Large Cap Fundamental Value

Period ended June 30, 2019
 

MARKET COMMENTARY

The S&P 500 Index returned +4.3% in the second quarter and is now up +18.5% since the beginning of the year, fully recouping its losses from the fourth quarter of 2018.  An increasingly dovish tone from the US Federal Reserve contributed to positive equity markets, as Chairman Jay Powell indicated a readiness to lower interest rates for the first time in more than a decade. The Federal Funds futures market is pricing in a high likelihood of a rate cut during the Fed’s next meeting. In addition, geopolitical tensions subsided, as the US reached a deal with Mexico to halt proposed tariffs, and US-China trade talks resumed.  All S&P sectors were positive except energy, as crude oil prices declined by 3% in the quarter.  Growth again outpaced value, further widening the valuation gap.  Over the past five years, the Russell 1000 Growth Index has more than doubled the Russell 1000 Value Index, returning +87% compared to +43%, cumulatively. 

We continue to view the overall equity market as about fairly valued, perhaps slightly overvalued.  However, this is far from a normal market.  On the one hand, the market’s valuation suggests that investors have a reasonably healthy risk appetite.  On the other hand, certain attributes imply that investors are exceptionally risk averse.  A glaring example outside of US equity markets is the negative yield on some country’s government debt (e.g. German bunds), where investors are guaranteed to lose money if held to maturity.  A preference for a small, yet certain loss over a wider range of outcomes exemplifies extreme risk aversion.  This risk aversion is borne out in US equity markets through a comparison of different sectors.  Sectors with low economic sensitivity and stable earnings streams have been flooded with capital while cyclical sectors have been shunned, irrespective of valuation.  Regulated utilities, for example, are largely insulated from economic slowdowns and exhibit more stable earnings than most other businesses.  This has appealed to risk averse equity investors, which have flooded the sector with capital.  As a result, utilities’ P/E multiples are now close to 20x, an increase of 20% over the past five years.  We view this as a rich price to pay for a sector with modest prospects for growth, and do not view this as a safe investment.  While it does not represent a certain loss, the long-term upside potential at these valuations are paltry at best.  Most REITs, consumer staples, and healthcare companies exhibit a similarly unappealing long-term risk-reward tradeoff. 

In many cases, banks and other financials trade at half the valuation of the non-cyclical markets segments.  Select companies within technology, industrials, and energy also trade at substantial discounts to their intrinsic values.  These sectors have a higher correlation with economic cycles than non-cyclicals, but valuations render the long-term prospects more appealing irrespective of near-term economic growth.  Also, we have a deep-rooted preference for strong balance sheets, which provides a form of protection should the macro environment take a turn for the worse.  In our view, this combination represents a considerably less risky investment—and one with considerably more upside potential. 

The wide dichotomy between undervalued and overvalued pockets of the market has facilitated a portfolio that trades at a large valuation discount to the market, in our view, without assuming undue risk.  The portfolio trades at 8.6x normal earnings compared to 14.8x for the Russell 1000 Value Index and 24.4x for the Russell 1000 Growth Index.  It trades at 1.5x book value compared to 2.1x and 6.9x for the value and growth indices, respectively.  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: 2Q 2019

The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the second quarter of 2019.  The overweight position and positive stock selection in financials was the largest positive contributor during the quarter.  Positive stock selection in consumer discretionary, consumer staples, and technology also helped performance.  The overweight position and stock selection in energy was the largest performance detractor in the quarter, along with stock selection in materials and healthcare.  The largest positive contributors to relative performance in the quarter were AIG, Adient, Microsoft, Citigroup, and Discovery; the largest detractors were Apache, Marathon Oil, State Street, National Oilwell Varco, and Murphy Oil. 

LARGEST NEW PURCHASES: 2Q 2019

None this quarter.