Large Cap Fundamental Value

Market Commentary

Period ended June 30, 2014

Despite several bouts of geopolitical unrest, the S&P 500 Index gained +5.2% during the second quarter and has returned +7.1% since the beginning of the year.  Equity investors appeared to largely dismiss both the Russia/Ukraine and Iraq/ISIS conflicts as economically inconsequential.  In fact, the VIX Index, often used as a proxy for overall investor apprehension, reached a seven-year low in mid-June.  Economic activity over the past quarter was positive and seems to have invigorated investor confidence.  The unemployment rate fell to a post-financial crisis low, and now stands at 6.1% compared to 10.0% in 2009.  The housing market demonstrated signs of improvement, with new home sales reaching six-year highs and pending sales of existing homes reaching four-year highs.  Corporate performance continues to be robust with more than 75% of S&P 500 Index companies exceeding consensus earnings estimates this quarter.  In response to these developments, the Federal Open Market Committee’s official statement in mid-June struck a more optimistic tone than its late-April statement, which helped boost equity prices.  With the VIX Index reaching a multi-year low, however, we would not be surprised to encounter stints of increased volatility in the near/medium term.

All sectors posted positive returns during the quarter, but dispersion between the best and worst performers was notable.  The energy sector led the way, more than doubling the S&P 500 Index return.  The price of crude oil rose modestly amid renewed turmoil in Iraq.  Financials and consumer discretionary stocks lagged, which is slightly unusual in a positive market environment given their pro-cyclical nature.

The strong economic and corporate backdrop supports higher stock prices but increased valuations have tempered our expectations. The S&P 500 Index trades at 16.7x next year’s consensus earnings estimates, which is slightly above the 25-year median (16.0x).  The Index trades at 2.6x book value, which is in line with the 25-year median.  The portfolio, however, trades at 11x our estimate of normal earnings and 1.5x book value, which represents a considerable discount to the market.  While higher price-to-earnings levels suggest equity prices may be getting ahead of earnings, interest rates remain near historic lows and the risk premium to own equities versus bonds is still quite compelling.

ATTRIBUTION: 2Q 2014

The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index during the second quarter of 2014.  Stock selection in technology was the largest performance detractor for the quarter.  Oracle lagged after reporting results slightly below consensus estimates, though our investment thesis remains fully intact.  Stock selection in telecommunications also detracted from performance, as our lone position (Vodafone) lagged the market.  Vodafone reported modest results and a disappointing outlook due to elevated capital expenditures.  Vodafone, Bank of America, and Target were the largest individual performance detractors.  Positive stock selection in healthcare, energy, and utilities contributed to performance during the quarter.  Royal Dutch Shell, NRG Energy, and American International Group were the largest individual performance contributors.

PORTFOLIO ACTIVITY: 2Q 2014

The largest sector increase over the quarter was consumer discretionary, primarily by way of adding new positions in two automobile companies: General Motors and Honda Motor.  Both companies trade at a single digit multiple of our normal earnings estimates.  General Motors possesses a rapidly growing, highly profitable emerging markets position and a low cost domestic business.  It also has a considerable net operating loss minimizing cash taxes.  Honda has a diligently-cultivated brand, best-in-class flexible production capability, strong position in economic vehicles and motorcycles, and growing geographic diversity.  We reduced the weight in utilities by trimming the position in Exelon, which had been a strong performer recently.

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. Specific securities identified are the largest contributors (or detractors) on a relative basis to the Russell 1000 Value Index. Securities’ absolute performance may reflect different results. 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 June 30, 2014 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. Certain information presented is based on proprietary or third-party estimates, which are subject to change and cannot be guaranteed. Equity securities may have greater risks and price volatility than U.S. Treasuries and bonds, where the price of these securities may decline due to various company, industry and market factors.  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.
 

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