Large Cap Fundamental Value
Period ended March 31, 2013
The seemingly insurmountable federal budget impasse and the tense bailout of a small European country (Cyprus) did not prevent equity markets from reaching record price levels. While all-time highs normally warrant caution, corporate earnings have kept pace so valuations remain reasonably appealing. The S&P 500 Index returned +10.6% and the Russell 1000 Value Index returned +12.3%—the best Q1 for the value index in more than two decades.
We believe the enigmatic relationship between geopolitical turmoil and rising equities can be explained by several factors. First, the market appears to view budgetary proposals as political posturing rather than plans with genuine substance. Accordingly, little credence is placed on deadlines, or more appropriately, a failure to meet deadlines. Kicking the can down the road has been the most politically tenable solution and has now become the market’s expectation; the length of this road remains the big unknown. Second, the economy continues to exhibit meaningful signs of improvement in spite of political gridlock. Housing, employment, and manufacturing have demonstrated legitimate signs of recovery. Third, equity valuations remain reasonable even with the market’s appreciation. The recession forced companies to trim excess costs aggressively, which has led to considerable profit margin improvement across Corporate America. Consequently, equities’ real earnings yield remains above historical averages and well above the negative real yields of high grade bonds. Finally, investors have shifted from equities to bonds and cash in a big way over the past several years. Given the under-allocation of equities, a return toward traditional allocations could continue to propel equity markets.
The long-term outlook for the equity market should be predicated on its ability to generate earnings and deploy those earnings effectively. Bearish investors argue that profit margins are abnormally high and will revert downward via competitive forces and less prudent capital deployment. Bullish investors argue that balance sheets have been de-risked, operating leverage has not been expended, and managements’ capital allocation policies will remain prudent in the wake of the recent recession. We do not believe that either viewpoint will be universally validated and that the outcomes will vary from company to company. As active managers, we are charged with making this distinction. We gravitate toward companies that trade at a low multiple of normal earnings, have strong balance sheets, and possess sustainable competitive advantages. While we believe this is the optimal combination for navigating any environment, it is particularly important today given the looming geopolitical issues. We find interesting opportunities across sectors, but are modestly partial to technology, healthcare, and financials in the current market.
ATTRIBUTION: 1Q 2013
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index for the quarter. Seven of the ten S&P GICS sectors contributed to the outperformance over the quarter with information technology leading the way. Hewlett-Packard, the portfolio’s largest underperformer in 2012, returned +68% after an earnings beat, raised guidance, and bullish sell side reports. Due to its irrationally low valuation at the year’s outset, it remains a compelling risk/reward opportunity. Positive stock selection in financials, consumer discretionary, and telecommunications also contributed to performance. After Hewlett-Packard, the largest individual contributors were H&R Block and Unum. Stock selection in energy and healthcare, along with an underweight in consumer staples detracted from performance over the quarter. The largest individual detractors were J.C. Penney, Royal Dutch Shell, and Total.
PORTFOLIO ACTIVITY: 1Q 2013
Over the quarter, we reduced the weight in financials and consumer discretionary modestly, by exiting or trimming several strong performers (e.g. H&R Block, State Street, MetLife). The largest sector increase was in healthcare, where we added some attractively valued managed care companies with strong competitive positioning within the industry (e.g. UnitedHealth Group, Aetna).
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 are not 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 March 31, 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.