Large Cap Fundamental Value
Period ended September 30, 2013
The budgetary stalemate and subsequent government shutdown underscore the delicate nature of the current political landscape. Considering equity market volatility escalates rapidly when faced with uncertainty, investors have remained relatively calm while grappling with the legislative standoff and looming debt ceiling issue. Despite the political headwinds, the S&P 500 Index posted its third consecutive positive quarter, returning +5.2% for the three months ended September 30. Performance deviation by sector was unusually large as materials, industrials, and consumer discretionary outperformed telecommunications and utilities by a wide margin; this produced a large discrepancy between the Russell 1000 Value Index and the Russell 1000 Growth Index during the quarter. The growth index outperformed predominantly because it has a larger weight in the three top-performing sectors and a smaller weight in the two worst-performing sectors.
US consumers have increased their wealth by more than $10 trillion since the beginning of 2012 owing to the combination of stock market and home price appreciation1. Reverberations from the recession, however, have produced a severe aversion to risk. Spending on housing and durable goods has recovered from record lows but remain well below long-term averages, and the percentage of US adults invested in the stock market has declined for six consecutive years2. While some of this new wealth has been prudently used to improve personal balance sheets, much of it has been used to purchase Treasuries and other high grade fixed income securities. Consequently, there is not only pent-up demand for housing and durables, but also for equities. Fund flows have begun to show signs of reversion (out of bonds and into equities) but remain about $1 trillion off trend—given the magnitude, we believe this reversion will continue.
Meanwhile, the US economy and the private sector appear to be on solid footing. Each recession in the past fifty years has been preceded by three conditions: 1) an inverted yield curve; 2) a tight labor market; and 3) a positive output gap3. None of these conditions are evident today. In fact, the yield curve is steep, there is considerable slack in the labor market, and the output gap is decidedly negative. While the political impasse is somewhat unprecedented and has the potential to inflict economic damage, current conditions suggest a full derailment is unlikely. Furthermore, corporate earnings have outpaced stock prices since the depths of the recession which has kept valuations reasonable despite the market’s rally. Balance sheets and capital allocation policies have improved markedly in recent years, reducing equities’ risk profiles. Certain segments of the market appear overvalued and/or risky, but we remain optimistic regarding the portfolio’s upside prospects relative to the risks at hand.
ATTRIBUTION: 3Q 2013
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index for the quarter. Positive stock selection produced all of the outperformance during the quarter with energy, telecommunications, and industrials leading the way. The overweight in consumer discretionary was marginally beneficial. The largest individual contributors were Total, Vodafone, and Cummins. Stock selection in technology and no exposure to materials, the index’s best-performing sector, detracted from performance. The largest individual detractors were Hewlett-Packard, Microsoft, and Exelon.
PORTFOLIO ACTIVITY: 3Q 2013
Over the quarter, we reduced the weight in technology by exiting positions in CA Inc. and Texas Instruments, which were approaching our valuation targets. This was partially offset by the new position in IBM, which is the largest IT services company in the world. It possesses high barriers to entry, is returning its strong cash flows to shareholders, and has more cash than debt on its balance sheet. We also trimmed the financials weight by exiting the position in Regions Financial in favor of better risk/return opportunities. We increased the weight in consumer staples by adding to the existing positions in Wal-Mart and Target.
1Source: JPMorgan, Federal Reserve
3The output gap represents actual GDP as a percentage of potential GDP. Potential GDP represents the output produced when an economy is at its most efficient; note that this is not analogous to maximum output. A positive output gap exists when actual GDP exceeds efficient GDP. In these circumstances, an economy is said to be overworking its resources, which economic theory suggests should increase inflation as labor costs rise.
Composite performance for the strategy is located on the Performance tab. 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 the 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 and is calculated using daily holding information. Returns calculated using this buy-and-hold methodology 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. Securities identified do not represent all of the securities purchased, sold, or recommended for advisory clients, and may not be indicative of current or future holdings or trading activity. H&W has no obligation to disclose purchases or sales of these 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 Communications tabs (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 September 30, 2013 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. 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.