Large Cap Fundamental Value

Market Commentary

Period ended March 31, 2016

The S&P 500 Index returned +1.4% during the first quarter of 2016, though it was anything but a steady trajectory.  On February 11th, the S&P 500 Index was down by more than 10% for the year before recovering over the quarter’s final seven weeks.  This date also represented a turning point in the value/growth cycle.  From the beginning of the year through February 11th, S&P 500 Index stocks with the lowest price-to-book ratios (lowest quintile) underperformed the broad index -16.1% vs. -10.3%.  From February 11th through the end of the quarter, however, this lowest valued quintile outperformed the broad index +16.2% vs. +13.0%.  While it is too early to proclaim a new value cycle is upon us, it is noteworthy that such cycles have lasted between 5 and 8 years historically once they have taken hold—this would be a welcomed tailwind for our approach. 
 
In most market environments, some sectors/industries are coveted while others are shunned depending on the market’s disposition at the time.  This behavior often results in a market that exhibits a bifurcation in stock valuations.  Currently, this dichotomy is quite pronounced.  Investors are fearful that the economic woes in China and other emerging economies will spill over into the US and other developed markets.  This fear has caused investors to pay 20x earnings or more for the perceived safety of non-cyclicals like consumer staples or real estate and sell cyclicals like energy or industrials at a fraction of the valuation.  When “safe” stocks trade at excessive valuations they become risky, not safe, which is the market’s current paradox.  Taking the long-term view, we see compelling risk-adjusted valuation opportunities in select market segments that have been shunned.  Our bottom-up search for value in today’s market is yielding a portfolio that trades for 8.4x normal earnings and 1.1x book value, which represents a considerable discount to the Russell 1000 Value Index (13.2x and 1.7x, respectively) and an even larger discount to the S&P 500 Index (15.9x and 2.6x, respectively).   

Performance deviations by sector were large during the quarter as non-cyclical sectors telecommunications and utilities both returned more than +15% while healthcare and financials both declined by more than -5%.  The financial sector remains the portfolio’s largest weight, although we are slightly underweight relative to the Russell 1000 Value Index.  We are overweight banks, many of which trade at deep discounts to book value.  The banks we own also trade at low multiples of current earnings, which we believe are depressed due to the low interest rate environment. We are also underweight energy but have found select opportunities that trade at a discount to book value and low multiples of normal earnings.  We anticipate a recovery in crude oil prices, which is needed to spur the production needed to replace naturally depleting oil supplies.  We are also finding attractive risk/return opportunities in autos/trucking, software, and insurance.

ATTRIBUTION: 1Q 2016

The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index in the first quarter of 2016.  Stocks within the Russell 1000 Value Index that trade at a discount to book value (i.e. P/B < 1.0x) returned -8% during the quarter, while the balance of the Index (i.e. P/B > 1.0x) generated positive returns.  This hurt relative performance as about 1/3 of the portfolio is invested in stocks with a price-to-book ratio of less than 1.0x compared to about 10% for the Russell 1000 Value Index.  The portfolio’s exposure to financials (many of which trade below book value) detracted from relative performance as the overweight and stock selection in banks weighed on results.  The largest individual detractors to relative performance were Citigroup, AIG, and Bank of America.  Positive stock selection in technology, industrials, and energy contributed to relative performance.  The largest individual contributors to relative performance were Cummins, Corning, and Hewlett Packard Enterprise. 

PORTFOLIO ACTIVITY: 1Q 2016

We began the quarter with 53 holdings and ended the quarter with 52; we exited two positions that began to approach our valuation targets and took a new position in an attractively valued retailer with an improving business mix that returns a lot of cash to shareholders.  While the portfolio’s weight in financials was flat over the quarter, we added to several existing positions that underperformed.  We reduced the weight in healthcare and staples as these sectors outperformed and the valuations became less compelling. 

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 March 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