Large Cap Fundamental Value
Period ended December 31, 2015
While the S&P 500 Index closed 2015 in positive territory (+1.4%), most stocks finished the year lower than where they started. Excluding a handful of richly valued growth stocks it would have been a negative year. In fact, the S&P 500 Equal Weight Index returned -4.1%, lagging the more commonly used market cap weighted index by its largest magnitude in nearly a decade. A handful of mega capitalization stocks that represent a disproportionate weight in the popular equity indexes enjoyed handsome returns. Some of this effect was a perceived (or perhaps misperceived) flight to safety, while some of it was infatuation with top-line growth.
Outside the mega-cap effect, we observed two dominant factors that influenced market returns in 2015. The first factor was investor concerns about economic growth driven by a slowdown in China. The world’s second largest economy is experiencing growing pains that are affecting economies beyond its borders. Stocks in economically sensitive market segments such as heavy industry, basic materials, and energy have been punished accordingly. The precipitous decline in these economically sensitive industries has resulted in statistically significant value dislocations, and in select circumstances, attractive investment opportunities. The energy sector has been hit particularly hard. It was, by far, the worst-performing sector for the second consecutive year. The S&P energy sector lagged the broad index by more than 20 percentage points in each of the last two calendar years. Brent crude oil has fallen 67% over the past 1.5 years, including its 35% decline in 2015. Concerns about weak demand and excess supply have combined to pressure crude prices—supply being the dominant factor. Supply concerns are focused on increased production, most notably from US shale regions, and potentially Iran going forward. Given the dramatic decline in energy prices, however, capital spending budgets have been slashed. We believe the combination of capex cuts and natural decline rates will cause a slowdown, or even a decline in production within a reasonable timeframe. This would put upward pressure on energy prices. Despite attractive valuations for many energy companies, however, we have invested cautiously. Our strategy has been to invest in stocks of companies that should benefit handsomely from a rise in crude prices but have balance sheet strength sufficient to endure a prolonged period of low prices. We have also favored companies with attractive and sizable acreage, which allows for capital reinvestment at attractive rates of return—an imperative quality for exploration and production companies in today’s environment.
The second dominant factor that drove 2015 returns was the value effect, or more accurately a lack thereof. The Russell 1000 Value Index underperformed the Russell 1000 Growth Index by 9.5% in 2015, returning -3.8% compared to +5.7%. While that underperformance is not as severe as the tech bubble of the late 1990s or the financial crisis of the mid/late 2000s, it was nevertheless a significant headwind for value investors. History has shown, however, that buying value rewards the patient investor. Russell style index data is available beginning in 1979; since then, the value index has outperformed the growth index by more than 1900%, cumulatively.* We see nothing in this market that suggests value has lost its long-term appeal.
Our experience has taught us that remaining true to our value investment philosophy and disciplined in our approach is the best course of action in trying times. The portfolio trades at 8.7x normal earnings and 1.1x book value, which represents a considerable valuation discount to the Russell 1000 Value Index (13.2x and 1.7x, respectively) and an even larger discount to the S&P 500 Index (15.9x and 2.6x, respectively).
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index in 2015. The portfolio’s average exposure to stocks in the lowest P/B quintile was 35% compared to approximately 20% for the index. This group of stocks underperformed the index by 400 basis points over the course of the year, so our overweight exposure hurt relative performance. The portfolio’s average energy weight was about 3 percentage points less than the index, which helped relative performance, but stock selection in the sector detracted from returns. Stock selection in industrials and utilities were also detractors. Positive stock selection in financials was the largest contributor to relative returns throughout the year, with our insurance positions leading the way. Positive stock selection in healthcare was a modest contributor as several managed care positions performed well. During the year, the largest individual performance detractors were Marathon Oil, Murphy Oil, and Cummins; the largest individual performance contributors were AIG, Chubb, and Microsoft.
PORTFOLIO ACTIVITY: 2015
We began calendar year 2015 with 56 holdings in the Large Cap Fundamental Value strategy. Over the course of the year, we exited 12 positions and added 9 new positions, ending the year with 53 holdings. This implies name turnover of roughly 20%, which is close to our 10 year average (~25%). We took gains in the portfolio’s two best-performing sectors (healthcare and financials) and added capital to two lagging sectors (energy and industrials). The effect of this was very modest changes in sector weights from the beginning of the year to the end of the year (i.e. sector changes would have been larger had we made no trades). We reduced the healthcare weight by exiting positions in a managed care company and a pharmaceutical company, both of which appreciated and began to approach our valuation targets. While we remain cautious in the energy sector, we added a new position in a US-based exploration and production company. This company possesses attractive acreage that is large enough to enable them to reinvest capital at attractive rates of return without the need to invest in new projects with more uncertain outcomes. In industrials, we added to several existing positions that had underperformed and where our investment thesis remains intact.
*Russell 1000 Value & Russell 1000 Growth data/indexes
Prior to the inception dates of the Russell indexes, historical data was calculated based on the same companies, and information, which would have been available (or interpolated if unavailable) at the specific times throughout history as if it was actually created during that time.