Large Cap Fundamental Value

Period ended March 31, 2013

The seemingly insurmountable federal budget impasse and the tense bailout of a small European country (Cyprus) did not prevent equity markets from reaching record price levels.  While all-time highs normally warrant caution, corporate earnings have kept pace so valuations remain reasonably appealing.  The S&P 500 Index returned +10.6% and the Russell 1000 Value Index returned +12.3%—the best Q1 for the value index in more than two decades.

We believe the enigmatic relationship between geopolitical turmoil and rising equities can be explained by several factors.  First, the market appears to view budgetary proposals as political posturing rather than plans with genuine substance.  Accordingly, little credence is placed on deadlines, or more appropriately, a failure to meet deadlines.  Kicking the can down the road has been the most politically tenable solution and has now become the market’s expectation; the length of this road remains the big unknown.  Second, the economy continues to exhibit meaningful signs of improvement in spite of political gridlock.  Housing, employment, and manufacturing have demonstrated legitimate signs of recovery.  Third, equity valuations remain reasonable even with the market’s appreciation.  The recession forced companies to trim excess costs aggressively, which has led to considerable profit margin improvement across Corporate America.  Consequently, equities’ real earnings yield remains above historical averages and well above the negative real yields of high grade bonds.  Finally, investors have shifted from equities to bonds and cash in a big way over the past several years.  Given the under-allocation of equities, a return toward traditional allocations could continue to propel equity markets.

The long-term outlook for the equity market should be predicated on its ability to generate earnings and deploy those earnings effectively.  Bearish investors argue that profit margins are abnormally high and will revert downward via competitive forces and less prudent capital deployment.  Bullish investors argue that balance sheets have been de-risked, operating leverage has not been expended, and managements’ capital allocation policies will remain prudent in the wake of the recent recession.  We do not believe that either viewpoint will be universally validated and that the outcomes will vary from company to company.  As active managers, we are charged with making this distinction.  We gravitate toward companies that trade at a low multiple of normal earnings, have strong balance sheets, and possess sustainable competitive advantages.  While we believe this is the optimal combination for navigating any environment, it is particularly important today given the looming geopolitical issues.  We find interesting opportunities across sectors, but are modestly partial to technology, healthcare, and financials in the current market.
 

ATTRIBUTION: 1Q 2013

The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index for the quarter.  Seven of the ten S&P GICS sectors contributed to the outperformance over the quarter with information technology leading the way.  Hewlett-Packard, the portfolio’s largest underperformer in 2012, returned +68% after an earnings beat, raised guidance, and bullish sell side reports.  Due to its irrationally low valuation at the year’s outset, it remains a compelling risk/reward opportunity.  Positive stock selection in financials, consumer discretionary, and telecommunications also contributed to performance.  After Hewlett-Packard, the largest individual contributors were H&R Block and Unum.  Stock selection in energy and healthcare, along with an underweight in consumer staples detracted from performance over the quarter.  The largest individual detractors were J.C. Penney, Royal Dutch Shell, and Total.
 

PORTFOLIO ACTIVITY: 1Q 2013

Over the quarter, we reduced the weight in financials and consumer discretionary modestly, by exiting or trimming several strong performers (e.g. H&R Block, State Street, MetLife).  The largest sector increase was in healthcare, where we added some attractively valued managed care companies with strong competitive positioning within the industry (e.g. UnitedHealth Group, Aetna).