Large Cap Fundamental Value

Market Commentary

Period ended June 30, 2016

The S&P 500 Index returned +2.5% during the second quarter of 2016.  There was wide performance dispersion across sectors, with the best-performing sector (energy) outperforming the worst-performing sector (technology) by more than 14 percentage points.  Despite the partial rebound in energy this quarter, over the last 12 months we have observed a massive flight away from cyclical market segments in favor of non-cyclicals.  Pundits have described this trend as “risk off”, “flight to safety”, “low volatility”, “bond proxy” etc. but the reality is that non-cyclical businesses now appear to trade at an unusually high premium to cyclical businesses.  Macroeconomic shocks like Brexit have only exacerbated the divergence.  True to Benjamin Graham, we view stocks trading at discounts to intrinsic value as having a margin of safety.  Ironically, it has become difficult to identify a margin of safety in businesses currently perceived as “safe” because their valuations have become stretched.  Accordingly, our modest overweight allocation to cyclicals reflects the risk-adjusted valuation opportunities available and not a macroeconomic outlook.  The most attractive individual opportunities reside within financials and energy, though we remain slightly underweight both sectors relative to the Russell 1000 Value as only select segments within the sectors offer compelling risk adjusted valuations—albeit highly compelling.  Relative to the Russell 1000 Value Index the portfolio is overweight consumer discretionary and technology, underweight consumer staples, and relatively equal-weight other sectors.  We do not know when value dislocations will revert, nor are we certain that these dislocations will not widen further before reverting.  We have learned from past experience, however, that these cycles inevitably do normalize and we believe that our portfolio is well-positioned to benefit. 

Interest rates declined during the quarter, largely influenced by investors’ flight to US Treasuries in the aftermath of Brexit.  The low rate environment has been a stubbornly persistent macroeconomic headwind for most financials, with banks disproportionately affected because their net interest margins are pressured.  From a bottom-up fundamental perspective, however, the strengthening posture of US banks has been quite encouraging.  Profitability has been solid and capital ratios are at/near all-time highs.  All companies subjected to the Fed’s stress test have passed, which improves the potential for increased returns of capital to shareholders.  Buying back shares at/below book value can be highly accretive and this group’s payout yield (dividends + share repurchases) currently stands at 8%1.  Financials represent the portfolio’s largest sector, though the weight is about equal to that of the Russell 1000 Value—we are overweight banks and underweight REITs. 

The portfolio’s largest sector weights relative to the Russell 1000 Value Index are technology and consumer discretionary.  Our technology positions are centered on attractively-valued companies with sticky customer bases, predictable cash flow streams, and net cash balance sheets.  Our consumer discretionary weight is composed of an eclectic mix of media and automobile-related companies, combined with a small weight in retailers.  The common thread here is also attractive valuations with sufficient balance sheet strength to withstand near-term challenges. 

Recent trends have been challenging for our short-term performance but this environment has presented value investors with some uncommon opportunities.  The valuation discrepancy between our portfolio and the benchmark(s) is rather striking:  the portfolio trades at 8.5x normal earnings compared to 13.7x for the Russell 1000 Value and 16.2x for the S&P 500.  Valuation will continue to be our guiding beacon, and we believe prudent investors should be increasing allocations to value given the attractive prospects.

ATTRIBUTION: 2Q 2016

The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index in the second quarter of 2016.  Sector allocation was a considerable performance drag during the quarter; we were underweight the three best-performing sectors and overweight the three worst-performing.  This is partly due to the portfolio’s cyclical exposure as we have identified more interesting risk-adjusted valuation opportunities in cyclical market segments which underperformed during the quarter.  Stock selection in financials and technology detracted from performance, which was partially offset by positive stock selection in energy.  The largest individual contributors to relative performance were energy companies: Marathon Oil, Hess, and Murphy Oil.  The largest individual detractors to relative performance were Ericsson, Nordstrom, and Bed Bath & Beyond.  

PORTFOLIO ACTIVITY: 2Q 2016

There were no new additions to the portfolio and no complete sales, though we added and trimmed around existing holdings as valuations dictated.  The portfolio’s energy positions appreciated by +23% during the quarter as a group; we trimmed some of the better performers.  We added to consumer discretionary primary by increasing the existing position in cable content provider, which has an attractively valued stock with compelling growth potential in its core business and a shareholder friendly management team.  At quarter end, 53 positions comprised the portfolio.  

 

1Source: Empirical Research

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 hotchkisandwiley@hwcm.com.  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 June 30, 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.
 

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