Capital Income

Period ended March 31, 2013

The seemingly insurmountable federal budget impasse and the tense bailout of a small European country (Cyprus) did not prevent positive performance from U.S. equity and high yield markets.  While low yields and high equity market prices normally warrant caution, corporate earnings have remained strong, defaults have remained low, and economic developments have been largely positive.  The S&P 500 Index returned +10.6% and the BofA Merrill Lynch U.S. High Yield Master II Index returned +2.9% for the quarter.

We believe the enigmatic relationship between geopolitical turmoil and the appreciation of risk assets (e.g. high yield bonds, equities) can be explained by several factors.  First, the market appears to view budgetary proposals as political posturing rather than plans with genuine substance.  Accordingly, little credence is placed on deadlines, or more appropriately, a failure to meet deadlines.  Kicking the can down the road has been the most politically tenable solution and has now become the market’s expectation; the length of this road remains the big unknown.  Second, the economy continues to exhibit meaningful signs of improvement in spite of political gridlock.  Housing, employment, and manufacturing have demonstrated legitimate signs of recovery.  Despite these improvements, the Federal Reserve Open Market Committee (FOMC) has signaled that interest rates will remain low and elevated asset purchases will continue for the foreseeable future.  Third, equity valuations remain reasonable even with the market’s appreciation.  The recession forced companies to trim excess costs aggressively, which has led to considerable profit margin improvement across Corporate America.  Consequently, equities’ real earnings yield remains above historical averages and well above the negative real yields of high grade bonds.  Finally, on top of improved economic conditions, default risk has been reduced through improved balance sheets and robust refinancing.

The long-term outlook for the equity market should be predicated on its ability to generate earnings and deploy those earnings effectively.  Bearish investors argue that profit margins are abnormally high and will revert downward via competitive forces and less prudent capital deployment.  Bullish investors argue that balance sheets have been de-risked, operating leverage has not been expended, and managements’ capital allocation policies will remain prudent in the wake of the recent recession.  We do not believe that either viewpoint will be universally validated and that the outcomes will vary from company to company.  As active managers, we are charged with making this distinction.  We gravitate toward companies that trade at a low multiple of normal earnings, have strong balance sheets, and possess sustainable competitive advantages.  While we believe this is the optimal combination for navigating any environment, it is particularly important today given the looming geopolitical issues.

Yields declined and spreads tightened over the course of the quarter, by about 50 basis points each.  Yields are quite low and spreads are modestly below their historical averages.  Taking the low default rate and high recovery rate environment into consideration, however, spreads remain rather sensible.  The distribution of spreads also remains reasonable, which we believe is conducive to our bottom up credit research approach.  Interesting valuation opportunities are less bountiful than in 2009, but interesting risk/reward opportunities are available selectively for diligent investors. 
 

ATTRIBUTION: 1Q 2013

Asset Allocation - Disproportionately attractive equity valuations led us to overweight equities during the quarter.  The portfolio averaged about 58% equity and 42% high yield bonds, which benefited performance as equities outperformed high yield.

Equities - The equity portion of the Hotchkis & Wiley Capital Income portfolio (gross and net of management fees) outperformed the S&P 500 Index for the quarter.  More than 80% of the outperformance was due to positive stock selection, with technology and consumer discretionary leading the way.  The largest individual contributors were Hewlett-Packard, H&R Block, and Geo Group.  Stock selection in energy and industrials detracted from performance over the quarter.  The largest individual detractors were Total, Royal Dutch Shell, and Lockheed Martin. 

Fixed Income - The high yield portion of the Hotchkis & Wiley Capital Income portfolio (gross and net of management fees) outperformed the BofA Merrill Lynch U.S. High Yield Master II Index for the quarter.  Positive credit selection drove all of the outperformance for the quarter; credit selection was positive in 13 of the 16 Merrill Lynch sectors.  The sectors with the largest contribution to relative return were basic industry, energy, services, and financial services.  A modest cash position and slight underperformance in the banking and insurance sectors detracted from relative performance.