Large Cap Diversified Value

Market Commentary

Period ended September 30, 2018


The S&P 500 Index returned +7.7% in the third quarter and is now up +10.6% since the beginning of the year.  Failed Brexit negotiations and the threat of a global trade war have triggered short-lived bouts of equity market 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 outperformed value in the quarter, extending its considerable lead in recent years.  Some of the disparity was due to differences in sector exposures: the growth index has more exposure to technology which outperformed, and less exposure to energy and financials which underperformed.  Sector weights aside, however, stocks with high valuations outperformed stocks with low valuations.  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.  

We remain overweight technology and energy compared to the Russell 1000 Value, but we have taken capital out of these sectors since the beginning of the year.  The sectors overall, and our portfolio holdings in particular, have outperformed and so we have shifted capital to more compelling valuation opportunities.  We have added capital to financials, industrials, and consumer discretionary for the opposite reason—the sectors overall, and our holdings in particular, have underperformed and now exhibit improved valuations without a commensurate change in risk relative to other areas.  Portfolio changes have been modest in 2018, however, with year-to-date turnover about 22% by weight and 11% by name. 

The portfolio’s valuation discount relative to the market has moved from wide to wider, which gets us excited about the portfolio going forward.  The portfolio trades at 9.8x normal earnings compared to 15.2x for the Russell 1000 Value and 18.4x for the S&P 500 (nearly double the portfolio).  The portfolio’s price-to-book ratio is 1.6x compared to 2.1x and 3.4x for the Russell 1000 Value and the S&P 500, respectively.   


The Hotchkis & Wiley Large Cap Diversified Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value in the third quarter of 2018.  Growth outperformed value by a considerable margin, which presents a general headwind for our value-focused approach.  Stock selection in consumer discretionary, healthcare, and industrials detracted from performance.  The underweight position in healthcare, the index’s top-performing sector, was also a detractor.  The overweight position and positive stock selection in technology helped relative performance, along with positive stock selection in the energy sector.  The largest detractors to relative performance were General Motors, Vodafone, Adient, AIG, and General Electric; the largest positive contributors were Corning, Oracle, Microsoft, Discovery, and Hewlett-Packard Enterprise.   


Halliburton, headquartered in Houston, is the second largest global provider of oilfield services. The downturn in energy prices has reduced oilfield activity below sustainable levels, hurting HAL’s sales and profitability. As activity rebounds, the majority of HAL’s product lines should experience significant increases in volumes and pricing. HAL is currently under-earning but should normalize more quickly than for competitors given HAL’s strength in U.S.-centric completions businesses.

News Corp’s valuation is supported by its real-estate advertising businesses alone.  It also has a mature Pay TV and national media business and a regional newspaper business, though the latter is in secular decline.

Synchrony Financial’s stock trades at less than 8x current and normal earnings.  As we look at the impact on normal earnings from the loss of its Wal-Mart account, we feel that it is much closer to zero than to the recent move in the stock.  We also think that as one contemplates how dire this account loss is in terms of signaling a huge increase in the competitive environment for private label cards we should keep in mind that this loss follows shortly on the heels of the company’s win of the PayPal account.  With the ability to buy back 10% of its market cap in the next twelve months we feel that Synchrony is well positioned to take advantage of any extended weakness in its stock price.

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 Large Cap Diversified Value 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. 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 Russell 1000 Value Index. Other securities may have been the best and worst performers on an absolute basis. The “Largest New Purchases” section includes the three largest new security positions during the quarter based on the security’s quarter-end weight adjusted for its relative return contribution; does not include any security received as a result of a corporate action; if fewer than three new security positions at quarter-end, all new security positions are included.  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 value discipline used in managing accounts in the Large Cap Diversified Value strategy may prevent or limit investment in major stocks in the S&P 500 and Russell 1000 Value indices and returns may not be correlated to the indexes. 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  Portfolio information is subject to the firm’s portfolio holdings disclosure policy.
Past performance is no guarantee of future results.

Index definitions