Large Cap Fundamental Value
Period ended September 30, 2019
MARKET COMMENTARY
The S&P 500 Index returned +1.7% in the third quarter of 2019, and is now up more than +20% since the beginning of the year. The Federal Reserve’s FOMC lowered the Fed Funds rate by 25 basis points for the second time this year, which now stands at 2.0% (upper bound). With inflation benign and economic growth modest, albeit positive, the rate cut was widely expected and triggered little reaction from equity markets. The price of crude oil spiked following the drone attacks on Saudi refineries, but this was short-lived and WTI crude finished the quarter down -8%. Energy was the S&P 500’s worst-performing sector, declining -6% in the quarter. It has been the index’s worst-performing sector over the past year returning -19% (WTI has declined -27% over the past year), and has been the worst-performing sector in three of the past four calendar quarters. Utilities +9%, real estate +8%, and consumer staples +6% were the best-performing sectors in the quarter. These are also the top three sectors, by far, over the past year. The S&P 500 is up 4% over the past 12 months but these three sectors are up considerably more: utilities +27%, real estate +25%, and consumer staples +17%.
Concerns about slowing economic growth and a possible recession have become increasingly pervasive amid erratic trade negotiations and geopolitical uncertainty (e.g. Brexit in the UK, potential impeachment proceedings in the US). As a result, treasuries rallied during the quarter with the yield on the 10 year note falling below 1.5% in late August—for about a week, the 2-year treasury yield exceeded the 10-year treasury yield. This caught investors’ attention because contemporary recessions have been preceded by similar 10-year/2-year yield curve inversions. The time between inversion and recession has varied significantly, from several months to more than 2 years.
The timing of the next economic slowdown and/or recession is unclear but it is certainly possible in the near to intermediate term, and we acknowledge this as a legitimate risk. In periods leading into economic slowdowns, intuition would suggest that equity investors should gravitate toward stocks with less economic sensitivity. For the most part, this was a winning strategy during the early 2000s recession. During that period, richly valued internet, telecom, and media stocks cratered and many less cyclical stocks outperformed. In today’s market, however, the richly valued stocks are the non-cyclicals, which suggests that an economic slowdown is already priced in—perhaps overly priced in. As noted above, utilities, real estate, and consumer staples—non-cyclical sectors—have outperformed more cyclical areas significantly. Consequently, the valuation dispersion between certain market segments is uncommonly wide.
To illustrate our approach given the current state of affairs, consider the thesis behind our overweight position in banks and underweight position in utilities. The S&P 500 Bank Index trades at 10.9x consensus earnings, which is 9% below its long term average of 12.0x. The S&P 500 Utilities Index trades at 21.0x consensus earnings, which is 45% above its long term average of 14.5x. 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 about 1/3 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 8.4x normal earnings compared to 14.7x for the Russell 1000 Value Index and 25.7x for the Russell 1000 Growth Index. It trades at 1.5x book value compared to 2.0x and 7.6x 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: 3Q 2019
The Hotchkis & Wiley Large Cap Fundamental Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index in the third quarter of 2019. Stock selection in industrials, technology, and communication services hurt relative performance, along with the underweight positions in REITs, staples, and utilities. Positive stock selection in healthcare and financials were the largest positive contributors in the quarter. The largest individual detractors to relative performance in the quarter were General Electric, Discovery, Corning, Marathon Oil, and Ericsson; the largest positive contributors were Vodafone, Wells Fargo, AIG, Medtronic, and State Street.
LARGEST NEW PURCHASES: 3Q 2019
UnitedHealth Group (UNH) is the largest and most diversified managed care organization in an industry where scale is a significant competitive advantage. UNH has the largest and fastest growing share in Medicare Advantage, the biggest opportunity in managed care. UNH is also well positioned in Medicaid, another growth opportunity. UNH is a high quality business with above average growth prospects, sticky and stable earnings, and a good balance sheet.
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111.6% ROE for banks, 10.9% ROE for utilities, based on FY1 consensus estimates.
2 2.9% dividend yield for banks, 3.1% dividend yield for utilities. 32% dividend payout ratio for banks, 64% payout ratio for utilities.
