Large Cap Fundamental Value

Period ended March 31, 2012

The U.S. equity market delivered its best opening quarter since 1998, as the S&P 500 Index posted a 12.6% return.  The market’s advance was prompted by continued signs of a strengthening U.S. economy and the absence of new negative global macroeconomic developments.  Consequently, the VIX Index (i.e. the “Fear Index”) declined from well above its historical average at the beginning of the quarter, to well below its historical average at the end of the quarter.  As short-term fears subsided and became a less prominent driver of investor behavior, we observed a shift in the market’s focus toward underlying fundamentals and valuations of individual stocks.  This type of shift tends to reduce the correlation of returns across stocks and forms an environment conducive for bottom-up, fundamental value investors. 

During the quarter, cyclical sectors outperformed non-cyclical sectors.  Financials, technology, and consumer discretionary stocks were among the leaders while utilities, telecommunications, and energy stocks were among the laggards.  The large cap growth indices outperformed large cap value indices, primarily due to the larger weight in the strong-performing technology sector.  Large, mid, and small cap stocks performed similarly. 

Going forward, we remain optimistic regarding the equity market’s prospects due to considerable fundamental improvements exhibited across the corporate sector.  Despite modest economic growth, companies have generated robust earnings and cash flows, which have been predominately used to reduce debt.  Valuations continue to be compelling even after this quarter’s appreciation.  Also, we believe the market’s affection for Treasuries is likely to recede as real yields at/below zero will eventually erode the purchasing power of institutional and individual investors alike.  The 30 basis point rise in 10-year Treasury yields over the first quarter may well be a harbinger of this cautionary message.

With the lingering sovereign debt issues in Europe and the uncertain growth prospects in emerging markets, we are prepared to combat bouts of elevated volatility in the near/medium-term.  During these episodes, we have found that the changes in security prices (i.e. volatility) are often not commensurate with the changes in real risk.  Our experience has shown us that focusing on corporate fundamentals is the most effective course when navigating erratic waters; we attempt to mitigate risk through sound valuation support and an exhaustive assessment of underlying company risks (excessive/hidden financial leverage, for example).

The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index for the quarter.  Positive stock selection in financials, consumer discretionary, and industrials was the primary performance contributor for the quarter.  CA Technologies, Gap, and JP Morgan were the largest individual contributors.  Stock selection in energy, healthcare, and utilities was the primary performance detractor for the quarter.  Royal Dutch Shell, Hewlett-Packard, and Exelon were the largest individual detractors.  

We took gains in the consumer discretionary sector by trimming strong-performing retailers J.C. Penney and Gap.  We reduced our energy weight in favor of stocks offering a more favorable risk/return profile.  The only position we exited entirely was Fifth Third Bancorp, which we sold in favor of other opportunities with similar risk but better valuation.  The two most notable new purchases during the quarter were AIG and Pepsi.  The reorganized AIG has a simplified balance sheet that has been considerably de-risked.  The earnings power of its core insurance assets remains intact and it represents a compelling valuation opportunity after conservatively adjusting for its non-core liabilities.  Pepsi trades at an attractive valuation given the quality of its franchise.  It has many strong, recognizable brands and an extensive global distribution network which allow it to generate sustainably high returns on invested capital.