Large Cap Fundamental Value

Market Commentary

Period ended December 31, 2016

The S&P 500 Index finished 2016 +12%, a particularly impressive feat given the index was down more than -10% in early February.  Since its -37% return in 2008, the S&P 500 Index has produced positive returns for eight consecutive calendar years.  The primary performance drivers, however, have varied considerably from year to year.  In 2015, for example, stocks in the highest price-to-book (“P/B”) quintile outperformed stocks in the lowest P/B quintile by about 20 percentage points; in 2016 the lowest P/B quintile outperformed the highest P/B quintile by about 20 percentage points.  The energy sector went from the worst underperformer in 2015 to the top outperformer in 2016. 

Until recently investors had favored REITs, consumer staples, regulated utilities, and other market segments with relatively stable revenue streams and high dividend payout ratios.  The market viewed these stocks as bond surrogates, particularly because of the low interest rate environment.  Our opinion has been that these sectors were bid up to excessive valuation levels; stable businesses make for risky investments if you have to overpay for the intrinsic value of the enterprise.  In contrast, stocks of companies with more cyclical businesses were shunned irrespective of valuation; hence, this is where we identified the most compelling risk-adjusted return opportunities.  Value dislocations eventually revert to reflect underlying economic fundamentals.  We observed such a reversion in 2016, as the large dislocation between bond proxies and cyclical companies narrowed; the yield on the 10-year treasury finished the year at 2.45%, an increase of more than 100 basis points from its July low of 1.36%.  While the value reversion was large, spreads remain wider than average because the dichotomy had reached such extreme levels.  Accordingly, the portfolio trades at a larger-than-average discount to the value benchmark, though the discount is smaller than it had been early in 2016.  The portfolio’s current P/B ratio is 73% of the Russell 1000 Value’s P/B, compared to the historical average of 83%.  The portfolio’s price-to-normal earnings ratio (“P/E”) is 64% of the Russell 1000 Value’s P/E, compared to the historical average of 73%.  The overall equity market appears neither overvalued nor undervalued in any meaningful way, but valuation opportunities exist selectively for active fundamental investors. 

Over the long-term, a company’s earnings power and associated intrinsic value are the dominant drivers of stock performance.  In the short-term, changes in market sentiment can drive stock performance as macroeconomic factors, geopolitical issues, or other major events can cause investors to become skittish or greedy.  Early in 2016, for example, US equities declined amid investor panic that economic growth in China would slow precipitously.  Stocks in economically sensitive industries were punished irrespective of fundamental valuation as investors flocked to bond substitutes—also irrespective of valuation.  This reverted later in the year as the value dislocation was ultimately recognized by the market, which benefited disciplined investors that stayed the course.  As we look to 2017 and beyond, we maintain our unwavering commitment to the time-tested principles of long-term fundamental value investing and prudent risk management.   


The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in 2016.  About one-third of the portfolio was invested in stocks trading at a discount to book value compared to about one-tenth for the Russell 1000 Value; this deeply discounted cohort outperformed the rest of the market substantially.  Positive stock selection in energy and industrials, along with the underweight allocation to consumer staples also contributed to outperformance.  Stock selection in utilities and telecommunications, along with the overweight allocation to consumer discretionary detracted from relative performance.  The five largest individual positive contributors to relative performance over the year were Marathon Oil, Cummins, Corning, Hewlett-Packard Enterprise, and Bank of America; the five largest detractors were Ericsson, Calpine, Vodafone, Bed Bath & Beyond, and Sanofi.   


The portfolio began the year with 54 holdings.  During the year we exited six positions and added four, ending the year with 52 holdings.  Most of the trading consisted of adding and trimming around existing positions as dictated by valuation changes.  The largest trims during the year were among the portfolio’s best relative performers (e.g. Corning) and the largest additions were among the worst relative performers (e.g. Ericsson).  This is common given our long-term fundamental value approach—intrinsic value is more stable than market prices.  Sector weight changes were rather modest over the course of the year.  We reduced the weight in consumer staples, healthcare, and utilities.  We have no chronic aversion to these sectors but find few compelling valuation opportunities in the current environment.  We also trimmed our energy exposure but the sector weight increased slightly due to performance.  We added to industrials and technology—both by a modest magnitude.  

Composite performance for the strategy is located on the Performance tab. Returns discussed 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. 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 each 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, is calculated using daily holding information and does not reflect management fees and other transaction costs and expenses.  Specific securities identified are the largest contributors (or detractors) to the portfolio’s performance relative to the Russell 1000 Value Index. Other securities may have been the best and worst performers on an absolute basis. Securities identified do not represent all of the securities purchased or sold 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 the 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 Literature tabs. For a list showing every holding’s contribution to the overall account’s performance and portfolio activity for a given time period, please contact H&W at  Portfolio information is 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, 2016 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. Certain information presented is based on proprietary or third-party estimates, which are subject to change and cannot be guaranteed. 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.

Index definitions