- Smaller growth companies led a sharp rebound for equities in the first quarter which was supported by the Fed’s signal that interest rates will stay low for longer.
- The portfolio’s limited exposure to small cap biotechnology was a headwind in a strong period for biotech M&A.
- We are unperturbed by the near-term noise around capital investments made by portfolio companies and remain confident in their long-term growth opportunities.
Wow, what a whipsaw!
After the sharp downdraft of the fourth quarter (during which the benchmark Russell 2000 Growth Index declined 21.65%), equity markets rallied sharply in the first quarter to within a few percentage points of record highs. Small cap growth stocks returned 17.14% during the quarter, essentially bridging the fourth quarter “gap.”
Investors have been thinking about decelerating growth prospects since last summer while concomitant corporate profit concerns weighed on equities. The added anxieties of China trade negotiations, tariffs, Brexit and the Fed’s interest rate trajectory were equity market millstones and further reasons to reduce risk in the fourth quarter.
While many of those macro issues remain unresolved, the Fed’s March decision to go slow on further interest rate increases was a welcome tonic for an equity market thirsty for good news. As a result of decelerating macroeconomies, long-term interest rates have fallen globally, in some geographies to negative nominal yields. The attraction of U.S. Treasurys in a once-again low-yield world pushed U.S. interest rates substantially lower (beneficial for stocks) and caused a modestly inverted yield curve at quarter’s end.
Investors may well be bidding up stocks in anticipation of better times and improved corporate earnings ahead. Lower rates are a prescription not only for higher equity valuations, but also relief for credit-sensitive sectors of the real economy such as housing and auto loans. Repeated stimulus moves in China to blunt U.S. trade frictions may finally be showing results. And while global merger and acquisition activity has been muted, transaction volumes in North America remain strong.
While we were pleased with the portfolio’s absolute returns during the quarter, we didn’t match market returns due to robust biotechnology stock performance and modest cash drag. Fourth-quarter reporting and the 2019 guidance season also brought the inevitable downdraft in a few stocks as managements balanced long-term investment with short-term profit trends.
"Cash has been deployed into new investment ideas as we’ve found the intersection of good businesses with proper valuation."
The biopharmaceutical industry was galvanized by significant pharmaceutical industry merger and acquisition activity. During the quarter, Eli Lilly purchased Loxo Oncology for $8 billion, Bristol-Meyers Squibb agreed to acquire Celgene for in excess of $74 billion, and Roche Holdings announced the purchase of Spark Therapeutics for $4.8 billion. The small cap growth biopharma sector rallied 22% during the quarter and our limited investment in that industry was the quarter’s major performance detractor.
The rapid turn in the market also led to some cash drag. In addition, we held a few investments which were awaiting deal closure and had limited upside/downside, including Integrated Device Technology, athenahealth and MindBody.
Cash has been deployed back into new investment ideas as we’ve found the intersection of good businesses with proper valuation. We’ve seeded over 20 investments in the Strategy over the past two years and have been building positions in many of those holdings. Two new investments joined the portfolio during the first quarter. Aerojet Rocketdyne is an aerospace manufacturer with essential technology for primarily military applications. PJT Partners is an advisory investment bank with strengths in merger and acquisition, restructuring and fund placement.
Several of our holdings chose to invest aggressively behind opportunity, for which some investors have limited patience. For instance, Vocera Communications, a provider of wearable alert and communications devices and software for health care and safety functions, is transitioning to an enhanced product set which is causing a modest pause in its earnings trajectory. Online restaurant delivery platform Grubhub, meanwhile, is driving adoption of its food order/delivery service at the expense of short-term operating leverage. We have confidence in the business models and managements of these and other businesses and continue to hold the positions despite the near-term noise.
The ClearBridge Small Cap Growth Strategy underperformed its Russell 2000 Growth Index benchmark during the first quarter. On an absolute basis, the Strategy had gains across all 10 sectors in which it was invested during the quarter (out of 11 sectors total). The primary contributors to performance were the information technology (IT), industrials and consumer discretionary sectors.
In relative terms, the Strategy’s underperformance was driven primarily by stock selection. Specifically, stock selection in the health care and IT sectors and the Strategy’s cash position weighed on results. Meanwhile, stock selection in the consumer discretionary sector and an overweight to IT had positive impacts on relative performance.
The biggest contributors to absolute returns during the first quarter included Copart, Chegg, Wix.com, Core-Mark Holding and Syneos Health. Positions in Vocera Communications, Hudson, Pacira Pharmaceuticals, US Ecology and Casa Systems were the greatest detractors from absolute returns.
During the first quarter, in addition to making the additions discussed above, we received shares of Twilio in the IT sector following the closure of its acquisition of portfolio holding SendGrid. We also closed positions in SunOpta in the consumer staples sector, Casa Systems, Imperva and MindBody in the IT sector as well as athenahealth in the health care sector.