Capital Income

Period ended March 31, 2019
 

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

After falling -13.5% and -4.7% in 4Q 2018, the S&P 500 and ICE BofAML US High Yield Indices returned +13.7% and +7.4% in the first quarter of 2019, respectively.  The swift decline and equally rapid recovery were both triggered by changes in investor sentiment as opposed to changes in underlying economic or business fundamentals.  Investor concerns emerged late in 2018 regarding trade tensions and a hawkish Fed; this combination created fears of impending global economic recession.  These concerns appeared to fade during the first quarter of 2019 due to positive progress on US/China trade talks and dovish comments from the Federal Reserve. Throughout this period we have witnessed a significant decline in longer maturity Treasury yields and a flattening of the yield curve.  After reaching 3.2% in late 2018, the 10-year note yield fell below 2.4% in March, its lowest level in more than a year despite the Fed’s four 2018 rate hikes.  In response to these changes, all S&P 500 sectors were positive in the first quarter, with the best returning +20% (technology) and the worst returning +7% (healthcare).  The S&P 500’s forward P/E ratio increased from 15.4x at the end of 2018 to 17.1x at the end of the first quarter.  The index’s median valuation over the past ~30 years is 16.4x; while it is now slightly above median, it is considerably lower than the 20x level where it began 2018. 

While the overall equity market appears fairly valued, we find solace in the large valuation disparity between certain segments of the market—some are attractively valued, some richly valued.  The S&P Banks Industry Group trades at 9.9x forward earnings.  The median multiple for banks over the last 30 years is 12.0x, so the group currently trades at about 80% of its historical average.  Considering that banks’ balance sheets are as strong as they have been in decades, and nearly 80% of earnings are being returned to shareholders via dividends and share repurchases, we view banks’ risk/reward tradeoff as especially compelling.  Conversely, the S&P Utilities Industry Group trades at 18.8x forward earnings, or double the valuation of banks.  The median multiple for utilities over the last 30 years is 14.4x, so the group currently trades at about 130% of its historical average.  Opposite of banks, utilities have added financial leverage, increasing net debt to EBITDA by 50% over the past decade from 3.4x to 5.1x.  Utilities can support higher debt levels than most other businesses, but paying high multiples for slow growing businesses with increased leverage is not an attractive proposition in our view.  Recognizing the considerable valuation dispersion across sectors, the portfolio exhibits larger sector deviations from the benchmark, including a large equity overweight in financials and no exposure to utilities.   

This was its best calendar quarter for the high yield market since immediately following the great recession’s low point when the index returned +23% and +15% in back-to-back quarters (2Q and 3Q of 2009, respectively).  During the first quarter of 2019, high yield credits outperformed investment grade credits.  Within high yield, performance dispersion was wide when assessing the market by either credit size or by sector, though it was relatively narrow when contrasting by credit rating.  Large cap credits outperformed small cap credits by about 1.4% in the quarter, a considerable margin and a headwind for our focus on small and mid cap credits.  All sectors were positive, with energy, retail, and financial services each returning more than 8%.  Transportation, autos, and telecom lagged, returning +3.2%, +5.5%, and +5.9%, respectively.  CCC rated bonds narrowly outperformed the overall market, while BB and B rated bonds performed similarly. 

The overall high yield market remains quite healthy and well-behaved, with low defaults, low leverage, and robust revenue and earnings growth.  This condition, however, is reflected in valuations.  Our focus on small and mid cap credits facilitates a considerable spread advantage relative to our benchmarks, and in our view, without assuming disproportionate credit risk.  As a result, we are optimistic regarding the portfolio’s prospects relative to the market as we look forward. 

Both the high yield and equity markets are close to fairly valued, but both also provide opportunities for active managers.  We view the ability to invest across companies of all sizes and across the capital structure as a considerable advantage in such environments.  We have identified interesting opportunities across both spectrums and are optimistic about the portfolio’s prospects as we look forward.   

ATTRIBUTION AND MANAGEMENT DISCUSSION: 1Q 2019

The Hotchkis & Wiley Capital Income portfolio (gross and net of management fees) outperformed the 50/50 blended benchmark in the first quarter of 2019.  The average equity weight was 56% and the average high yield bond weight was 44% over the course of the quarter.  The equity overweight helped as equities outperformed bonds.

The equity portion of the portfolio underperformed the S&P 500 Index during the quarter.  Growth outperformed value by more than 4 percentage points, so the value equity portion of the portfolio nearly matching the broad benchmark is an acceptable outcome given the headwind.  Positive stock selection in energy, along with the underweight position in healthcare and overweight position in industrials helped relative performance.  Stock selection in communication services, technology, and industrials detracted from performance, along with the overweight position in financials.  The largest individual detractors to relative performance were Royal Mail, Societe Generale, Vodafone, Danieli, and GEO Group; the largest positive contributors were Seritage Growth Properties, General Electric, Ophir Energy, Kosmos Energy, and Office Depot. 

The high yield bond portion of the portfolio outperformed the ICE BofAML US Corporate, Government & Mortgage Index and underperformed the ICE BofAML US High Yield Index.  Relative to the high yield benchmark, credit selection in energy, basic industry, and consumer goods hurt relative performance.  The preference for small and mid cap credits was also a headwind as large cap credits outperformed.  Positive credit selection in healthcare and an underweight allocation to telecommunications helped relative performance.