- Heightening uncertainty from trade, geopolitics and manufacturing weakness has turned investors and businesses defensive, hampering capital spending.
- Stock selection had a negative impact on performance, with particular weakness in industrials and health care.
- We continued to reposition the portfolio, lowering our exposure to higher-beta growth names in favor of companies with more stable growth profiles.
Rising risks turned investors defensive in the third quarter, with the largest stocks managing gains while overall market performance was mixed. The S&P 500 Index advanced 1.70% during the quarter to hold onto a 20.55% return year-to-date. The Russell 1000 Index added 1.42% while the Russell Midcap Index rose 0.48%. Growth stocks rallied late in the quarter to retake leadership from value stocks, with the benchmark Russell 1000 Growth Index (+1.49%) besting its value counterpart by 13 basis points for the quarter and 549 bps year-to-date.
From a sector standpoint, real estate (+7.50%) and consumer staples (+5.98%) were the strongest performers, reflecting a rotation into defensive stocks. Information technology (IT, +2.58%) also outperformed the benchmark while communication services (+0.85%) and consumer discretionary (-0.48%), the other areas of the market home to momentum stocks, lagged. Health care (-2.56%) and energy (-7.73%) were the worst overall performers.
Volatility spiked over the last three months on the ebbs and flows of U.S.-China trade tensions, attacks on Saudi Arabia’s energy infrastructure and increasing signs of a global economic slowdown. Mindful of these risks and the potential impact of weakening U.S. manufacturing activity, the U.S. Federal Reserve cut short-term interest rates 0.25% at both its July and September meetings. Following the September move, Fed Chairman Jerome Powell noted that a still strong U.S. economy and low unemployment are being offset by heightened uncertainty that has hurt business spending.
As active managers, we seek to deliver differentiated performance from the market. Over time, stock selection has proven to be a strong contributor to portfolio results. But in the short term, the active risk we take as stock pickers can work against us. This was the case in the third quarter as disappointing results from a handful of companies caused the portfolio to lag the benchmark. Uber Technologies and Grubhub, two of the newest names in our select bucket of higher-risk companies
with above-average growth rates, have struggled as they invest heavily to expand market share. We believe both companies possess superior business models and are on the path to improved profitability. Uber dominates the global rideshare market and both companies are leading players in a food delivery market that has a long growth runway ahead.
Health care was also a headwind as political rhetoric heated up over potential changes to the U.S. health care system. We have alluded to the 2020 presidential election as an overhang for the sector and the improving poll numbers for Democratic candidates pushing a “Medicare for All” system specifically hurt UnitedHealth Group, the nation’s largest managed care provider and the company whose business model could be affected by regulatory changes in health care delivery. Biotechnology companies have also been pressured by the risk of prescription drug pricing controls. Alexion Pharmaceuticals was additionally hurt by European regulators’ failure to approve new patents for its Soliris treatment while a competitor has challenged additional U.S. patents for the drug that addresses rare blood disorders.
"Momentum stocks have lost valuation support and we anticipate a continued rotation into more value-oriented and free cash flow rich companies."
Technology is another area under regulatory scrutiny, especially among the largest companies in the space, but souring investor sentiment toward the sector has hurt the most recently. The unwind and eventual withdrawal of the WeWork IPO has more investors questioning the growth rates and longer-term profitability of smaller, disruptive companies. This led to a rotation out of IT that hurt portfolio holdings that had run up earlier in the year, including software makers Splunk, VMware and Palo Alto Networks.
The Strategy’s diversified approach to growth, however, did help in a quarter that pressured most momentum stocks and the growth managers that are overweight such stocks. We saw resilient performance from our stable bucket of growth companies that constitute the majority of the portfolio. These are established franchises in leadership positions with the ability to steadily compound earnings and cash flow growth through difficult conditions. United Parcel Service (UPS) rose on strong quarterly results and plans to automate more distribution facilities, which should lower costs for business-to-consumer shipments. Data center operator Equinix maintains a strong business serving hyperscale cloud providers and raised its revenue guidance following better than expected second-quarter results. Shares of animal health provider Zoetis, meanwhile, moved higher on the anticipated approval of a new combination flea and tick treatment for pets. A robust employment picture has also supported the portfolio’s consumer holdings, with stable names Home Depot and Costco delivering solid results.
Despite a rocky third quarter, growth stocks are up 23.30% for the year, well above our expectations coming into 2019. This strong run has motivated us to take profits in some of our better performers in IT and the select bucket overall and redeploy that cash into stable and cyclical growth companies. As part of this effort, we closed a position in online payment provider PayPal. The stock has been a strong performer for the portfolio since it was spun off from eBay in 2015 and its valuation had reached a level where we believe future growth was priced in.
We gained similar, albeit broader enterprise exposure with the purchase of Fidelity National Information Services (FIS), a leading provider of payment and financial software, transaction processing and electronic payment solutions for banking, asset management, wealth management and retail customers. FIS is a stable grower that generates over 50% of its revenue from banking software and services that are sticky and resilient in a downturn. The company is paid through software sales, which provide a stable and predictable stream of recurring revenues, and has a foothold in mid-sized banks where consolidation of smaller competitors could be a positive. FIS recently acquired global payment processor WorldPay, which should lead to cost synergies and earnings growth as long as the integration goes smoothly. In terms of risks, the company is highly levered and directly exposed to the cyclicality of consumer spending.
Consumer spending looks solid for the foreseeable future, which benefits another new position, Booking Holdings. Booking maintains the world’s largest online travel agency through its ownership of Booking.com, Priceline and Kayak and also operates restaurant reservation app OpenTable. The
majority of the company’s business is outside the U.S. and it has meaningful exposure to both the secular shift to online travel reservations and the fast-growing alternative lodging market of apartment and house rentals. While the company faces growing competition in its core markets and could be hurt by a global slowdown, we believe it has the market leadership, balance sheet strength and management experience to manage these risks.
With global economic indicators now flat to down, we reduced the global cyclicality of the portfolio during the quarter by selling out of two more economically sensitive positions. We exited industrial equipment supplier Caterpillar due to slowing GDP growth as well as its direct exposure to a Chinese economy facing the headwinds of tariffs. We also took advantage of case and unit growth at Coca-Cola that was the highest in many years to close out our position. Long-term earnings trends for the beverage maker have been sluggish and foreign exchange continues to be a massive headwind for the company as it does business in 120 countries.
From our perspective as an owner of large, multinational growth companies, the biggest risk for the rest of 2019 is that the fragile support of easing monetary policy will collapse and the global business slowdown already in place will spread to U.S. consumer spending. Our portfolio companies have been communicating a lack of visibility on final demand for the last several months, with tariffs and an impending U.S. profits recession causing managements to delay capital spending. This anecdotal evidence is now showing up in government data on manufacturing, with U.S. industrial activity contracting in August and September.
When businesses had no incentive to spend in 2015, the equity market sold off. We are concerned that the market is not currently pricing in the risks of reduced capex and a myriad of other uncertainties.
Low, and in many cases, negative interest rates have so far masked the full impact of a global economic slowdown. Should the manufacturing recession continue, this will impact company hiring and wage increases, with a knock-on negative impact on consumer spending. In this environment, momentum stocks have lost valuation support and we anticipate a continued rotation into more value-oriented companies and those with rich free cash flows. We are confident that our moves over the last several quarters have the portfolio well positioned to weather swiftly changing market conditions.
The ClearBridge Large Cap Growth Strategy underperformed its Russell 1000 Growth Index benchmark during the third quarter. On an absolute basis, the Strategy had gains across four of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors to performance were the IT and consumer staples sectors while the primary detractor was the health care sector.
On a relative basis, overall stock selection detracted from performance. Specifically, stock selection in the health care and industrials sectors had the most significant negative impact on results. Stock selection in the consumer discretionary and IT sectors also hurt. On the positive side, stock selection in the real estate sector was beneficial.
On an individual stock basis, leading individual contributors to absolute returns in the third quarter included positions in Alphabet, UPS, Apple, Equinix and Akamai Technologies. Amazon.com, Uber Technologies, Alexion Pharmaceuticals, Facebook and UnitedHealth Group were the biggest detractors.