfolio looks very different from the benchmark. As long-term business owners, we seek to buy and hold attractively priced, profitable growth companies with high levels of free cash flow across the market capitalization spectrum. This creates a portfolio with a weighted average market cap approximately one-sixth that of the Russell 3000 Growth Index. The valuation discount of our holdings versus the index also remains among its widest in 20 years across most metrics, including forward price/earnings and price/sales ratios.
In the second quarter, stock selection within communication services was a detractor from performance. Twitter and Discovery saw strong engagement driven by stay-at-home consumer activity while Liberty Broadband and Comcast benefited from growth in high-speed broadband connections into homes. However, these strengths were more than offset by lower advertising spending due to a lack of live events and sports as well as increased cord cutting. The medium-term underperformance of programming companies AMC Networks and Discovery leaves both stocks with record-high free cash flow yields and record-low valuations. Longer-term, these gaps between public and private market values could lead to multiple expansion as well as the potential for M&A or leveraged buyout activity. We expect advertising growth to resume ahead of a broad economic recovery, aided by the return of live sports, which should provide a boost to the sector. Additionally, many programmers are now expanding internationally and bringing content direct to consumers through streaming platforms to capture a higher degree of the economics.
The Strategy’s health care exposure was the primary headwind to relative results, a recurring situation for most of the last five years due to fears over prescription drug pricing and broad government health care reform. The primary laggard in the second quarter was Biogen, which traded lower due to a court ruling that ruled its patent for multiple sclerosis treatment Tecfidera invalid. The decision comes after the company won a similar patent judgement in the first quarter. The Tecfidera patent has been challenged repeatedly and will now go to a Federal appeals court. The larger catalyst for Biogen remains aducanumab, its experimental Alzheimer’s treatment that it expects to file for FDA approval this quarter.
We believe the innovative drugs being developed by Biogen and Vertex Pharmaceuticals will ultimately be recognized for their ability to treat unmet needs earlier in disease progression, which can lead to significant cost savings in a health care system struggling with soaring costs. We expect the sector to resume leadership as a main driver of solutions to the COVID-19 crisis, including the need for more investment in early detection of disease by companies such as portfolio holding Guardant Health and prevention through vaccines to avoid future crises. The global pandemic also highlighted the need for greater investment to move critical components of the health care supply chain back to the U.S.
"The ongoing dominance of the momentum trade has not dissuaded us from an approach that has created long-term value for shareholders over several decades."
The IT and Internet segments are where we look most different from the benchmark due to our lack of exposure to the mega cap FAANG stocks and more recently, the high-multiple momentum names that surged in the second quarter as the Fed rewarded the market with liquidity. We have always believed that the primarily consumer markets served by Apple, Google and Netflix, for example, face significant competitive and regulatory pressures and the bidding up of their stock prices by passive investors makes them less attractive compared to many of the companies that enable their growth in the storage and connectivity markets.
Our IT exposure is currently focused on the long-term themes of 5G and infrastructure buildout through communications chip maker Broadcom, digital storage (Seagate Technology and Western Digital), cybersecurity (FireEye), electric vehicles (Cree and TE Connectivity) and speech recognition (Cerence and Nuance Communications). All of these stocks were strong performers in the quarter and all have the fundamentals to maintain and grow leadership positions in their respective end markets.
In light of the decline in oil prices caused by the coincident supply and demand shock recently, we exited our position in Occidental Petroleum. The portfolio originally received shares in Occidental through the Anadarko acquisition last year, of which approximately 80% of the proceeds were paid in cash. While the company has taken aggressive steps to manage costs during this period, with a meaningful dividend cut and an approximate 50% cut to capital spending in order to reduce the oil price required to generate free cash flow, significant near- and long-term debt levels remain. Given the lack of visibility on a long-term recovery in oil prices or on near-term asset sales to reduce leverage, we felt it prudent to exit the position and used it as a source of funds to reposition the portfolio in names with better lines of sight to growth with less balance sheet uncertainty. With the sale of Occidental, our energy exposure is the lowest in 20 years.
Meanwhile, we have increased the portfolio’s weightings in the IT and health care sectors — two areas where we are well-positioned to participate in innovative trends such as electric vehicles and gene therapy — in the last 12 months by 600 and 300 bps, respectively. Going forward, we are confident the stocks we own have the fundamentals and leading market positions in areas with durable growth characteristics to deliver consistent long-term returns for our investors.
We are surprised at the speed of the market recovery and the fact that stocks have not retested their March lows. Equities are responding to abundant stimulus and liquidity, but this could result in unintended consequences (as speculation has grown and excessive valuations are being largely ignored in certain sectors). We are also less constructive on a rapid, V-shaped economic recovery barring the discovery of a vaccine or scientific breakthrough to treat COVID-19. Many stocks and sectors are already pricing in a quick recovery to full economic growth and others looking very expensive. Some companies in software and Internet services now trade at 20x to 40x sales with little or no profits, while other sectors like health care and media are mired at historically low multiples.
The market is experiencing a heavy degree of retail participation and speculation analogous to the height of the dot.com bubble. From what could be a near-term market peak, we expect mean reversion in valuations and a rotation to different sector leadership, similar to what occurred in the aftermath of the Nasdaq meltdown in 2000 and 2001. As shown in Exhibit 1, more value-oriented stocks whose multiples did not get out of hand during that period outperformed more speculative growth stocks from 2000 to 2006. We expect more M&A, both public deals and leveraged buyouts by private investors, will be a driver of change going forward.
The Multi Cap Growth Strategy underperformed its Russell 3000 Growth Index benchmark in the second quarter. On an absolute basis, the Strategy generated gains across the seven sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were in the IT and health care sectors.
Relative to the benchmark, overall stock selection and sector allocation detracted from performance. In particular, stock selection in the health care, IT, communication services, and industrials sectors, an underweight to the consumer discretionary sector and an overweight to health care detracted the most from results. On the positive side, stock selection in the materials sector supported relative performance.
On an individual stock basis, positions in Autodesk, Broadcom, UnitedHealth Group, Vertex Pharmaceuticals and Twitter were the leading contributors to absolute returns during the period. The lone detractors were Biogen, L3Harris Technologies and AMC Networks.
During the quarter, we gained shares in AbbVie in the health care sector following its acquisition of portfolio holding Allergan.