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Third Quarter in U.S. Stock Funds: Pressing On, Regardless

Major U.S. market indexes reached all-time highs even as threats loomed.

U.S. stocks fended off various challenges in 2018's third quarter, bolstered by the strength of the domestic economy.

International stocks, especially in emerging markets, struggled in the third quarter because of tariff tiffs, currency moves, and political and economic disruptions. Back home, however, the story was different. The S&P 500 closed at an all-time high on Sept. 20 and spent much of the quarter in record-high territory. The index posted a solid 7.4% total return for the quarter. Investors showed their love for good growth stories by driving  Apple (AAPL) and (AMZN) to $1 trillion valuations. Even so, there were some brutal reminders of growth stocks' limitations. Elon Musk considered taking  Tesla (TSLA) private only to back away (the SEC sued over the matter in late September), giving Tesla's stock a wild ride for the quarter. Theranos, the once-promising Silicon Valley startup that tried to disrupt the blood-testing market, faded into oblivion.

For many investors, the strength of the U.S. economy offered reasons for optimism. August's unemployment rate was 3.9%--a low not seen since December 2000. Another quarter-point Federal Reserve rate hike in September still left interest rates historically low. Despite the international backdrop, the U.S. economy continued the run it started 10 Septembers ago after the global financial crisis.

Healthcare was the third quarter's top-performing sector, pushing  Vanguard Health Care (VGHCX) to the top of the Morningstar 500 (a list of funds in the Morningstar FundInvestor newsletter that meet or clear some fundamental hurdles) with a 12.9% quarterly gain through Sept. 27. Pharmaceuticals drove the strong performance, led by healthy gains in large caps such as  Eli Lilly (LLY) (up 26%),  Bristol-Myers Squibb (BMY) (up 13%), and  Allergan (AGN) (up 15%). Although the portfolio, which has a Morningstar Analyst Rating of Gold, is currently focused on U.S. firms, lead manager Jean Hynes will look across the globe for innovators. She's held Japanese drugmaker Eisai since 1999; the stock surged 36% in the quarter.

Gold-rated  Brown Capital Management Small Company (BCSIX) has benefited from two tailwinds recently: a strong market for U.S.-focused small-cap stocks and hefty stakes in technology and healthcare. Small caps have been among the market's brightest segments year to date, with the Russell 2000 gaining 7.7% so far in 2018. The strategy is loaded with technology stocks (they took up an average of 53% of the fund's assets in the period), including top performer Paycom Software (PAYC). The provider of human-resources solutions spiked 57% in the quarter. On the healthcare side, Inogen (INGN)--a maker of oxygen tanks for patients with respiratory problems--jumped 31%.

Silver-rated  Mairs & Power Growth (MPGFX), with its conservative definition of growth, rose a respectable 10.9% after a lackluster 2017 and early 2018. Managers Mark Henneman and Andy Adams hunt for firms that can grow faster than the overall economy, and that typically leads them to established firms with defensible competitive positions. More than a fifth of its assets were in healthcare during the quarter, including more-staid large caps such as medical-technology firm  Medtronic (MDT) and device maker  Abbott Laboratories (ABT), both of which posted nice gains.

The Fed's rate hike added pressure to rate-sensitive sectors such as real estate, and that drove Fidelity Event Driven Opportunities (FARNX) down 1.7% in the period. Real estate firms took up nearly a fourth of the July 2018 portfolio. That included CorePoint Lodging (CPLG), one of the fund's top holdings, whose shares dropped nearly 25%. The company, which had its initial public offering in June 2018, owns a collection of midtier hotels. Real estate wasn't the whole story here, however. Diebold Nixdorf (DBD), the automated-teller-machine specialist, shed over 60% of its value as it continued to struggle with its 2016 Nixdorf acquisition.

It wasn't all sunshine in the world of technology strategies, either. T. Rowe Price Science and Technology (PRSCX) limped to a 1.5% decline. Worries about China's economy dragged down International (CTRP)--the country's leading online travel agency (and one of the portfolio's top five holdings)--during the quarter. U.S. tech holdings also posed problems, including  Facebook (FB),  Micron Technology (MU), and  Lam Research (LRCX). The strategy also counted a small Tesla position in its June 2018 portfolio, though manager Kennard Allen had cut it significantly in the second quarter.

Finally, tiny Perritt MicroCap Opportunities (PRCGX) didn't benefit from the good market for smaller companies. The $180 million fund fell 2.8% despite the portfolio's sector diversification across industrials, financials, technology, and basic materials. BlueLinx Holdings (BXC), a building products distributor and a top-five holding, lost 15%--but the stock has more than tripled since Jan. 1. Construction project manager Hill International dropped over 30% following news of a delay in the company's SEC reporting and a delisting from the New York Stock Exchange.

For all Morningstar Category returns through the previous day, visit the Fund Category Performance page

Tony Thomas has a position in the following securities mentioned above: INGN. Find out about Morningstar’s editorial policies.