Mid-Cap 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 and the Russell Midcap Index posted a 12.9% 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.  Midcap technology and consumer discretionary stocks were among the leaders while midcap utilities and energy stocks were among the laggards.  The midcap growth indices outperformed midcap 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 Mid-Cap Value portfolio (gross and net of management fees) outperformed the Russell Midcap Value Index for the quarter by a considerable margin.  Positive stock selection drove the outperformance—it was strongest in energy, financials, and industrials.  Ten of the largest eleven positions outperformed the index; Cobalt International Energy, Regions Financial, and Magna International were the largest individual contributors.  Stock selection in consumer staples and an underweight in materials were the primary performance detractors for the quarter; SuperValu, Goodyear Tire & Rubber, and Great Plains Energy were the largest individual detractors.   

We took gains in the energy sector by trimming strong-performers Stone Energy and Cobalt International Energy.  We reduced our overweight position in technology by trimming the position in ON Semiconductor following a favorable stock price movement.  NRG Energy is a new position, which increased the weight in utilities (though we remain underweight the benchmark).  We increased our weight in healthcare (though we remain underweight the benchmark here also) by adding to the existing position in Omnicare—the company should benefit from the proliferation of generic drugs and its valuation improved relative to the market during the quarter.