Large Cap Fundamental Value
Period ended June 30, 2015
The S&P 500 Index returned a modest +0.3% during the second quarter of 2015 and is now up +1.2% since the beginning of the year. Growth and value performed similarly during the quarter but value stocks have lagged considerably over the past 12 months. Typically, such environments present a headwind for our value-focused strategy but we have managed to navigate the past twelve months satisfactorily considering the circumstances. Naturally, however, we would welcome a value tailwind which our experience has taught us should inevitably emerge in due course.
The economic perils in Greece have reemerged as an important concern that is giving investors pause. The good news is that Greece is small, representing about 2% of the total economic output of all countries that use the euro as their currency. The primary risk for equity investors is that a Greek exit from the Eurozone sets a new precedent, and investors may ponder the possibility that a larger European economy (e.g. Italy, Spain) may share a similar fate if/when stressed, which could trigger economic turmoil throughout the region. Thus far, the market appears to perceive the Greece situation as largely quarantined—government bond spreads for other European periphery countries have remained relatively tight versus the German Bund. Nonetheless, we are monitoring the situation closely and have evaluated in detail each of our positions’ exposure to changes in the value of the dollar; we remain confident that we are not bearing unnecessary risk.
Strengthened corporate balance sheets, robust earnings growth, and an improved economic backdrop have supported the strong rise in US stock prices in recent years. In our view, the broad equity market’s valuation appears about average—neither exceptionally attractive nor dramatically overextended. Fortunately, we have been able to identify select pockets of attractive valuation opportunities. We have identified a disproportionate number of such opportunities in financials, which remain out-of-favor despite representing the most de-risked segment of the market. Select insurers and money center banks, for example, trade near or even below book value despite undergoing unprecedented efforts to improve their capital positions. These are businesses that provide essential services to the marketplace and would be next to impossible to replicate organically. The prospects for increased ROE and earnings growth have improved, and the companies are either returning considerable capital to shareholders or have plans to do so in the near term. The prospect of paying less than book value for a company possessing such qualities represents an uncommon and compelling valuation opportunity.
While we have identified select opportunities, the breadth of attractive risk-adjusted valuation opportunities is not what it was five years ago. Our experience has taught us that a keen focus on risk controls in such environments is especially critical. We gravitate to companies with sustainable cash flows, strong balance sheets, prudent capital allocation, and appropriate valuation support. The portfolio’s risk/return profile is attractive in the current environment and trades at a considerable discount to the market. The portfolio trades at 10.5x our normal earnings estimate versus 13.8x for the Russell 1000 Value Index and 16.3x for the S&P 500 Index. It also trades at 1.4x book value compared to 1.8x and 2.7x for the Russell 1000 Value Index and the S&P 500 Index, respectively.
ATTRIBUTION: 2Q 2015
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the second quarter of 2015. The largest contributor to relative performance, by far, was positive stock selection in the financial sector. The portfolio’s banks and insurers both outperformed. REITs returned -10.5% in the quarter, which also helped relative performance as we have viewed the industry as one of the more overvalued segments of the market—the portfolio has zero REIT exposure. Stock selection in telecom and consumer discretionary also helped performance. The largest individual contributors were AIG, Vodafone, and Time Warner Cable. On the negative side, stock selection in consumer staples, technology, and utilities detracted from relative performance. Calpine, Corning, and Murphy Oil were the largest individual performance detractors.