Capital Income
Period ended September 30, 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
The S&P 500 Index returned +7.7% and the ICE BofAML US High Yield Index returned +2.4% in the third quarter of 2018. Failed Brexit negotiations and the threat of a global trade war have triggered short-lived bouts of volatility, but positive economic data and strong corporate earnings growth has overwhelmed those concerns. Despite Wall Street having revised estimates upward rather persistently, 84% of S&P 500 companies beat consensus earnings estimates in the most recent quarter. The median positive surprise was 6% above consensus estimates. In technology and healthcare, the two top-performing sectors in the quarter, more than 90% of companies reported an earnings beat.
Growth stocks outperformed value stocks in the quarter, extending its considerable lead in recent years. The Russell 1000 Growth Index has outperformed the Russell 1000 Value Index by more than 13 percentage points since the beginning of the year, after outperforming by nearly 17 percentage points in 2017. As a result, the valuation gap between growth stocks and value stocks has widened. Three years ago, the forward P/E for the Russell 1000 Growth was 18.6x compared to 15.3x for the Russell 1000 Value, for a difference of 3.3x (“growth premium”). Excluding the internet bubble, the average growth premium over that last 20 years has been 4.0x, so three years ago spreads were modestly narrower than average. Today, however, the forward P/E ratio for the Russell 1000 Growth has expanded to 22.9x while the Russell 1000 Value trades at 15.3x, the same multiple as three years ago. The current growth premium, therefore, is 7.6x (22.9x – 15.3x), or nearly double the long term average. Earnings growth between the two indices has been comparable, thus the primary cause of the outperformance has been the repricing of growth stocks, i.e. multiple expansion. We do not believe that this valuation gap can widen indefinitely, and consequently we are optimistic about the prospects of value relative to growth as we look forward.
The FOMC raised the Fed Funds Target Rate by another quarter point to 2.25%, its third such raise of the year. Consequently, government bonds declined while spread sectors outperformed. Investment grade corporates were slightly positive (about +1%) and high yield corporates were slightly more positive (+2.4%). Treasury yields with maturities between 2 and 30 years rose between 20 and 30 basis points, with an ever-so-slight flattening of the yield curve. The high yield market absorbed the rate hike and then some, experiencing a decline in the yield-to-worst of 0.24% during the quarter, which finished at 6.30%. Spreads tightened by 43 basis points, closing the quarter at 329 basis points over comparable duration treasuries. BB-rated and single B-rated credits performed similarly, while CCC-rated (and below) outperformed slightly—yields declined and spreads narrowed disproportionately for this lowest-rated cohort. Performance variation among sectors was modest: healthcare returned +3.4%, retail returned +1.1%, and all other sectors where somewhere in between.
A primary reason for high yield’s outperformance relative to other fixed income asset classes has been the market’s overall health. Only 2 high yield bonds defaulted in the quarter, following just 3 in the previous quarter—this represents the fewest defaults over a six month period in more than 7 years. The trailing 12 month default rate, including distressed exchanges, now stands at 2.0% which is well below long term averages. A meager 0.5% of the market trades at 50% of par or less, implying that the market believes the docile environment will persist. Recovery rates over the past 12 months averaged 46%, which is also slightly better than long term averages, though the sample size is small due to the low number of defaults. Rating agencies have agreed with the market’s assessment of tranquility, and have upgraded 5 credits for every 4 they have downgraded.
The strategy remains focused on the most compelling risk-adjusted valuation opportunities in companies of all sizes and in all parts of the capital structure. The portfolio’s equities trade at a large discount to the broad equity market. The portfolio’s bonds are focused in single-B rated credits across the cap spectrum with strong/quality asset coverage and a spread advantage1 relative to the high yield market.
ATTRIBUTION AND MANAGEMENT DISCUSSION: 3Q 2018
The Hotchkis & Wiley Capital Income portfolio (gross and net of management fees) underperformed the 50/50 blended benchmark in the third quarter of 2018. The average equity weight was 56% and the average high yield bond weight was 44% over the course of the quarter, similar to its average over the course of the year. The equity overweight helped as equities outperformed bonds, but it helped less than it should have because the portfolio’s equities underperformed.
The equity portion of the portfolio underperformed the S&P 500 Index during the quarter. Growth outperformed value, which is a difficult environment for our value focused approach. The portfolio lacks exposure to some large benchmark constituents that performed well in the quarter (e.g. Apple, Amazon). The overweight and stock selection in energy also hurt, along with stock selection in industrials and consumer discretionary. Positive stock selection in communication services and technology helped relative performance. The largest individual detractors to relative performance were Sanchez Energy, Ophir Energy, General Motors, Vodafone, and AIG; the largest positive contributors were WestJet Airlines, Office Depot, Corning, Discovery, and Popular.
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 underperformed the ICE BofAML US High Yield Index. Positive credit selection in the basic industry and healthcare sectors was offset by negative credit selection in energy. The underweight exposure to telecommunications was a modest performance detractor.
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1Spread advantage is based on the option adjusted spread (OAS)
Unless otherwise noted, the "high yield" or "broad" market refers to the ICE BofAML US High Yield Index.
Composite performance for the strategy is located on the Performance tab. Returns discussed 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. Portfolio characteristics and attribution based on representative Capital Income portfolio. Certain client portfolio(s) may or may not hold the securities discussed due to each account’s guideline restrictions, cash flow, tax and other relevant considerations. Fixed Income performance attribution is an analysis of the portfolio's return relative to the ICE BofAML US High Yield Index and is calculated using trade information, does not reflect cash flow transactions and the payment of transaction costs, fees and expenses. Equity performance attribution is an analysis of the portfolio's return relative to a selected benchmark, is calculated using daily holding information and does not reflect management fees and other transaction costs and expenses. Specific securities identified are the largest contributors (or detractors) to the portfolio’s performance relative to the S&P 500 Index. Other securities may have been the best and worst performers on an absolute basis. Securities identified do not represent all of the securities purchased or sold 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 the securities. No assurance is made that any securities identified, or all investment decisions by H&W were or will be profitable. The Capital Income strategy may prevent or limit investments in major bonds or stocks in the S&P 500, Russell 1000 Growth, Russell 1000 Value, ICE BofAML US Corporate, Government & Mortgage and ICE BofAML US High Yield indices and returns may not be correlated to the indexes. Indices provided as benchmarks are for reference only and are not directly comparable to the Capital Income strategy’s performance. Quarterly characteristics and portfolio holdings are available on the Characteristics and Literature tabs. For a list showing every holding’s contribution to the overall account’s performance and portfolio activity for a given time period, please contact H&W at hotchkisandwiley@hwcm.com. Portfolio information is 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 September 30, 2018 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 US Treasuries and bonds, where the price of these securities may decline due to various company, industry and market factors. Investing in high yield securities is subject to certain risks, including market, credit, liquidity, issuer, interest-rate, inflation, and derivatives risks. Lower-rated and non-rated securities involve greater risk than higher-rated securities. High yield bonds and other asset classes have different risk-return profiles, which should be considered when investing. Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during a given period. All investments contain risk and may lose value. Past performance is no guarantee of future results.
