Large Cap Fundamental Value
Period ended September 30, 2016
The S&P 500 Index returned +3.9% in the third quarter of 2016. In recent years we have observed a valuation dichotomy between market segments perceived as safe compared to those perceived as risky. During this period, investors have fully embraced businesses that have a low correlation to economic cycles (e.g. regulated utilities, consumer staples) amid looming fears that global economic contagion could wreak havoc on the US economy. Investors have also coveted high dividend paying companies (e.g. REITs), viewing them as compelling alternatives to low-yielding investment grade bonds. At the same time, investors have shunned businesses with a cyclical tilt, irrespective of valuation. While the overall equity market trades at valuation levels close to historical averages, the difference between the most and least expensive areas of the market is extreme. This wide valuation disparity represents an opportunity for bottom-up investors focused on fundamental valuation. Accordingly, we are overweight cyclical stocks with conservatively capitalized balance sheets as low valuations and low leverage provide a margin of safety in challenging times. We are underweight stocks of non-cyclical businesses because we believe that the excessive valuation premiums present a risky proposition in the long run. While this positioning hurt our performance in the past year, the third quarter demonstrated nascent signs of a value reversion. Our work suggests that the recent value reversion has just begun and has a long ways to go.
During the quarter, cyclical sectors outperformed non-cyclical sectors and stocks with the lowest valuations performed best, a somewhat redundant statement given the current state of affairs. Technology and financials performed best; utilities and telecom lagged; small caps outperformed large caps; and commodity sectors were about average as oil prices were flat.
Financials, technology, and consumer discretionary represent the portfolio’s largest sector weights. The 11 financial positions are disproportionately focused on banks and insurers that trade at/below tangible book value, return considerable capital to shareholders through dividends and share repurchases, and possess balance sheets at/near healthiest-ever levels. The 6 technology holdings include software and equipment providers with high recurring revenues and fortress balance sheets. The consumer discretionary allocation is composed of an eclectic mix of 12 attractively-valued positions across businesses ranging from media, to autos, to specialty retail. The portfolio’s largest underweights relative to the Russell 1000 Value Index are consumer staples, real estate, and utilities. We have no predisposition against these sectors but with most companies trading at 20x earnings or more, we have been unable to identify many interesting risk-adjusted valuation opportunities.
The market’s valuation dichotomy has presented an opportunity to construct a portfolio that trades at an uncommonly large discount to the market without assuming undue risk, and we believe it is an attractive time to increase allocations to value equities. The portfolio trades at 8.9x normal earnings compared to 14.1x for the Russell 1000 Value Index and 16.8x for the S&P 500 Index; the portfolio trades at 1.2x book value compared to 1.8x for the Russell 1000 Value Index and 2.8x for the S&P 500 Index.
ATTRIBUTION: 3Q 2016
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the third quarter of 2016. Positive stock selection in financials was the primary contributor to performance as the portfolio’s banks and insurance holdings did well. Positive stock selection in industrials and the overweight position in technology also helped performance. Stock selection in utilities was a performance detractor in the quarter; the portfolio is underweight regulated utilities and overweight independent power producers which hurt relative returns in the quarter. Stock selection in energy and healthcare were also relative detractors. The five largest individual positive contributors to relative performance in the quarter were State Street, Bank of America, Corning, AIG, and Microsoft; the five largest detractors were Hess, Calpine, NRG Energy, Sanofi, and Royal Dutch Shell.