Large Cap Fundamental Value
Period ended December 31, 2013
U.S. equity investors enjoyed strong gains in 2013 as the S&P 500 Index produced an impressive +32.4% total return for the year. Although companies have yet to report fourth quarter results, 2013 earnings appear to have grown in the high teens compared with 2012. The strong earnings growth was accompanied by even stronger stock price appreciation, which has led to more extended equity market valuations. The valuation expansion was supported by scores of positive economic developments in housing, employment, manufacturing, and consumer confidence. Also, with balance sheets strengthened, corporations returned considerable cash to shareholders.
Taking a closer look at the equity market, valuation discrepancies have narrowed during the year. At the beginning of the year, cyclical sectors traded at a considerable valuation discount to non-cyclical sectors, which is no longer the case. Moreover, the “yield trade”, in which investors sought out securities that were perceived as bond substitutes (e.g. REITs, telecom), began to unwind in 2013. Given these changes, we have shifted the portfolio moderately to favor broader diversification and quality franchises, without having to pay a significant premium.
The U.S. political landscape remained contentious throughout the year. The prolonged budgetary stalemate, government shutdown, and enactment of the so-called “nuclear option1” exemplified Congress’ inability to compromise. At long last, Congress demonstrated encouraging signs of bipartisanship by passing a budget deal in December. It also appears primed to confirm Janet Yellen as the next Federal Reserve Chairwoman, which should result in the continuation of the central bank’s dovish monetary stance. Whether this cooperation can be sustained, however, remains uncertain.
The unprecedented shift from equities into bonds began to reverse in 2013 as plan sponsors balked at the paltry yields. Persistently low yields combined with the threat of both rising interest rates and rising inflation should continue to provide support for the equity market by way of positive fund flows. Nevertheless, many of the exceptional valuation opportunities have been at least partially expended, so we have dialed down the risk/return profile of the portfolio to an extent. The portfolio continues to trade at a considerable discount to the overall equity market, however, and we remain optimistic regarding the risk-adjusted potential of the current portfolio.
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in 2013. Positive stock selection drove more than 85% of the outperformance for the year. Stock selection was particularly strong in financials, technology, and telecommunications. Within financials, we held several strong-performing insurers that traded near or less than tangible book value despite substantial/excess reserves. Five technology stocks in three different industries (hardware, software, and equipment) each returned more than 40% over the year. The sole telecom holding (Vodafone), which had exhibited a considerably depressed valuation, quintupled the benchmark’s telecom return during the year as the company agreed to sell its interest in Verizon Wireless. The largest individual performance contributors over the year were Hewlett-Packard, Vodafone, and Unum.
An overweight and stock selection in utilities detracted from performance. The portfolio’s modest cash position, which averaged less than 3% throughout the year, was also a relative detractor due to the strong positive market. The largest individual performance detractors for the year were Exelon, J.C. Penney, and Royal Dutch Shell.
PORTFOLIO ACTIVITY: 2013
Over the year, the largest sector increase was in healthcare, where the added exposure to managed care companies more than offset the trim in pharmaceuticals. UnitedHealth Group and Humana were new purchases during the year; both are attractively valued due to excessive concerns regarding healthcare reform and its impact on profitability. We also increased the weight in technology despite trimming several strong performers. We took a new position in IBM, which is a well-positioned, diversified technology company with a strong balance sheet, prudent capital allocation, and an attractive valuation. The largest sector decrease was in financials where we exited/trimmed several strong performing insurers. We also lowered the consumer discretionary weight by exiting the positions in H&R Block (it approached our valuation target) and J.C. Penney (increased risk profile).
1The nuclear option replaces the 60-vote requirement for all Presidential appointees with a simple majority requirement (51 votes).
Composite performance for the strategy is located on the Performance tab. Portfolio attribution is based on a representative Large Cap Fundamental Value portfolio. Certain client portfolio(s) may or may not hold the securities discussed due to the account’s guideline restrictions, cash flow, tax and other relevant considerations. Equity performance attribution is an analysis of the portfolio's return relative to a selected benchmark and is calculated using daily holding information. Returns calculated using this buy-and-hold methodology can differ from actual portfolio returns due to intraday trades, cash flows, corporate actions, accrued/miscellaneous income, and trade price and closing price difference of any given security. Specific securities identified are the largest contributors (or detractors) on a relative basis to the Russell 1000 Value Index. Securities’ absolute performance may reflect different results. Securities identified do not represent all of the securities purchased, sold, or recommended for advisory clients, and are not indicative of current or future holdings or trading activity. H&W has no obligation to disclose purchases or sales of these securities. No assurance is made that any securities identified, or all investment decisions by H&W were, or will be profitable. Quarterly characteristics and portfolio holdings are available on the Characteristics and Communications tabs (subject to the firm’s portfolio holdings disclosure policy).
The commentary is for information purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Portfolio managers’ opinions and data included in this commentary are as of December 31, 2013 and are subject to change without notice. Any forecasts made cannot be guaranteed. Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. Equity securities may have greater risks and price volatility than U.S. Treasuries and bonds, where the price of these securities may decline due to various company, industry and market factors. Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods. All investments contain risk and may lose value.
Past performance is no guarantee of future results.