Large Cap Fundamental Value
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.