3Q:2019 Quarterly Update – A Challenging Mix of Uncertainty, Concerns, and Positives Suggests Caution Ahead


  • Stocks were mixed as sentiment shifted. Investors weathered a challenging, uncertain environment during the quarter. The market’s attention focused on a softening global economy, US–China trade tensions, monetary policy, and the outlook for corporate earnings. The global growth outlook continued to deteriorate, as PMIs (purchasing manager indices) for most large economies continued to contract. The global PMI reading in September was 49.7, according to FactSet and Markit PMI. (Note: A reading below 50 indicates economic contraction.)
  • The US and China continued to spar over their disagreements on trade. Expectations of a resolution rose and fell throughout the quarter as the two sides appeared to soften their stances, only to stiffen again.
  • The Federal Reserve acted pre-emptively to quell fears of a slowdown by cutting interest rates twice—the first such cuts since December 2008.

Large caps continued to lead. Investors favored large caps amid the uncertainty, driving them to outperform mid and small caps for the fifth consecutive quarter.

  • The S&P 500 rose 1.7%.
  • The Russell 2000 Index declined by -2.4%.
  • Value outperformed growth across small and mid cap ranges—by the widest margin since 2008, according to Jefferies. Style difference in large cap were a push whereas much of the style reversal in small and mid cap occurred during an extreme rotation in September (R2G: -4.2% vs. R2V: -0.6%; RMCG: -0.7% vs. RMCV: 1.2% and R1G: 1.5% vs. R1V: 1.4%), when momentum investors sold high-momentum growth stocks and value benefited accordingly.

Bonds rose on weakening economic growth and Fed easing. Bond prices rose as investors sought safety from weakening global economic growth, as well as the Fed’s cuts.

  • The 10-year Treasury yield closed at 1.65%, down -35 basis points during the quarter.
  • The high-quality Bloomberg Barclays US Aggregate Bond Index gained 2.3% and outperformed the Bloomberg Barclays US Corporate High-Yield Bond Index, which rose 1.3%.

Convertibles held up better than underlying small- and mid-cap growth equities. Convertibles are predominantly issued by small- and mid-cap companies in growthier sectors, so they declined along with their underlying equities. The Thomson Reuters All Cap Focus Convertible Index fell -0.4%, while the cap-weighted BofA/Merrill AQ Convertible Index, which tilts toward large-cap issues, picked up 0.2%.


September dominated the quarter’s results and proved challenging for most our strategies amid intense factor rotation, as both companies without earnings and those with the fastest growth rates sold off. Since there wasn’t a material breakdown in the fundamentals of our holdings (in biotech and software specifically), we believe our strategies were disproportionately hurt by this tactical move. (See page 4 of the pdf for performance results)

In our view, these types of shifts are not uncommon and navigating them requires experience, a disciplined process, and conviction in our companies’ long-term growth prospects. As we write in early October, performance has already begun to improve in absolute and relative terms.


Caution is warranted. Entering the fourth quarter, the environment is a challenging mix of uncertainty, areas of concern, and some positives. Thus, our outlook is appropriately cautious.

A variety of economic and market indicators are most problematic:

  • Second-quarter annualized real US GDP growth was 2.0%, substantially lower than the first quarter’s 3.1% pace. Recent indices of activity in the manufacturing and services sectors provided further signs that the economy is slowing.
  • The classic form of yield-curve inversion occurred briefly in August (i.e., when two-year Treasury yields exceed 10-year yields, a historically reliable signal of recession). It’s worth noting that yields for maturities of less than one year have been higher than 10-year yields since late May.
  • The quality of corporate earnings is deteriorating. According to Ned David Research, seven metrics point to such quality being at its lowest level in the current economic expansion.
  • A number of recent high-profile initial public offerings—notably those of Slack Technologies, Peloton, SmileDirectClub, Uber, and Lyft—have fared poorly, suggesting that they were priced at frothy valuations. The withdrawal of WeWork’s hotly anticipated IPO underscores investors’ wariness.

The outlook for earnings and revenue growth is weaker. FactSet’s consensus year-over-year growth rate forecast for third-quarter S&P 500 earnings is -2.8, vs. -0.06% three months ago. The corresponding numbers for revenue growth are 2.8% now vs. 3.5% earlier. Coming into third-quarter reporting season, analysts have reduced earnings expectations by an aggregate 4.0%. This is modestly worse than the average pre-earnings-season downward revision of 3.0% in the post-crisis period, according to Wolfe Research.

Major political uncertainties weigh heavily on investors… By far, the most significant is the trade conflict between the US and China. The longer it goes on, the greater the risk that it will hurt global economic growth. Recent data from multiple countries indicates that this may already have begun. In addition:

  • US political conditions are increasingly rocky as the possibility of impeachment rises and the 2020 presidential race heats up. Companies and investors alike are more hesitant to make longer-term plans.
  • The absence of a Brexit agreement between the UK and the European Union persists, with no clear solution in sight.
  • The threat of worsening armed conflict in the Middle East remains real amid rising tensions in Iran, Syria, and Saudi Arabia. Any such escalation would undoubtedly affect oil prices—and thus economic activity worldwide.

…Yet there are encouraging economic green shoots as well. Lower interest rates—both from the Fed’s cuts and falling Treasury yields—are favorable for the housing sector and consumption more broadly. Prominent economic “surprise” metrics have swung sharply upward. 2019 holiday retail sales are projected to jump 5% over 2018, a sign of consumer bullishness. And GDP growth, while softer than 2018 levels, is still solidly positive.


A difficult environment in which earnings growth and stock selection remain vital. Given the numerous challenges to revenue and earnings growth that companies face, we’ve re-examined our holdings and confirmed that our original purchase rationales are intact. We continue to believe that the companies we own have sustainable long-term growth catalysts that will drive superior earnings performance and, therefore, strong returns.

With this firmly in mind, we remain focused on dynamic companies whose disruptive innovation and differentiated business models can drive faster growth, as well as those whose businesses are domestically focused and less vulnerable to global economic weakness.

Valuations are key. Credit Suisse research indicates that while valuation increases have been an outsized contributor to returns year to date, their contribution has been lowest for growth stocks. This suggests higher potential upside for growth stocks if their earnings multiples can expand. We note that high-visibility secular growth stocks are often prized in times of economic uncertainty.

Our positioning is unchanged. We continue to favor disruptive and innovative niches in healthcare, technology, certain consumer sectors, and REITs.

  • Healthcare: We own well-capitalized small- and mid-cap growth companies working on curative therapies to address unmet medical needs—and have no exposure to large cap biotech and pharma companies.
  • Tech: Our holdings emphasize subscription software providers whose consistent revenues lessen the risk of financial underperformance.
  • Consumer: We are focused on companies innovating new verticals (e.g., serving pet owners) or refreshing their brands and business strategy.
  • REITs: We favor those positioned to capitalize on accelerating direct-to-consumer e-commerce trends such as home delivery of fresh, high-quality foods and meals.



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