Capital Income

Period ended March 31, 2012

The U.S. equity market’s 12.6% return was its best opening quarter since 1998, while the U.S. high yield market’s 5.2% return was its best opening quarter since 2003.  The advance was prompted by continued signs of a strengthening U.S. economy and the absence of new negative global macroeconomic developments.  As short-term fears subsided and became a less prominent driver of investor behavior, we observed a shift in the market’s focus toward underlying fundamentals and valuations of individual securities.  This type of shift tends to reduce the correlation of returns across securities and forms an environment conducive for bottom-up, fundamental value investors. 

Going forward, we remain optimistic regarding the equity and high yield market’s prospects due to considerable fundamental improvements exhibited across the corporate sector.  Despite modest economic growth, companies have generated robust earnings and cash flows.  Valuations continue to be compelling even after this quarter’s appreciation.  Also, we believe the market’s affection for Treasuries is likely to recede as real yields at/below zero will eventually erode the purchasing power of institutional and individual investors alike.  The rise in Treasury yields over the first quarter may well be a harbinger of this cautionary message.

With the lingering sovereign debt issues in Europe and the uncertain growth prospects in emerging markets, we are prepared to combat bouts of elevated volatility in the near/medium-term.  During these episodes, we have found that the changes in security prices (i.e. volatility) are often not commensurate with the changes in real risk.  Our experience has shown us that focusing on corporate fundamentals is the most effective course when navigating erratic waters; we attempt to mitigate risk through sound valuation support and an exhaustive assessment of underlying company risks. 

Allocation - The Hotchkis & Wiley Capital Income composite returned +7.3% and +7.2% (gross and net of management fees) during the quarter versus the S&P 500 return of +12.6% and the BofA Merrill Lynch U.S. Corporate, Government & Mortgage Index  return of +0.3%.  Disproportionately attractive equity valuations led us to overweight equities during the quarter, which helped performance. 

Equities - High dividend payers underperformed low/non dividend payers considerably during the quarter, which hurt the performance of the equity portion of the portfolio. About 16% of the S&P 500 is composed of companies that do not pay a dividend—this group returned +22% over the quarter. In contrast, about 8% of the S&P 500 is composed of companies with a dividend yield greater than 4%--this group returned +2% for the quarter. The portfolio is considerably underweight the former and overweight the latter, which caused the equity portion of the portfolio to lag the S&P 500 for the quarter. 

Fixed Income - The high yield portion of the portfolio (gross and net of management fees) outperformed the broad benchmark (BofA Merrill Lynch U.S. Corporate, Government & Mortgage Index) and the high yield benchmark (BofA Merrill Lynch U.S. High Yield Master II Index) for the quarter.  All of the outperformance is attributed to positive credit selection as sector allocation was neutral.  Positive credit selection in the basic industry, banking, and automotive sectors were the largest performance contributors over the quarter.  Credit selection was positive or neutral in 16 of the 17 BofA Merrill Lynch industries.  The only blemish was utilities, where we modestly underperformed the index.