Large Cap Fundamental Value
Period ended September 30, 2015
The S&P 500 Index declined -6.4% during the third quarter of 2015 and is now down -5.3% since the beginning of the year. Concerns about China’s economy have dominated financial headlines and are the primary impetus of the equity market’s decline. The China National Bureau of Statistics reported second quarter real GDP growth of +7.0%, which is modestly slower than prior years’ growth. Leadership in Beijing, however, took unprecedented action to bolster its economy suggesting the economic situation is worse than the official data indicate. The People’s Bank of China cut interest rates, lowered the reserve requirement ratio, devalued the yuan, and encouraged increased financial leverage. Thus far, Chinese interventions have failed to stabilize the market, as investors appear to have perceived the actions as frantic.
China represents 13% of global GDP and is the world’s second largest economy. The economy’s effect on global commodity markets is significant but its effect on other global sectors is much more muted—in fact, just 2% of S&P 500 Index revenue is generated from China directly. Be that as it may, US stock volatility skyrocketed during the quarter as investors grew concerned about indirect linkages to China. The VIX Index, a gauge of implied S&P 500 Index volatility, increased from 13 to 41 in less than a week, its highest level in four years. We often welcome periods of elevated volatility because our experience has taught us that stock prices fluctuate more than underlying business values, which creates opportunity.
The epicenter of marketplace fear—and opportunity—resides largely in commodity markets, where prices have been exceedingly turbulent. In the past twelve months, Brent crude oil has traded from a high of $91/barrel to a low of $38/barrel (a 58% decline). Crude prices fell -24% in the third quarter alone. Concerns about a slowdown in China (i.e. weakening demand) and elevated inventory levels in the US (i.e. excess supply) have combined to drive down crude prices. The market appears overly focused on current conditions rather than normal economic relationships, and as such, we believe that current crude prices are unsustainably low.
There was sizable performance dispersion between sectors during the quarter, as commodity-tied sectors lagged and non-cyclicals held up relatively well. Energy and materials each declined -18% while utilities and consumer staples returned +4% and -4%, respectively. Value underperformed growth by about 3 percentage points and small caps lagged large caps by a considerable margin.
In both times of calm and times of market turmoil, our approach to investing remains consistent and disciplined. While we have adjusted portfolio positioning as changes to valuations and/or risk profiles have dictated, we have made no changes to our general investment strategy. We have, and will always maintain an unwavering commitment to our value-focused investment approach. We have facilitated an investment culture at Hotchkis & Wiley that embraces non-consensus thinking and we are comfortable sticking to our approach irrespective of market temperament. This has been a critical component of our past success and we believe will continue to benefit our clients in the future.
ATTRIBUTION: 3Q 2015
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index in the third quarter of 2015. The outperformance of growth over value was a broad headwind for our value-focused approached and the primary detractor from relative performance. While we were underweight energy and materials—the worst-performing sectors in the market—the portfolio’s energy exposure is in exploration and production companies which tend to exhibit greater sensitivity to commodity price changes compared to the large integrated oil companies. With crude oil declining -24% in the quarter, this E&P exposure hurt relative performance. Stock selection in utilities and industrials were more modest detractors. Positive stock selection in materials and healthcare helped relative performance, along with the underweight exposure to energy and materials. The largest individual performance detractors were Marathon Oil, Murphy Oil, and CNH Industrials; the largest individual performance contributors were Chubb, PPL, and Microsoft.
PORTFOLIO ACTIVITY: 3Q 2015
Sector changes were modest during the quarter, with the largest increases in energy and materials and the largest decreases in healthcare and industrials. We added a new position in Hess, an oil & gas exploration and production company. The company has a large acreage position in the Bakken region (North Dakota and surrounding areas) and recent discoveries in both the Gulf of Mexico and Guyana. These areas provide the company with opportunity to reinvest capital at high rates of return without the need to acquire more acreage—an important factor for E&P companies. It also has a strong balance sheet, a favorable tax position, and an attractive valuation. We trimmed our weight in healthcare largely by exiting positions in Eli Lilly and UnitedHealth Group—both stocks returned more than +30% over the past year and began to approach our valuation targets.