Global Value

Market Commentary

Period ended December 31, 2018
 

MARKET COMMENTARY

In US dollar terms, the MSCI World Index was up more than +5% through the first nine months of the year before posting its worst calendar quarter in 7 years, falling -13.4% in Q4.  The end result was a -8.7% return for calendar year 2018, in US dollar terms.  In local currency terms, the MSCI World finished the year -7.4%.  The dollar strengthened about 4% vs. the Euro and about 6% vs. the Sterling, and weakened about 3% vs. the Yen.  Until the most recent quarter, robust corporate earnings growth had overcome political unrest across the globe. In the fourth quarter, however, ongoing trade tensions came to the forefront.  Markets began pricing in slowing economic growth in several major economies. At the same time, both the Federal Reserve and the European Central Bank implemented and spoke of future restrictive monetary policy which appears to have added to equity investor apprehension.  The forward P/E ratio for the MSCI World declined from 18.1x at the beginning of the year to 14.2x at the end of the year.  The index’s median P/E since 2000 is 15.4x, so it went from well above average to comfortably below average over the course of the year. 

Fears that slowing economic growth would weaken demand – along with higher than expected production - weighed heavily on oil prices.  Brent crude closed the year at $54/barrel, down 20% from the beginning of the year ($67) and nearly 40% from its early October high ($86).  Commodity securities were among the worst-performers of the year, with the energy (-15%) and materials sectors (-16%) lagging the broad benchmark significantly.  Financials and industrials, also cyclical sectors, declined -16% and -14%, respectively.  The non-cyclical healthcare and utilities sectors performed best, returning +3% each.  The performance dispersion and resulting valuation spread between “cyclicals” and “defensives” suggests the market views a global recession as likely.  At present, while acknowledging the uncertain economic outlook, we view the value opportunity in cyclical stocks as vastly superior to non-cyclicals.  The low price we pay for such businesses provides a margin of safety in the long run almost irrespective of near term economic growth.

To illustrate the stark contrast in valuation between sectors, consider banks relative to utilities.  Five years ago, US banks traded at 12.5x consensus earnings while US utilities traded at 15.5x.  Since then, bank earnings have grown 53% compared to 36% for utilities, but bank stocks have lagged utility stocks.  As a result, US banks now trade at just 9.9x consensus earnings while utilities trade at 17.1x.  Similar sector incongruities exist elsewhere. 

Given the wide value spreads between sectors, our portfolio today looks very different from the benchmark. The portfolio also trades at a substantial valuation discount to the index, which makes us optimistic about its prospects irrespective of market direction or temperament.  The portfolio trades at 5.9x normal earnings compared to 14.4x for the MSCI World Index, and 0.9x book value compared to 2.1x for the index.  

ATTRIBUTION: 2018

The Hotchkis & Wiley Global Value portfolio (gross and net of management fees) underperformed the MSCI World Index in 2018.  The strategy’s focus on valuation and its ability to invest across the market cap spectrum are two important advantages, in our view.  Both of these characteristics detracted from relative performance in 2018; however, as global value lagged global growth and small caps lagged large caps.  Nearly 75% of the portfolio was invested in stocks with a price-to-book ratio of less than 2x compared to 30% for the index—this group of stocks lagged the overall market significantly, and was therefore a notable detractor to relative performance.  Also, about 40% of the portfolio was invested in small and mid cap stocks, about double the benchmark weight—this too hurt performance as larger cap stocks bested smaller cap stocks.  This headwind was partially offset by positive stock selection in technology, healthcare, and consumer staples, along with the underweight allocation to materials.  The largest individual detractors to relative performance were AIG, Adient, WestJet Airlines, Societe Generale, and Vodafone; the largest positive contributors were Ericsson, Popular, Hewlett Packard Enterprise, ARRIS International, and Discovery.

LARGEST NEW PURCHASES: 2018

General Electric has leading positions in power turbines, jet engines, diesel locomotives, and diagnostic imaging systems.  The stock trades at an attractive valuation considering it has a high quality set of businesses with interesting future prospects.  Shares have underperformed due to disappointing earnings in its power business, weak corporate cash flow, and concerns about its balance sheet.  While the power business is earning returns below normal and it will face ongoing challenges in the near term, its earnings decline is more than reflected in its current share price.  The market also misses that GE has great market positions in its aviation, healthcare, and other businesses, with a dominant installed base to service and sell equipment.  Concerns about its balance sheet are overblown because the company has significant liquidity and assets worth well in excess of the company’s debt levels. 

Goldman Sachs is one of the world’s largest investment banks.  In addition to consistently claiming the #1 market share of global investment banking revenues and a top 5 share of fixed income and equity trading revenues, it also operates a wealth and investment management business with $1.5 trillion in client AUM.   After navigating the financial crisis more effectively than any other large investment bank, Goldman has built tangible book value per share at a high single digit CAGR since 2009.  Despite these accomplishments GS trades at an attractive valuation relative to its tangible book value because investors are concerned that increased capital requirements, new restrictions on permissible activities, and a steady decline in global fixed income trading revenues.  We believe these concerns are more than reflected in the current share price, and based on our estimate of normal EPS it trades at a well below market multiple and is attractive on that basis.    

ING is the largest Dutch bank, providing retail and wholesale banking services to private clients, small businesses, large corporations, financial institutions, and governments. The Netherlands and Belgium account for 50% of revenue with the majority of the remaining revenue from elsewhere within Europe. ING is healthy: asset quality is good, the Company’s capital position is strong, and operations are profitable. ING trades at low multiples of current and normal earnings, and pays out more than 50% of its earnings.   

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 Global 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 MSCI World 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 year based on the security’s year-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 during the year, 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 Global Value strategy may prevent or limit investment in major stocks in the MSCI World Index and returns may not be correlated to the index. 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 December 31, 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 U.S. Treasuries and bonds, where the price of these securities may decline due to various company, industry and market factors.  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. The strategy invests in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. All investments contain risk and may lose value. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. See www.hwcm.com/definitions for full disclaimer.
 
Past performance is no guarantee of future results.
 

Index definitions