Capital Income
Period ended March 31, 2018
INVESTMENT STRATEGY
The Hotchkis & Wiley Capital Income portfolio invests in both value equity securities and high yielding fixed income securities with an emphasis on income generation. The long-term allocation target between value equities and high yielding fixed income securities is 50/50. The portfolio has two benchmarks, the S&P 500 Index (“the equity benchmark”) and the ICE BofAML US Corporate, Government & Mortgage Index (“the fixed income benchmark”). These benchmarks are averaged, using the portfolio’s long-term allocation targets, to produce a “50/50 blended benchmark” to help assess performance.
MARKET COMMENTARY
In the first quarter of 2018, the S&P 500 Index fell -0.8% and the ICE BofAML US High Yield Index fell -0.9%, each ending impressive streaks of positive quarterly performance.
In equities, growth outperformed value. The Russell 1000 Growth Index returned +1.4% while the Russell 1000 Value Index fell -2.8%, extending growth’s recent performance advantage. Over the last 10 years, the value index has returned +111% cumulatively compared to +193% for the growth index (+7.8% and +11.3% annualized, respectively). The only other period that favored growth to such an extent was the internet bubble of the late 1990s. While the broad market’s valuation today is much less extreme than it was in 1999, a number of popular stocks exhibit exorbitant valuation multiples akin to internet bubble levels. We believe this poses risks for passive investors because they are, either consciously or naively, allocating capital to excessively valued securities. Very few people would buy a new house, car, or even a meal without regard to price, but this frame of mind seems to breakdown at times when buying stocks. In our view, to justify the current valuations of today’s most richly valued stocks, many things have to go perfectly right for a very long period. In our experience, such unbridled optimism rarely materializes.
Fortunately for active investors, some segments of the equity market offer attractive valuations for the risks at hand. Financials continue to represent the largest sector weight in the portfolio and largest overweight relative to the S&P 500 Index. Despite healthy stock price appreciation in recent years, banks continue to trade at valuations well below their historical averages. Critics argue that lower valuations are justified because banks will be unable to earn the same returns on capital they have earned in the past due to more stringent capital requirements. We agree, but competitively advantaged banks like the ones we own should be able to earn above cost-of-capital returns. Accordingly, we view 11x normal earnings and a small premium to book value as compelling valuations, particularly considering that the excess capital on their balance sheets reduce the risk profiles dramatically. We have also been partial to industrials. Our focus has been on attractively valued, well-managed companies with strong balance sheets and good prospects for growth. The sector is composed of mostly cyclical businesses but with different end markets. Different industries experience cyclical troughs at different times and therefore exhibit compelling valuation opportunities at different times. Thus, we have been overweight industrials for an extended period but our investment mix has changed through time.
At the end of the quarter, the yield-to-worst on the high yield market stood at 6.35%, a 0.51% increase from the beginning of the year. The high yield market’s spread over treasuries widened by 9 basis points, refusing to absorb the increase in interest rates. Interestingly, the lowest rated credits (CCC & below) posted a slightly positive return in the quarter while higher rated credits declined the most. More often than not, lower rated credits underperform when the high yield market falls and outperform when it rises. Exceptions tend to occur when the market’s decline is due to the increase in interest rates, which transpired this quarter, because higher rated credits are more rate sensitive than lower rated credits.
All 18 high yield sectors declined in the quarter but the worst-performer declined a rather modest -2.6% (banking). In last two calendar years, the best-performing sector outperformed the worst-performing sector by 11 and 34 percentage points, respectively, so this quarter’s sector dispersion was quite narrow. Small and mid cap credits outperformed large cap credits, which tends to be (and was) conducive to our bottom-up credit picking approach. While the market is tighter than average, fundamentals are reasonable and we have invested in credits that our research indicates have strong/quality asset coverage. We continue to adhere to our core competency of focusing on credits of all sizes as well as fallen angels, which are often overlooked by other investors.
ATTRIBUTION AND MANAGEMENT DISCUSSION: 1Q 2018
The Hotchkis & Wiley Capital Income portfolio (gross and net of management fees) outperformed, by declining less than, the 50/50 blended benchmark in the first quarter of 2018. The average equity weight was 56% and the average high yield bond weight was 44% over the course of the quarter. The equity overweight had little effect as both asset classes performed similarly in the period.
The equity portion of the portfolio underperformed the S&P 500 Index during the quarter. Growth stocks outperformed value stocks, which is a headwind for our value investment approach. Stock selection in consumer discretionary along with the overweight position in energy and underweight position in technology hurt relative performance. Positive stock selection in technology, consumer staples, industrials, and healthcare helped relative performance. The largest individual detractors to relative performance in the quarter were Office Depot, Energy XXI, WestJet Airlines, Ophir Energy, and AIG; the largest positive contributors were Hewlett-Packard Enterprise, Whiting Petroleum, Royal Mail, Popular, and Danieli.
The high yield bond portion of the portfolio outperformed the ICE BofAML US Corporate, Government & Mortgage Index as high yield bonds outperformed investment grade bonds. The portfolio also outperformed the ICE BofAML US High Yield Index due to positive credit selection. Credit selection was positive or neutral in 15 of the 18 BofAML sectors, and was particularly positive in basic industry, energy, and retail credits. Credit selection in services was a modest detractor.
