International Value

Market Commentary

Period ended September 30, 2019
 

MARKET COMMENTARY

The MSCI World ex-USA Index returned -0.9% in the third quarter of 2019 but is up more than +13% since the beginning of the year.  Global central bank policy continues to be accommodative.  The price of crude oil spiked following the drone attacks on Saudi refineries, but this was short-lived and Brent crude finished the quarter down -9%.  Energy was the MSCI World ex-USA Index’s second worst-performing sector (after materials), declining -5% in the quarter.  It has been the index’s worst-performing sector over the past year returning -12% (Brent has declined -27% over the past year).  Utilities +3% and consumer staples +2% were the best-performing sectors in the quarter.  These are also the top sectors, by far, over the past year.  The MSCI World ex-USA Index returned -1% over the past 12 months but these sectors are up considerably: utilities +15% and consumer staples +8%. 

Concerns about slowing economic growth have become increasingly pervasive amid trade negotiations and geopolitical uncertainty (e.g. Brexit in the UK, potential impeachment proceedings in the US).  The timing of the next global economic slowdown and/or recession is unclear but it is certainly possible in the near to intermediate term. Despite this, we are overweight cyclicality in our portfolio – particularly financials and industrials – as this is where we see the greatest price vs. fair value dislocation in the market. We believe we own good businesses with strong balance sheets that will enable these companies to grow their value through the economic cycle.

To illustrate our approach given the current state of affairs, consider the thesis behind our positions in banks (the portfolio’s largest absolute and relative industry weight) and utilities (the portfolio has no exposure).  The MSCI World Bank Index trades at 10.1x consensus earnings, which is 13% below its long term average of 11.7x.  The MSCI World Utilities Index trades at 18.1x consensus earnings, which is 14% above its long term average of 15.8x.  Returns-on-equity for the two indexes are similar1.  Dividend yields are also similar but because valuations are so different, utilities have to pay out about 2/3 of their earnings in dividends while banks pay out less than half of their earnings to arrive at similar yields2.  Because banks retain more of their earnings, it has allowed them to amass capital and strengthen their balance sheets, and in recent years, buyback their own stock.  Given the information above, for the two indexes to generate equivalent returns going forward, one of several things would need to occur.  The valuation gap would need to widen even further, utilities would need to accelerate earnings growth, or banks would need to suffer a major destruction of capital.  To us these seem like unlikely scenarios because the valuation gap is already near an all-time wide, organic growth prospects for utilities are limited, and banks have accumulated near record levels of excess capital on their balance sheets to protect against a downturn.  Thus, we view banks as superior risk-adjusted investments irrespective of near-term economic growth. 

The portfolio continues to trade at a large discount to the market.  The portfolio trades at 7.3x normal earnings compared to 13.8x for the MSCI World ex-USA Index.  It trades at 0.9x book value compared to 1.6x for the index.  This valuation discount combined with healthy balance sheets and good underlying businesses has us confident about the portfolio’s prospects as we look forward.    

ATTRIBUTION: 3Q 2019

The Hotchkis & Wiley International Value portfolio (gross and net of management fees) outperformed the MSCI World ex-USA Index in the third quarter of 2019.  Positive stock selection drove all of the outperformance, and was most positive in financials, communications services, and healthcare.  The underweight allocation to materials also helped.  We believe the strategy’s ability to invest across the cap spectrum is a long-term advantage, but this was a headwind during the quarter as small and mid cap stocks lagged large and mega caps.  The overweight and stock selection in energy was the largest detractor, along with stock selection in consumer staples and technology.  The largest positive contributors to relative performance in the quarter were Vodafone, BAE Systems, Tokio Marine, Enstar Group, and Societe Generale; the largest detractors were Embraer, Frank’s International, Ericsson, Danieli, and Global Indemnity.    

LARGEST NEW PURCHASES: 3Q 2019

Britvic is the largest supplier of still soft drinks in and the number two supplier of carbonated soft drinks in Great Britain.  Britvic owns the #1 or #2 brand in each of its respective categories, in addition to distributing key Pepsi brands.   The company will soon complete a major multi-year supply chain investment that will significantly increase profitability and free cash flow, as well as allow for meaningful new revenue opportunities.  Valuation is attractive. 

Haseko is a contractor for the condominium industry in Japan and is vertically integrated into the design, construction, sales, management and refurbishment of condominiums. The Company has a dominant market-share in its core geographies trades at a low multiple of earnings, has a net cash balance sheet and returns capital to shareholders.   

Taiwan Semiconductor is the world’s leading semi-conductor foundry. The industry is seeing growing demand for leading edge logic/processing chips, and TSMC is well positioned to manufacture the majority of these chips. TSMC has massive market share and limited competition, as the high capital costs and R&D expertise required in this space make it is difficult to replicate. TSMC has good capital allocation, net cash on its balance sheet, and is attractively valued.

 

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1 9.1% ROE for banks, 10.9% ROE for utilities, based on FY1 consensus estimates.
2 4.3% dividend yield for banks, 3.5% dividend yield for utilities.  44% dividend payout ratio for banks, 64% payout ratio for utilities.
 

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 International 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 ex-USA 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 during the quarter, 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 International Value strategy may prevent or limit investment in major stocks in the MSCI World ex-USA, MSCI World ex-USA Value, MSCI World Bank and MSCI World Utilities 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 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, 2019 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 as well as emerging market 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.
 

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