Large Cap Fundamental Value

Market Commentary

Period ended September 30, 2016

The S&P 500 Index returned +3.9% in the third quarter of 2016.  In recent years we have observed a valuation dichotomy between market segments perceived as safe compared to those perceived as risky.  During this period, investors have fully embraced businesses that have a low correlation to economic cycles (e.g. regulated utilities, consumer staples) amid looming fears that global economic contagion could wreak havoc on the US economy.  Investors have also coveted high dividend paying companies (e.g. REITs), viewing them as compelling alternatives to low-yielding investment grade bonds.  At the same time, investors have shunned businesses with a cyclical tilt, irrespective of valuation.  While the overall equity market trades at valuation levels close to historical averages, the difference between the most and least expensive areas of the market is extreme.  This wide valuation disparity represents an opportunity for bottom-up investors focused on fundamental valuation.  Accordingly, we are overweight cyclical stocks with conservatively capitalized balance sheets as low valuations and low leverage provide a margin of safety in challenging times.  We are underweight stocks of non-cyclical businesses because we believe that the excessive valuation premiums present a risky proposition in the long run.  While this positioning hurt our performance in the past year, the third quarter demonstrated nascent signs of a value reversion.  Our work suggests that the recent value reversion has just begun and has a long ways to go.    

During the quarter, cyclical sectors outperformed non-cyclical sectors and stocks with the lowest valuations performed best, a somewhat redundant statement given the current state of affairs.  Technology and financials performed best; utilities and telecom lagged; small caps outperformed large caps; and commodity sectors were about average as oil prices were flat. 

Financials, technology, and consumer discretionary represent the portfolio’s largest sector weights.  The 11 financial positions are disproportionately focused on banks and insurers that trade at/below tangible book value, return considerable capital to shareholders through dividends and share repurchases, and possess balance sheets at/near healthiest-ever levels.  The 6 technology holdings include software and equipment providers with high recurring revenues and fortress balance sheets.  The consumer discretionary allocation is composed of an eclectic mix of 12 attractively-valued positions across businesses ranging from media, to autos, to specialty retail.  The portfolio’s largest underweights relative to the Russell 1000 Value Index are consumer staples, real estate, and utilities.  We have no predisposition against these sectors but with most companies trading at 20x earnings or more, we have been unable to identify many interesting risk-adjusted valuation opportunities.

The market’s valuation dichotomy has presented an opportunity to construct a portfolio that trades at an uncommonly large discount to the market without assuming undue risk, and we believe it is an attractive time to increase allocations to value equities.  The portfolio trades at 8.9x normal earnings compared to 14.1x for the Russell 1000 Value Index and 16.8x for the S&P 500 Index; the portfolio trades at 1.2x book value compared to 1.8x for the Russell 1000 Value Index and 2.8x for the S&P 500 Index.  


The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the third quarter of 2016.  Positive stock selection in financials was the primary contributor to performance as the portfolio’s banks and insurance holdings did well.  Positive stock selection in industrials and the overweight position in technology also helped performance.  Stock selection in utilities was a performance detractor in the quarter; the portfolio is underweight regulated utilities and overweight independent power producers which hurt relative returns in the quarter.  Stock selection in energy and healthcare were also relative detractors.  The five largest individual positive contributors to relative performance in the quarter were State Street, Bank of America, Corning, AIG, and Microsoft; the five largest detractors were Hess, Calpine, NRG Energy, Sanofi, and Royal Dutch Shell.  

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 September 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.

Index definitions