Large Cap Fundamental Value
Period ended June 30, 2014
Despite several bouts of geopolitical unrest, the S&P 500 Index gained +5.2% during the second quarter and has returned +7.1% since the beginning of the year. Equity investors appeared to largely dismiss both the Russia/Ukraine and Iraq/ISIS conflicts as economically inconsequential. In fact, the VIX Index, often used as a proxy for overall investor apprehension, reached a seven-year low in mid-June. Economic activity over the past quarter was positive and seems to have invigorated investor confidence. The unemployment rate fell to a post-financial crisis low, and now stands at 6.1% compared to 10.0% in 2009. The housing market demonstrated signs of improvement, with new home sales reaching six-year highs and pending sales of existing homes reaching four-year highs. Corporate performance continues to be robust with more than 75% of S&P 500 Index companies exceeding consensus earnings estimates this quarter. In response to these developments, the Federal Open Market Committee’s official statement in mid-June struck a more optimistic tone than its late-April statement, which helped boost equity prices. With the VIX Index reaching a multi-year low, however, we would not be surprised to encounter stints of increased volatility in the near/medium term.
All sectors posted positive returns during the quarter, but dispersion between the best and worst performers was notable. The energy sector led the way, more than doubling the S&P 500 Index return. The price of crude oil rose modestly amid renewed turmoil in Iraq. Financials and consumer discretionary stocks lagged, which is slightly unusual in a positive market environment given their pro-cyclical nature.
The strong economic and corporate backdrop supports higher stock prices but increased valuations have tempered our expectations. The S&P 500 Index trades at 16.7x next year’s consensus earnings estimates, which is slightly above the 25-year median (16.0x). The Index trades at 2.6x book value, which is in line with the 25-year median. The portfolio, however, trades at 11x our estimate of normal earnings and 1.5x book value, which represents a considerable discount to the market. While higher price-to-earnings levels suggest equity prices may be getting ahead of earnings, interest rates remain near historic lows and the risk premium to own equities versus bonds is still quite compelling.
ATTRIBUTION: 2Q 2014
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index during the second quarter of 2014. Stock selection in technology was the largest performance detractor for the quarter. Oracle lagged after reporting results slightly below consensus estimates, though our investment thesis remains fully intact. Stock selection in telecommunications also detracted from performance, as our lone position (Vodafone) lagged the market. Vodafone reported modest results and a disappointing outlook due to elevated capital expenditures. Vodafone, Bank of America, and Target were the largest individual performance detractors. Positive stock selection in healthcare, energy, and utilities contributed to performance during the quarter. Royal Dutch Shell, NRG Energy, and American International Group were the largest individual performance contributors.
PORTFOLIO ACTIVITY: 2Q 2014
The largest sector increase over the quarter was consumer discretionary, primarily by way of adding new positions in two automobile companies: General Motors and Honda Motor. Both companies trade at a single digit multiple of our normal earnings estimates. General Motors possesses a rapidly growing, highly profitable emerging markets position and a low cost domestic business. It also has a considerable net operating loss minimizing cash taxes. Honda has a diligently-cultivated brand, best-in-class flexible production capability, strong position in economic vehicles and motorcycles, and growing geographic diversity. We reduced the weight in utilities by trimming the position in Exelon, which had been a strong performer recently.