Large Cap Fundamental Value
Period ended December 31, 2016
The S&P 500 Index finished 2016 +12%, a particularly impressive feat given the index was down more than -10% in early February. Since its -37% return in 2008, the S&P 500 Index has produced positive returns for eight consecutive calendar years. The primary performance drivers, however, have varied considerably from year to year. In 2015, for example, stocks in the highest price-to-book (“P/B”) quintile outperformed stocks in the lowest P/B quintile by about 20 percentage points; in 2016 the lowest P/B quintile outperformed the highest P/B quintile by about 20 percentage points. The energy sector went from the worst underperformer in 2015 to the top outperformer in 2016.
Until recently investors had favored REITs, consumer staples, regulated utilities, and other market segments with relatively stable revenue streams and high dividend payout ratios. The market viewed these stocks as bond surrogates, particularly because of the low interest rate environment. Our opinion has been that these sectors were bid up to excessive valuation levels; stable businesses make for risky investments if you have to overpay for the intrinsic value of the enterprise. In contrast, stocks of companies with more cyclical businesses were shunned irrespective of valuation; hence, this is where we identified the most compelling risk-adjusted return opportunities. Value dislocations eventually revert to reflect underlying economic fundamentals. We observed such a reversion in 2016, as the large dislocation between bond proxies and cyclical companies narrowed; the yield on the 10-year treasury finished the year at 2.45%, an increase of more than 100 basis points from its July low of 1.36%. While the value reversion was large, spreads remain wider than average because the dichotomy had reached such extreme levels. Accordingly, the portfolio trades at a larger-than-average discount to the value benchmark, though the discount is smaller than it had been early in 2016. The portfolio’s current P/B ratio is 73% of the Russell 1000 Value’s P/B, compared to the historical average of 83%. The portfolio’s price-to-normal earnings ratio (“P/E”) is 64% of the Russell 1000 Value’s P/E, compared to the historical average of 73%. The overall equity market appears neither overvalued nor undervalued in any meaningful way, but valuation opportunities exist selectively for active fundamental investors.
Over the long-term, a company’s earnings power and associated intrinsic value are the dominant drivers of stock performance. In the short-term, changes in market sentiment can drive stock performance as macroeconomic factors, geopolitical issues, or other major events can cause investors to become skittish or greedy. Early in 2016, for example, US equities declined amid investor panic that economic growth in China would slow precipitously. Stocks in economically sensitive industries were punished irrespective of fundamental valuation as investors flocked to bond substitutes—also irrespective of valuation. This reverted later in the year as the value dislocation was ultimately recognized by the market, which benefited disciplined investors that stayed the course. As we look to 2017 and beyond, we maintain our unwavering commitment to the time-tested principles of long-term fundamental value investing and prudent risk management.
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in 2016. About one-third of the portfolio was invested in stocks trading at a discount to book value compared to about one-tenth for the Russell 1000 Value; this deeply discounted cohort outperformed the rest of the market substantially. Positive stock selection in energy and industrials, along with the underweight allocation to consumer staples also contributed to outperformance. Stock selection in utilities and telecommunications, along with the overweight allocation to consumer discretionary detracted from relative performance. The five largest individual positive contributors to relative performance over the year were Marathon Oil, Cummins, Corning, Hewlett-Packard Enterprise, and Bank of America; the five largest detractors were Ericsson, Calpine, Vodafone, Bed Bath & Beyond, and Sanofi.
PORTFOLIO ACTIVITY: 2016
The portfolio began the year with 54 holdings. During the year we exited six positions and added four, ending the year with 52 holdings. Most of the trading consisted of adding and trimming around existing positions as dictated by valuation changes. The largest trims during the year were among the portfolio’s best relative performers (e.g. Corning) and the largest additions were among the worst relative performers (e.g. Ericsson). This is common given our long-term fundamental value approach—intrinsic value is more stable than market prices. Sector weight changes were rather modest over the course of the year. We reduced the weight in consumer staples, healthcare, and utilities. We have no chronic aversion to these sectors but find few compelling valuation opportunities in the current environment. We also trimmed our energy exposure but the sector weight increased slightly due to performance. We added to industrials and technology—both by a modest magnitude.