Small 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 2000 Index posted a 12.4% return.  The market’s advance was prompted by continued signs of a strengthening US 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.  Small cap consumer discretionary and technology stocks were among the leaders while small cap utilities and consumer staples stocks were among the laggards.  The small cap growth indices outperformed small cap value indices, primarily due to the larger weight in the strong-performing technology sector and the smaller weight in the weak-performing utilities 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.

During periods of elevated volatility, 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 Small Cap Value portfolio (gross and net of management fees) outperformed the Russell 2000 Value Index for the quarter.  Positive stock selection drove the outperformance—it was strongest in energy, financials, and industrials.  Cobalt International Energy, Huntington Ingalls Industries, and PHH Corporation were the largest individual contributors.  Stock selection in healthcare and technology was the primary performance detractor for the quarter; Alliant Techsystems, Great Plains Energy, and Global Indemnity were the largest individual detractors.