Large Cap Fundamental Value
Period ended December 31, 2014
The S&P 500 Index returned +13.7% in 2014, its sixth consecutive positive year—the longest such streak since the mid to late 1990s. Unlike the extended bull market of the 1990s, which was driven by irrational growth expectations and swelling price-to-earnings multiples, the stock market’s rise over the past six years has been powered by broad corporate earnings growth. Moreover, household debt has been reduced by about 25% and corporate debt has been more than halved—an unprecedented deleveraging cycle that has de-risked the market considerably. Stock prices are up, earnings are higher, balance sheets are stronger, interest rates are lower, and inflation remains subdued. The U.S. economy has demonstrated clear progress though growth in Europe, Asia, and emerging markets has somewhat disappointed. Taking into account the confluence of these factors, we find the broad equity market reasonably valued for the risks at hand; it is neither especially compelling nor overextended. We have identified valuation opportunities selectively, as demonstrated by the portfolio’s discount to the market, but we remain highly reluctant to assume undue risk. The portfolio trades at 11.1x our estimate of normal/sustainable earnings compared to the S&P 500 Index trading at 16.6x normal earnings and 17.2x next year’s consensus earnings. We remain keenly focused not only on valuation support as a primary risk control, but also on strong balance sheets, sustainable cash flows, and prudent use of capital.
Crude oil prices tumbled 46% during 2014, precipitated by concerns about economic growth in developing economies (i.e. shrinking demand) without a corresponding slowdown in production from the world’s major oil producers (i.e. excess supply). Commodity price changes should not affect total economic growth globally, but net importers benefit at the expense of net exporters when crude oil prices plummet. Accordingly, equities in the U.S., Western Europe, and developed Asia performed significantly better than equities in oil producing countries such as Russia and Brazil. Also, performance disparity was significant between sectors because the energy sector lagged by a sizable margin. During the year, S&P 500 Index energy stocks returned -8% as a group, making it the only sector with a negative return.
In December, the Bureau of Economic Analysis revised real U.S. GDP growth to a +5.0% annual rate for the quarter ended 9/30/14. This was on the heels of a +4.6% real growth rate in the previous quarter and marked the fastest pace in more than a decade. The primary driver was increased consumer spending, but business investment, exports, and government spending also increased. Also in 2014, the unemployment rate dipped below 6% for the first time in six years and consumer confidence hit a seven-year high.
Against this backdrop, the U.S. Dollar appreciated relative to other major global currencies. The Dollar was up 12% versus the Euro, 6% versus the Pound, and 14% versus the Yen. An improved economy, robust corporate earnings, and lower financial leverage provide a solid foundation for the equity market though stock prices have increased commensurately. Amenable conditions can persist for long periods, though we remain somewhat guarded. In the current environment, we have identified attractive valuation opportunities selectively while emphasizing appropriate risk controls, and are optimistic regarding the portfolio’s resulting risk/return profile.
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in 2014. The portfolio’s energy weight averaged about 5% less than the index throughout the year, which helped relative performance as energy was the worst-performing sector by a considerable margin. Conversely, the portfolio’s technology weight averaged about 5% more than the index throughout the year, which also helped relative performance as technology was the best-performing sector over the year. Positive stock selection in industrials was also a performance contributor. The largest individual performance contributors in 2014 were Hewlett-Packard, Exelon, and Public Service Enterprise Group. Stock selection in financials, consumer staples, and telecommunications detracted from relative performance in the year. Within financials, Unum, Citigroup, and AIG were the largest individual detractors, though each had a positive return for the year. Within staples, Wal-Mart was the largest relative detractor despite a +12% return.
PORTFOLIO ACTIVITY: 2014
The portfolio’s largest sector increase over the year was consumer discretionary, largely due to adding new positions in automobile companies General Motors and Honda. We also increased the portfolio’s exposure to cable companies which exhibit an interesting risk/return opportunity. We reduced the weight in utilities, primarily by way of exiting the position in Exelon which had outperformed during the year. The portfolio’s healthcare weight remained fairly constant over the year but the composition changed; we exited the position in Johnson & Johnson as it approached our valuation target and took a new position in GlaxoSmithKline, a pharmaceutical company trading at a discount to our estimated net present value of its existing drug platform.