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Oct 19, 2016

Opportunity Equity 3Q 2016 Review

Christina Siegel Malbon

Market Commentary

The S&P 500 Index finished the quarter with a total return of 3.85%.The Dow Jones Industrial Average rose 2.78% and the Nasdaq Composite increased 10.02% on a total return basis for the quarter. Seven of the eleven sectors in the S&P 500 posted positive returns during the period. Information Technology and Financials were the biggest outperformers with returns of 12.86% and 4.59%, respectively. Small-cap stocks outperformed mid-cap stocks, which beat large-cap names. Specifically, the Russell 2000 Index’s 9.05% gain surpassed the returns of both the Russell mid-cap Index and the Russell 1000 Index which posted 4.52% and 4.03%, respectively for the quarter. Growth stocks beat their value counterparts, as the Russell 1000 Growth Index rose 4.58% compared to the 3.48% return of the Russell 1000 Value Index over the same period. The US Dollar Index declined 0.71% for the quarter and is down 3.21% for the year. Oil slightly decreased 0.19% but is still up 30.24% for the year. Gold declined 0.78% during the quarter.

Theresa May became the Prime Minister of the United Kingdom in July following the resignation of David Cameron. The 2016 Summer Olympics kicked off in Rio de Janeiro on August 5th which was followed by Brazil’s Senate voting to impeach Dilma Rousseff clearing the way for interim president Michel Temer to take the presidential oath. Turkey endured an attempted military coup in July and Italy suffered a 6.2-magnitude earthquake. Terror attacks continued around the world as the situation worsened in Syria where a UN aid convoy was targeted in an airstrike while trying to deliver food near Aleppo. The quarter ended with Hurricane Matthew hitting Haiti, where 1,000 people died, and moving up the east coast where many are without power. At the September meeting the Fed decided to leave rates unchanged continuing its wait-and-see policy to further hikes. During the quarter, the Bank of Japan announced its new policy of targeting the yield curve and its aim for inflation to exceed 2%. The ECB decided to keep interest rates unchanged.

Strategy Highlights

During the third quarter of 2016, Opportunity Equity generated a total return of 22.44% (net of fees)1. In comparison, the strategy’s unmanaged benchmark, the S&P 500 Index, returned 3.85%.

Using a three-factor performance attribution model, security selection, interaction effects and allocation effects contributed to the portfolio’s outperformance. Apple Inc. C95 1/18s, C300 1/17s, Genworth Financial Inc. (GNW), OneMain Holdings Inc. (OMF), and NXP Semiconductors (NXPI) were the largest contributors to performance, while Lennar Corp. (LEN), Platform Specialty Products Corp. (PAH), Gilead Sciences Inc. (GILD), Endurance International Group Holdings (EIGI), and Quotient Technology Inc. (QUOT) were the largest detractors.

Relative to the index, Opportunity was overweight the Financials, Consumer Discretionary, Industrials, Information Technology, and Materials sectors on average during the quarter. With zero allocation to Utilities, Consumer Staples, Telecommunications, Energy and Real Estate, the strategy was dramatically underweight these groups. In terms of sector allocation, the overweight position in the Consumer Discretionary sector, which underperformed the index, detracted the most from the portfolio’s relative performance. On the other hand, the underweight in Consumer Staples, which underperformed the index, contributed the most to relative performance.

We eliminated two positions during the quarter, ending the quarter with 37 holdings where the top 10 represented 50.6% of total assets compared to 19.74% for the index, highlighting Opportunity’s meaningful active share of around 108%2.

Top Contributors

    • AAPL C95 1/18 rebounded from the second quarter finishing the quarter up 93.7%. Second quarter results helped push the stock higher as results were better than investors had feared. The release of the iPhone 7 and 7 Plus on September 7TH helped push the stock even further as pre-orders for the phones were up nearly 4x from last year. Apple is expected to further benefit from Samsung discontinuing the production of the Galaxy Note 7.

    • AMZN C300 1/17 continued its move higher ending the period up 30.1%. Amazon reported stellar second quarter results with revenue growth accelerating 31% (vs. 29% last quarter). AWS revenue increased 58% YoY and margins in all areas increased YoY (CSOI 6.9%, NA 6.5%, International 0.9% and AWS 29.9%). In addition, Amazon’s Prime Day was better than last year with orders growing more than 60%.

    • Genworth Financial Inc. rebounded in the third quarter ending the quarter up 92.3%. Genworth beat second quarter expectations with operating EPS of $0.25 vs. consensus of $0.21. The performance was helped by US MI having a lower loss ratio than expected and some steadiness shown in the long term care business. The company is still working towards the separating of its MI, LTC and Life and Fixed Annuity Business.

Top Detractors

    • Lennar Corp. declined 8.1% over the quarter. Second quarter results were mixed with Lennar beating on EPS ($1.01 vs consensus of $0.90) but disappointing on gross margins (22.6% vs. consensus 22.9%). Gross margins were down 150bps YoY as a result of higher land costs and are expected to be at the lower end of guidance for the year (23%). Over the period, Lennar announced its agreement to acquire WCI Communities for $23.50/share in a cash and stock transaction.

    • Platform Specialty Products Corp. ended the quarter down 8.67% despite solid second quarter performance. For the second quarter, Platform posted adj. EBITDA of $193M vs consensus of $192M and increased the low end of the guidance for the year. The stock took a further hit when the company announced its plan to issue $350M of stock in order to fund its obligations regarding its Preferred Series B make-whole payment.

    • Gilead Sciences Inc. declined 4.6% with mixed second quarter performance. While Gilead beat on EPS ($3.08 vs $3.02), the revenue from the HCV business missed with sales of $3.9B vs consensus of $4.1B. This supported investors’ fears of further declines in the HCV business due to few patients, shorter treatment times and pricing pressure. In addition, the company lowered its 2016 guidance by $500M.

Read Samantha McLemore's 3Q 2016 Commentary.

Read the notes from our 3Q 2016 quarterly investor call.

1For important additional information on Opportunity Equity strategy performance, please click on the Opportunity Equity GIPS Composite Disclosure. This additional information applies to such performance for all time periods. Past performance is no guarantee of future results.

2Active share represents the share of strategy holdings that differs from the benchmark index holdings. The greater the difference between the asset composition of the strategy and its benchmark, the greater the active share.

Contact LMM to obtain information on how Top Contributors and Top Detractors were determined and/or to obtain a list showing every holding’s contribution to Strategy performance.

Investment Risks: All investments are subject to risk, including possible loss of principal.

The views expressed in this report reflect those of the LMM LLC (LMM) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.