Capital Appreciation & Spectra Strategy Update
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Amidst a lot of the short-term market noise, U.S. growth is showing signs of resilience and we continue to believe that we are in the early days of one of the most innovative times in history.
In our latest podcast, Portfolio Manager and Head of Alger Capital Appreciation and Spectra Strategies Patrick Kelly gives his update for the Alger Capital Appreciation, Capital Appreciation Focus, and Spectra strategies, as well as his broader outlo​ok for the markets.

BRAD NEUMAN:​ Hi, this is Brad Neuman, Director of Market Strategy at Alger.  And you’re listening to the Alger Podcast.  Today, I’m talking with Patrick Kelly, Portfolio Manager and Head of Alger Capital Appreciation and Spectra Strategies, which encompass our Capital Appreciation, Capital Appreciation Focus, and Spectra portfolios.  In today’s podcast, Patrick discusses his current economic and market observations and provides an update for the portfolios which he and Ankur Crawford manage.  Patrick, thanks for taking the time to speak with us today.
PATRICK KELLY:  Thanks, Brad.
BRAD:​ To start off, despite some recent churning in the market, you continue to have a very positive outlook on the U.S. economy.  Can you elaborate on that?
PATRICK:  2018 began with accelerating global growth trends in most regions around the world.  As the year progressed, a combination of tighter financial conditions, the effects of trade conflicts, and additional geopolitical risks weighed on global growth trends.  Europe softened early in 2018 and China growth conditions began to deteriorate.  
Despite these headwinds, U.S. growth is showing signs of resilience in Q4 and early 2019.  Momentum in the U.S. labor market is still very healthy with the unemployment rate around 4% and labor participation continuing to increase.  January monthly job gains were near a 12-month high.  U.S. consumer spending remains strong and exceeded 4% year over year growth in four of the last five quarters.   Tax cuts will continue to have a positive effect in 2019, and lending standards still remain accommodative in the U.S.   While we expect growth to slow in the U.S. in 2019, the good news is we are seeing a pause in the tightening of global financial conditions.  We also expect to see some positive outcomes to trade conflicts in 2019.  
Another key reason for our positive view on the U.S. economy is that the U.S. continues to lead the world economy in innovation. Many of the most innovative companies in the world are U.S.-based companies such as Apple, Alphabet, Amazon, Facebook, Netflix, Microsoft, Tesla and many others.
BRAD:​ Outside the U.S., we saw trade conflict driving volatility at the end of the year.  Do you see trade issues continuing to have an impact?
PATRICK:  Trade conflict risks could continue to cause volatility through the direct impact on higher pricing and the secondary impacts on confidence, growth and decision making.  It remains difficult to predict the timing or outcome of the trade conflicts.  We think there is some incremental progress on China/U.S. trade relations and think there is an likelihood of a deal that reaches some of the U.S.’s trade objectives in the coming months.  We also think it’s unlikely that the U.S. places an incremental 15% tariff on $200B of Chinese goods.        
Trade issues create near-term uncertainty but we think that ultimately the end result could be a positive outcome in which multiple countries reduce trade barriers.

BRAD:​ I know you and your investment team have been paying close attention to Fed rate movements.  Do you have concerns about potential rate hikes?
PATRICK:  The Fed’s position on interest rate hikes and the balance sheet has shifted fairly meaningfully over the past few months and, we think, clearly in a direction that’s positive for equity markets.  We think the Fed’s pause will extend until at least June, partially because core and headline inflation, are both likely to slow in 2019.   Wage growth is being tempered by productivity gains and a steady rise in the labor force participation rate.  

We continue to believe that technology, competition and globalization are helping to keep inflation in check, and technology’s impact on inflation remains underappreciated.  We think technology is one of the key reasons why the Fed has undershot its inflation target for eight straight years.  The contained inflation is positive for the U.S. economy and equity markets.  

Overall, we think the Fed’s early 2019 commentary increased the confidence level that it can deliver a relatively soft landing.  We continue to think the S&P 500 is attractive relative to 10-year U.S. Treasury bond yields.   The​ earnings yield on the S&P 500 (next twelve months) is 6.3% vs. the 10-year U.S. Treasury bond yield at 2.6%.
 
Equity valuations declined dramatically in 2018. The S&P 500 P/E decline was close to 20%, the second largest decline in the past three decades.  Historically, the market has recovered and posted strong returns after such a decline.  

Amidst the short-term noise of trade conflicts, concerns of rising rates, and debates of growth vs. value, we continue to focus on the bigger picture – that we are in the early days of one of the most innovative times in history. Our focus is to invest in companies that are innovating and benefitting from change and avoiding those that are being disrupted.

BRAD:​ Shifting to your portfolios, what primary themes have you and the investment team been focusing on?
PATRICK:  There are a number of big picture trends which will have a significant impact on companies across sectors. There are the continued trends in the Internet and mobile Internet and the emergence of trends such as cloud computing, digital transformation, artificial intelligence, electric vehicles, autonomous vehicles, augmented reality, IoT and 5G.

Our investment philosophy centers around our belief that companies undergoing positive dynamic change offer the best investment opportunities.  The good news for us is that we continue to expect a tremendous amount of change and innovation in the market over the next five to ten years. One of the reasons that we like to invest in change is that people often underestimate the change that is occurring, especially when it is as significant as it is today.

​We believe that investors continue to underestimate the impact of technology and innovation not only across sectors but across the entire economic and investment landscape.

BRAD:​ Can you drill down on some of the major themes that you’re tracking?
PATRICK:  We continue to think digital transformation will be a major theme over the next few years.   Businesses need to digitally transform themselves to remain competitive and relevant in their respective industries.  Companies such as Toys R Us  and Sears failed to digitally transform themselves and are now out of business.  ​​
We remain in the early stages of digital transformation, which is creating substantial opportunities across the software and technology landscape.  Since our last podcast, we believe that the urgency to transform businesses has only become more evident.   According to IDC's June 2018 Executive Sentiment Survey, 60% of global CEOs are facing significant pressure to deliver a successful digital transformation strategy.  We believe digital transformation is now a board-level priority.  

Microsoft’s CEO Satya Nadella recently commented that every company is becoming a digital company and essentially what used to be cost of goods sold and operating expense is all going digital.   

In financial services, digital transformation was the key theme behind the recent $66B merger between SunTrust and BB&T.  In our last podcast, we spoke about the acceleration in JP Morgan’s digital investments and the CEO Jamie Dimon referred to this investment as table stakes.  BB&T and SunTrust are combining to create the sixth-largest U.S. bank.  The combined bank plans to focus on technology to compete with giants like J.P. Morgan and stay relevant among endless mobile and start-up banking options.

“We face a fundamental choice – disrupt our business or be disrupted,” BB&T CEO Kelly S. King said in the bank’s most recent annual shareholder letter.  He summarized the current banking environment by saying he’s “seen more change in banking in the last three years, than in his previous 42 years” at BB&T.  While both banks are doing "fine today," King said going forward they need additional scale to make the technological investments necessary "to provide a digital platform."  He also added "we are all facing an increasing set of complex economic realities where we have to invest more and more in technology.”  

We are also seeing more signs of digital transformation in foreign markets.   At Societe Generale’s recent Investor Day, its CEO summarized what’s at stake today as “digitize or die”, as it competes against emerging new competitors in FinTech, startup banks, retailers and telcos.  

While we expect to see some deceleration from the high capital spending levels of 2018, we believe software spending in 2019 will remain quite strong.  

We continue to think that Microsoft, Salesforce.com and Adobe, three large software holdings in our portfolio, are well positioned to be beneficiaries of the trends in digital transformation.

BRAD:​ You mentioned that cloud computing has been a significant focus within your portfolio.  Can you talk more about that?
PATRICK:  Cloud computing is enabling a significant amount of innovation in the economy.  We believe cloud computing is in the early stages of disrupting a massive market - the $3.5T global IT market.  The pace of this disruption is staggering.  The rationale for cloud adoption is evolving from a cost saver, to the need to keep up with technological advances in order to compete which continues at an accelerating rate.  The value proposition of the cloud grows each year as the large cloud companies are rapidly innovating.  Internal IT departments simply can’t keep up with the innovation we are seeing in the cloud.  The scale advantages of the cloud companies are massive versus any one particular company.  We continue to think that companies from small to large are realizing that it is imperative that they move to the cloud.  Gartner believes that by 2022, public cloud services will be essential for 90% of business innovation.​
I attended the annual Amazon Web Services conference in Las Vegas late last year along with 52,000 other attendees. One key takeaway was cloud adoption has hit an inflection point.  I was amazed at how quickly many large companies are moving to the cloud.  I spoke to one CTO of one of the largest companies in the world who plans on going from 15% of workloads in the cloud to 85% in five years.  I spoke to a CTO of another large financial services company who has 5% of workloads in the cloud today and believes they will have 40-50% of workloads in the cloud in four to five years.  I asked this CTO what was driving such an accelerated movement to the cloud.  His response was survival - they need to innovate and digitally transform themselves in order to effectively compete with not only their traditional competitors but many of the FinTech startups.  Eventually, we think the vast majority of IT workloads will move to the cloud.  We think the level of innovation and disruption occurring in the cloud today is simply staggering.

We think Microsoft and Amazon are two of the biggest beneficiaries from the growth in cloud computing and these are the two largest positions in the portfolio.  Amazon’s AWS business grew 45% year over year in calendar Q4 2018 to an over $29B annual run rate and Microsoft’s Azure business grew 76%  year over year to an over $11B annual revenue run rate.  Google is the number three cloud vendor and, we think, will also benefit from the growth of cloud computing given it is such a large market opportunity.  Alibaba is also a large position in the portfolio and they are the market leader in cloud computing in Asia along with their dominant position in ecommerce - very similar to the Amazon business model.

BRAD:​ Let’s turn to health care which is also a contributor to the portfolio.  What innovations are you currently tracking in this sector?
PATRICK:  We are also seeing a tremendous amount of innovation in the health care sector.  The new medical technology product pipeline is as robust as it ever has been. Recently, Medtronic’s Michael Coyle (Executive VP and Group President of Cardiac and Vascular Group) suggested that he’s never seen the level of innovation that's coming out of this industry as a result of a lot of fundamental investment that is taking place within the companies on transformative technologies, things that are creating new markets or things that are fundamentally disrupting markets.

Minimally invasive procedures and robotic surgery are examples of transformative technology in med tech.  There are several $1B+ markets growing solidly double digits driven by consistent innovation that is making these procedures easier, faster, safer, and more durable with plenty of runway to go as penetration rates are low.  Minimally invasive surgery still represents less than 50% of world-wide surgical procedures.  And within minimally invasive surgery, robotic-assisted surgery is still less than 20% of those procedures.  It’s currently a $5B market growing close to 20%.  

We believe we are seeing the innovation in med tech lead to accelerating growth rates for several med tech companies such as Boston Scientific and Abbott Labs which are two large holdings in our portfolio.

BRAD:​ Patrick, any final thoughts?
PATRICK:  Amidst a lot of the short-term market noise, we continue to emphasize the bigger picture:  we believe we are in the early days of one of the most innovative times in history. This is creating a number of exciting investment opportunities. Our in-depth, fundamental research process focuses on investing in many of the most innovative companies in the market. Our competitive edge is identifying companies in the midst of positive dynamic change and seeking to capitalize on that change before it is recognized by the rest of the market.
BRAD:​ Patrick, thanks so much for speaking with us today about Capital Appreciation and Spectra strategies, and giving us your broader view for the markets.
PATRICK:  Thanks, Brad.  And thank you for listening and for your continued support.  Thank you.​
BRAD:​ For more information on Alger Capital Appreciation and Spectra strategies, please visit alger.com.


Click here for more information on Alger Capital Appreciation Strategy.
Click here for more information on Alger Capital Appreciation Focus Strategy.
Click here for more information on Alger Spectra Strategy.
Click here for more information on The Alger American Asset Growth Fund.

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Risk Disclosure:  Investing in the stock market involves risks, and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as their prices tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political, and economic developments. A significant portion of assets will be invested in technology and healthcare companies, which may be significantly affected by competition, innovation, regulation, and product obsolescence, and may be more volatile than the securities of other companies. Short sales could increase market exposure, magnifying losses and increasing volatility. Leverage increases volatility in both up and down markets and its costs may exceed the returns of borrowed securities.

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Companies discussed reflect the top holdings for various accounts in the strategy and is subject to change. Actual client holdings may vary. Portfolio holdings may change and stocks of companies noted may or may not be held by one or more Alger portfolios from time to time. Transactions in such securities may be made which seemingly contradict the references to them for a variety of reasons, including but not limited to, liquidity to meet redemptions or overall portfolio rebalancing.

As of 12/31/2018, the following companies represented the noted percentage of Capital Appreciation Strategy assets: Abbott Laboratories, 1.93%; Adobe, Inc., 3.42%; Alibaba Group Holding Ltd., 1.65%; Alphabet Inc., 5.92%; Amazon.com, Inc., 9.02%; Apple, Inc., 2.68%; Boston Scientific Corporation 3.15%; Facebook, Inc., 2.84%; Medtronic Plc, 0.72%; Microsoft Corporation, 9.22%; Netflix, Inc., 0.81%; Salesforce.Com, Inc., 3.43%; JPMorgan Chase & Co., 0.0%; BB&T Corporation, 0.0%; Gartner, Inc., 0.0%; Société Générale S.A., 0.0%; SunTrust Banks, Inc., 0.0%; and Tesla, Inc., 0.0%.

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