Large Cap Fundamental Value
Period ended September 30, 2014
The S&P 500 Index returned a modest +1.1% over the three months ended September 30th, the seventh consecutive positive quarter for the index. In August, the index closed above 2,000 for the first time, peaking at 2,011 in mid-September before a slight pullback. Unlike prior market peaks (e.g. 1999, 2007), elevated stock prices today are supported by both strong corporate earnings and an improving economic environment. At 16.5x forward earnings, the S&P 500 Index trades at a valuation slightly higher than the 25-year median of 16.0x. Meanwhile, the 10-year Treasury yields 2.5% versus the 25-year median of 4.8%; considering the low interest rate environment equity valuations appear reasonable. The U.S. housing market continues to recover, with new home sales considerably higher than consensus expectations and home prices on the rise. Higher home values create a wealth effect that boosts confidence and drives consumer spending, which accelerated during the quarter—consumer spending comprises two-thirds of U.S. GDP, so the housing market’s economic impact is material. Meanwhile, employment has steadily improved and inflation has remained in check. The U.S. dollar strengthened as a result of the productive economy, appreciating by more than 6% relative to a basket of major developed market currencies1. While the tense geopolitical landscape poses risks to the equity market, the earnings power of our portfolio holdings provides considerable valuation support. The portfolio trades at 10.8x our estimate of normal/sustainable earnings, a significant discount to the market average2.
Concerns about decelerating growth in emerging markets triggered a precipitous decline in commodities over the quarter. Crude oil, natural gas, precious metals, most industrial metals, and most agricultural commodities declined considerably—some by more than 10%. Consequently, sectors exposed to commodity price changes lagged the overall market. Energy, utilities, and industrials were the only three S&P 500 sectors that declined during the quarter. Healthcare, technology, and telecommunications were the top-performing sectors, rising +3% to +5%. Value underperformed growth for the quarter, largely because energy is a larger weight and technology a smaller weight in value indices as compared with growth indices. Small cap stocks lagged large cap stocks by a wide margin in the quarter3. As of one year ago (9/30/13), small cap equities had outperformed large cap equities by more than 50 percentage points since the market bottom in March of 2009. This resulted in a large valuation premium for small cap stocks relative to large cap stocks compared to historical averages—this premium has eroded over the past twelve months toward levels more typically observed because small cap stocks have since underperformed.
Improved balance sheets and a sound economic backdrop have at least partially de-risked the U.S. equity market over the past five years. Elevated stock prices and geopolitical unrest, however, have produced a market that is somewhat temperamental. The VIX index, a gauge of expected volatility, oscillated from 10, to 17, to 11, and then back to 16—all within the third quarter. Escalations in Syria, Iraq, Ukraine, or elsewhere could prompt additional bouts of volatility going forward, but we believe we are well positioned for such encounters as we remained focused on valuation support, strong balance sheets, sustainable cash flows, and prudent capital allocation.
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) slightly underperformed the Russell 1000 Value Index during the third quarter of 2014. Stock selection in technology, industrials, and utilities detracted from performance in the period. Much of the portfolio’s utility exposure has unregulated power generation businesses that are exposed to changes in natural gas prices, which declined nearly 8% in the quarter. The largest individual performance detractors were Cummins, Corning, and NRG Energy. Positive stock selection in financials and an underweight exposure to energy contributed to relative performance during the quarter. The largest individual performance contributors were Citigroup, Target, and Microsoft.
Sector weights were quite stable over the course of the quarter, as all changes were less than one percentage point. The most notable changes were intra-sector. Within financials, we took a new position in Citizens Financial Group, which completed an initial public offering in September. Meanwhile, we reduced the position in Wells Fargo and exited the position in BB&T Corporation because Citizens represented a more compelling risk/return profile. We also shifted the portfolio’s healthcare exposure, by adding to the position in GlaxoSmithKline and taking a new position in Medtronic. We exited the position in Johnson & Johnson, which had outperformed and approached our valuation target.
____________________________1The basket includes an equity market weighted average of major developed market currencies, the largest of which are the Euro, Yen, and Pound.
2The S&P 500 Index traded at 16.5x next years’ consensus earnings estimates, and 16.3x using our proprietary normal earnings methodology.
3The Russell 2000 Index is used as a proxy for small cap stocks; the Russell 1000 Index is used as a proxy for large cap stocks.