Commentaries

Large Cap Growth - Concentrated

For the Period Ending: 12/31/2018

Portfolio Manager:
Bradley M. Klapmeyer, CFA

Market Update

It seems like ages ago, but it was just early October when interest rates were moving higher as Federal Reserve (Fed) Chairman Powell comfortably expressed his view that an accommodative Fed policy was no longer needed given the strong environment. There was a temporary pause in escalating trade war tensions, U.S. economic data was clicking off decent numbers and investors were left to debate just one “minor” issue – the duration of the economic cycle.

Flash forward to year-end 2018 and one would think the wheels are off. There is carnage in the markets. The Fed moved forward with the ninth raise but carefully signaled to the market they are tiptoeing and are willing to pause, maybe for an extended period. The equity markets still screamed “policy error” as they worried about a list of concerning data points: Weakening growth in the U.S., eurozone and China, Brexit risk back to a boil, U.S. government shutdown over a border wall funding impasse, presidential attacks on Fed Chairman Powell, and the realization that the temporary trade truce was anything but clear. Oh, and don’t forget that “minor” issue – duration of the cycle.

All this to say that equity markets struggled in the fourth quarter and reversed course on what was shaping up to be another decent year of gains. This marks the first down year for the Russell 1000 Growth Index, strategy’s benchmark, since the Financial Crisis, and although the loss was small, it still stings.

Peeling back the market performance on the quarter, equities across all capitalization ranges and styles saw significant declines in the fourth quarter. Growth styles underperformed value styles while large outperformed mid and small. This style performance in a down environment is not surprising as investors seek safety and stability.

Portfolio Review

The strategy outperformed the benchmark in this volatile environment. Changes made throughout the year to dampen exposure to cyclical and more volatile stocks helped the portfolio relatively outperform and maintain positive performance for the year.

Starting on the win side, Information Technology provided positive attribution as our strategy held underweight positions to several poor performers in the sector. We also benefited from overweight exposure to payment stocks. The Financials sector was a strong contributor to relative outperformance. Performance in the quarter benefited from stock selection in Health Care, which was a new overweight during the year. The sector historically has been viewed as more resilient during periods of slowing economic growth.

On the miss side, stock selection in Consumer Discretionary detracted from performance. Investors sold consumer stocks due to worries about slowing U.S. growth. The Consumer Staples sector was another notable detractor of performance due to an underweight position versus the benchmark. This sector is typically viewed as more stable and thus outperforms during periods of economic and market stress. While we have spent energy looking for viable exposure in this sector, the fundamentals and valuations are not attractive to us at this point.

Outlook

Anxiety is clearly high in the markets, and we would expect this to remain. Investors seem to be bouncing between optimism about modest 2% economic growth and nervousness about the graying economic cycle. Time will determine whether the Fed’s last rate hike was justified, but it is important to remember how quickly sentiment turned from October to December. In our view the markets overreacted to the December hike, as we think a couple events falling in the right direction (e.g. a real trade war truce, more accommodative Fed language) could easily shift sentiment back to risk-on, at least temporarily.

With that said, we believe the script is largely written as we are three years into a Federal Reserve tightening cycle. The rate increases since 2015 have resulted in a more neutral Fed policy, regardless of what policy tweaks the Fed may make in 2019. This view formed the basis for the material changes made to the complexion of the portfolio during 2018. The more notable changes include reducing Information Technology exposure by exiting positions in semiconductor capital equipment and semiconductor stocks. We also reduced exposure to the Financials sector as those stocks became too highly correlated with changes in the yield curve versus stock-specific drivers.

These reductions were repositioned in Consumer Discretionary where we saw growth opportunities in strong consumer brands that we felt had successfully bridged the Amazon risk chasm and were set for more sustainable growth regardless of the market environment. We also added to Health Care with multi-year accelerating growth stories.

Very often, in these volatile periods, stock correlation spikes, and investors dump stocks irrespective of fundamentals. Therefore growth stocks with durable, sustainable competitive positions often get thrown out with the bath water, and this presents a welcome opportunity for long-term investors. The net result of these portfolio changes was to skew the portfolio more toward earnings quality and profitability while maintaining a focus on strong growth. As experienced in the fourth quarter, these improvements in quality have allowed the portfolio to better withstand choppy markets. We will continue to strategically position the portfolio to accentuate stock selection over factor bets, but whereas we can’t eliminate factors bets we will skew the portfolio toward these characteristics that align with our philosophy and process. For more radical changes to occur from this point forward we would need to become even more concerned about the economic backdrop, or inversely feel better about the sustainable strength of the economy. We don’t believe a recession is imminent, however. Despite the aging cycle, many of the excesses that often precede a recession are hard to find. These include consumer debt, excess inventories, corporate debt, and excess business investment, which are very muted this cycle. It’s possible we could even see a growth deceleration with a shallow recession or no recession.

The trade war remains a wild card as it is putting a dent in business and consumer confidence. There is currently no sign of a trajectory change on the issue, which bodes poorly for the durability of economic growth. The Trump administration may react to the softening economic growth with more progress on a trade war resolution, but there is little indication of that right now.

Barring a legitimate economic recession, the current modest growth environment remains supportive of durable, long-term growers. A slowdown in growth would likely narrow investors’ focus on stocks with these characteristics, hopefully driving continued outperformance for growth styles.

The opinions expressed are those of the portfolio manager(s) and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through December 31, 2018 and are subject to change due to market conditions or other factors. Any mention of investment performance refers to gross-of-fees performance, unless otherwise noted.
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Investment Team

Bradley M. Klapmeyer, CFA

Senior Vice President, Portfolio Manager

Mr. Klapmeyer is portfolio manager of the firm’s Large Cap Growth investment strategy, appointed to this role in 2016. He has been a member of the Large Cap Growth team since 2011. He held equity investment analyst research responsibilities prior to his appointment as portfolio manager, covering large cap growth securities and the biotechnology industry.

Prior to joining the organization in 2007 as an equity investment analyst, Mr. Klapmeyer held equity analyst positions with Prudential Equity Group, LLC from 2006 to 2007 and with Commerce Bank from 2000 to 2006.

Mr. Klapmeyer earned a BS in Finance from Truman State University.

Gage T. Krieger, CFA

Assistant Vice President, Assistant Portfolio Manager

Mr. Krieger is assistant portfolio manager of the firm’s Large Cap Growth investment strategy and assists the portfolio manager in idea generation, research, portfolio construction, and risk management efforts. He has been a member of the Large Cap Growth team since 2016. He is also a member of the firm’s equity research team, covering industries in the health care sector.

Prior to joining the organization in 2012 as an equity investment analyst, Mr. Krieger was a senior associate, equity research covering the telecommunications services sector for Citi Investment Research from 2009 to 2012. Prior to his role at Citi Investment Research in New York, Mr. Krieger was an associate, middle market equity sales for Citigroup Global Markets in Denver, CO from 2006 to 2009.

Mr. Krieger earned an MBA from Rockhurst University and a BSBA; concentration in Finance from Colorado State University.

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