After a strong first quarter, the US equity market reversed course during the second quarter to finish in negative territory for the first half of the year. The William Blair Mid Cap Growth Fund outperformed during the second quarter’s decline and is ahead of the benchmark for the year-to-date period as well.
While the year started off on a positive note on the heels of better-than-expected corporate sales and earnings, macro concerns across the globe instilled fear, and volatility, back into the markets. European sovereign debt downgrades and fiscal austerity measures, the Gulf of Mexico oil catastrophe, US state budget woes, and expiring stimulus programs all contributed to investor skepticism. More importantly, given the significance of job growth to a sustainable economic recovery, stubbornly lackluster employment and housing data have stoked fears of slipping back into a recession. Because of these negative developments and with the 2008 downturn fresh in investors’ minds, stock prices corrected as they once again succumbed to macro factors rather than company fundamentals.
During the second quarter, all sectors within the Russell Midcap Growth Index finished in the red. The Energy sector (-19%) was the worst performing sector given the macro concerns discussed above. Financials also underperformed with a -13% return. Outperforming modestly were Information Technology (-8%) and the typical defensive sectors, Health Care (-7%) and Consumer Staples (-8%).
For the year-to-date period, sector returns were more dispersed. Energy was the standout loser at -16%. Information Technology (-6%) and Financials (-5%) were the next worst performing sectors. Of the other major economic sectors in the index, Health Care performed best at +4%, while Consumer Discretionary also outperformed (+1%).
The Mid Cap Growth Fund’s outperformance during the second quarter is attributable to strong stock selection and our typical lower-beta investment style coming into favor. Fund holdings in Consumer Discretionary, Industrials, Materials and Energy were the largest positive contributors to relative return during the quarter. On the other hand, certain stocks in Health Care and Financials weighed on relative results.
For the first half of the year, the Fund’s outperformance was the result of good stock selection and a positive benefit of our typical smaller-than-benchmark weighted average market capitalization. Stock selection was most significant in the Industrials, Materials, Information Technology and Consumer Discretionary sectors. Detracting from relative performance were some of the Fund’s Health Care and Financials holdings.
Two specific stocks boosting relative performance were Illumina and Stericycle. Illumina develops and markets integrated systems used in the gene sequencing and genotyping markets. The company's machines enable medical and academic institutions to understand the genetic make-up of individuals which allows for more productive research in disease treatment and prevention. With its next generation machine launching soon, investors were expecting weak sales out of the company due to prospective customers delaying purchases in anticipation of the new machines. In reality, sales were better-than-expected. Illumina's order book remains robust and sales from non-genome research centers, the company's core customer base, were quite strong. We maintained our position in the name given Illumina's technological leadership position and growth in the genetic sciences.
Stericycle is the leading medical waste management company. The company collects and disposes of medical waste as a service for smaller facilities such as outpatient clinics and dental offices and larger facilities such as hospitals and blood banks. The stock was a leading contributor to return during the second quarter and for the first half of the year. Given the non-cyclical nature of Stericycle's business, investors often flock to the stock when economic concerns are high as they were during the second quarter. We continue to own the stock, as we have for several years, given the growth opportunity and stability driven by its dominate market position.
On the other hand, two stocks detracting from return were athenahealth and Greenhill & Co. Athenahealth Inc. is a provider of internet-based business services for physician practices. For example, the company's solutions allow physician practices to improve accounts receivable days outstanding, bad debt expenses, and patient scheduling and follow-up. The stock was one of the leading detractors from return during the second quarter and the first half of the year. During the first quarter, the company had to change a revenue recognition policy for a small piece of its business which weighed on investor confidence. During the second quarter, athenahealth announced disappointing contract wins with new physician practices, which brought into question whether the company has the appropriate infrastructure in place to compete with larger competitors. We liquidated our position on the news, but would consider it for repurchase if we became comfortable with the company’s investment in infrastructure to support its growth.
Greenhill & Co. is a boutique merger and acquisition (M&A) advisory firm which has attracted many talented bankers from large Wall Street investment banks, allowing it to expand into new industry verticals and new geographies across the globe. The stock detracted from return during the quarter and year-to-date period mainly due to disappointment regarding the expected reacceleration of the M&A cycle. We continue to hold a position as we believe the company is well-positioned to steal market share from larger competitors and will benefit when M&A activity improves.
Looking forward, while the economic recovery may have a different trajectory (less steep) than some were expecting earlier this year, the market’s decline has improved valuations and lowered expectations. Corporate financial discipline and balance sheets remain strong, and inventories are lean throughout most industries. This should lay the ground work for operating margin expansion, likely beyond prior peak margins, and drive continued earnings growth over the intermediate term. However, investor pessimism is understandably high given the expiration of stimulus plans and diminished appetite for additional programs, US state budget crunches, still absent employment growth and likely further consumer deleveraging.
We consider the impact of these economic scenarios into our stock-specific risk/reward assessments, and focus our time analyzing business models and managements of growth companies who “control their own destiny” to a greater degree and are less dependent on broad economic growth. We continue to find solid investment opportunities across sectors. We believe the Fund consists of great companies with solid competitive positions whose stock prices are trading at attractive valuations.