Large Cap Fundamental Value
Period ended March 31, 2015
Following six years of positive returns, the S&P 500 Index opened 2015 with a modest +1.0% return in the first quarter. The unprecedented corporate cost-cutting measures and general economic recovery following the financial crisis has fueled impressive earnings growth. Over the last six years, the S&P 500 is up +194% cumulatively. While such a rampant appreciation of market prices would normally give us pause, equity valuations are scarcely higher than historical averages due to these robust earnings.
After six years of zero interest rate policy, investors are acutely focused on the Federal Reserve’s plan to taper its lax monetary policy. Equity investors are not fully insulated from such actions, however, we believe the effect on equities should be more subdued than many investors expect. Firstly, increasing interest rates are often correlated with positive economic developments, which is good for corporate cash flows. Secondly, long bond rates are a component of the cost of capital used to discount corporate cash flows. Fed tapering should impact short term interest rates disproportionately to long term rates, which already reflect expectations of a less intrusive Fed. Finally, the premium equity investors require above treasuries is considerably higher than historical averages. If interest rates rise, we may see a reversion of the equity premium back to normal levels, resulting in equity prices remaining stable despite higher interest rates.
In commodity markets, crude oil prices continued to fall during the quarter, particularly WTI crude. Long term supply and demand dynamics are the primary drivers of oil prices over time. Current crude prices appear well below long term equilibrium levels. Global demand growth is about +1% annually while the natural decline rate in oil supply is about 6% annually. Given this decline rate, oil production needs to continue to grow in order to keep pace with demand. Over the last five years, most of the global production growth has come from the US and Canada, particularly US shale regions. First year decline rates for these regions are estimated between 60% and 75%, which could result in a meaningful production decline if new wells are not drilled. Capex budgets for 2015 have been slashed due to low crude prices so new wells appear to be on the decline. Other regions around the globe appear unlikely to increase production as well; many regions did not increase production when oil was over $100/barrel, so it seems unlikely they would increase production after crude prices halved. Our analysis suggests that oil prices around $70 to $80 per barrel are required for marginal producers to supply the market. The path to equilibrium can be rocky but we see opportunities to generate returns for patient investors.
The US dollar strengthened relative to other major currencies during the quarter. The US dollar index, which compares the dollar relative to a weighted basket of other major currencies, has appreciated by 23% since mid-2014. We receive many perceptive questions on how this affects equity valuations; the answer is somewhat complex as there are many moving pieces. A stronger dollar in and of itself would generally result in lower earnings for companies that generate more revenue than costs overseas (a prevalent occurrence). It is important to remember, however, the reason that the dollar has appreciated. An improved US economy, easy monetary policies overseas (e.g. quantitative easing in Europe), and heightened geopolitical risks have each contributed to a stronger dollar—and each justify higher US equity valuations.
Overall, compelling valuation opportunities with acceptable risk profiles are more difficult to find in today’s market than five years ago. In such environments, our experience has taught us that stressing risk controls is of paramount importance. We remain partial to companies with strong balance sheets, sustainable cash flows, sound capital allocation policies, and of course, attractive valuations. While it has become more challenging to find new opportunities that exhibit such traits, the current portfolio exemplifies these characteristics and exhibits an attractive risk/return profile. The portfolio trades at 10.8x our normal earnings estimate compared to 13.8x for the Russell 1000 Value Index and 16.2x for the S&P 500 Index.
ATTRIBUTION: 1Q 2015
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the first quarter of 2015. Positive stock selection in healthcare was the large contributor to outperformance as the portfolio’s managed care holdings performed well. An overweight position in consumer discretionary and positive stock selection in utilities also helped relative performance. The largest individual contributors were Anthem, GlaxoSmithKline, and Boeing. Stock selection in financials and energy, along with an overweight position in technology detracted from performance in the quarter. The largest individual detractors were Royal Dutch Shell, Hewlett-Packard, and Bank of America.
PORTFOLIO ACTIVITY: 1Q 2015
The portfolio’s largest sector increase was industrials, largely due to adding a new position in Owens Corning and adding to the existing position in CNH Industrial. We reduced the weight in technology by exiting the position in Texas Instruments and reduced the weight in consumer staples by trimming Wal-Mart—the valuation of both stocks had expanded. The financials weight was fairly constant but we exited our position in Allstate and initiated a new position in Chubb, which we believe offers a more compelling risk/return profile; this was the largest individual sale and largest individual buy, respectively.