Mid-Cap Value

Market Commentary

Period ended December 31, 2018
 

MARKET COMMENTARY

The Russell Midcap Index was up more than +7% through the first nine months of the year before posting its worst calendar quarter in 7 years, falling -15.4% in Q4.  The end result was a -9.1% return for calendar year 2018.  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 that are important trading partners with the US.   In contrast to this however, real GDP growth in the US was a healthy +3.4% in the most recent quarter and the unemployment rate remains below 4%.  Both the Federal Reserve and the European Central Bank implemented and spoke of future restrictive monetary policy.  This appears to have added to equity investor apprehension.  The forward P/E ratio for the Russell Midcap Index declined from 20.3x at the beginning of the year to 15.4x at the end of the year.  The index’s median P/E since 1995 is 15.7x, so it went from well above average to slightly below average over the course of the year. 

Fears that slowing economic growth would weaken demand weighed heavily on oil prices.  WTI crude closed the year at $45/barrel, down 25% from the beginning of the year ($60) and more than 40% from its early October high ($76).  Commodity securities were among the worst-performers of the year, with the mid cap energy (-26%) and materials sectors (-21%) leading the decline.  The portfolio has a large overweight in energy but has zero exposure in materials; combined, the portfolio is overweight the commodity sectors by about 8%.  Global demand for oil is significantly more stable than it is for industrial metals like steel or aluminum.  Over the past 20 years, global demand for oil has averaged +1.4% with a standard deviation of +1.1%, so a one standard deviation event still represents growing demand, and a
2 standard deviation event (just a ~2.5% probability on the down side) would represent a decline of just -0.8%.  Consequently, we view oil exposed businesses as less risky than steel or aluminum exposed businesses at the same valuation and capital structure.  In today’s market, however, these less risky businesses trade at substantially better valuations—hence, the large overweight to energy and large underweight to materials. 

Mid cap industrials, financials, and consumer discretionary, also cyclical sectors, each declined double digits and lagged the market by a wide margin.  Non-cyclical utilities performed best, returning +4% during the year.  The performance dispersion and resulting valuation differentials among stocks that are economically sensitive compared to those that are not suggests the market has begun to price in a recession scenario.  Economic metrics do not yet verify a meaningful change from positive economic growth.  At present, while acknowledging the uncertain economic outlook, we view the valuation support of cyclical stocks as vastly superior to non-cyclicals.  This valuation discrepancy 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, S&P 500 banks traded at 12.5x consensus earnings while S&P 500 utilities traded at 15.5x.  Since then, bank earnings have grown 53% compared to 36% for utilities, but bank stocks have lagged utility stocks.  Utilities’ total return outpaced its earnings growth considerably, while banks’ total return lagged its earnings growth substantially.  As a result, bank P/Es compressed while utility P/Es expanded.  Today, S&P 500 banks trade at just 9.9x consensus earnings while S&P 500 utilities trade at 17.1x.  This translates into an earnings yield of more than 10% for banks and just 5.8% for utilities—a rich valuation for an industry with modest growth prospects. 

The valuation disparities among sectors has led to the portfolio’s largest sector deviations from the benchmark since the financial crisis.  Accordingly, the portfolio 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 4.8x normal earnings compared to 13.5x for the Russell Midcap Value and 15.7x for the Russell Midcap.  The portfolio’s price-to-book ratio is 0.8x compared to 1.7x and 2.3x for the Russell Midcap Value and the Russell Midcap, respectively. 

ATTRIBUTION: 2018

The Hotchkis & Wiley Mid-Cap Value portfolio (gross and net of management fees) underperformed the Russell Midcap Value Index in 2018.  The portfolio’s valuation multiples are lower than that of the index, which hurt relative performance over the course of the year as mid cap value lagged mid cap growth by more than 7 percentage points.  Nearly 75% of the portfolio was invested in stocks with a price-to-book ratio of less than 2x compared to about 38% for the Russell Midcap Value—about twice the exposure.  This overweight, and corresponding underweight to more richly-valued securities, detracted from performance in the year as this group of stocks lagged the overall index.  The overweight position and stock selection in energy, the market’s worst-performing sector, also hurt performance as crude prices fell 25%.  The overweight position and positive stock selection in technology contributed to relative performance.  Positive stock selection in financials and utilities also helped.  The largest individual detractors to relative performance were Weatherford International, Superior Energy Services, C&J Energy, Adient, and Kosmos Energy; the largest positive contributors were Popular, ARRIS International, Ericsson, NRG Energy, and Hewlett Packard Enterprise. 

LARGEST NEW PURCHASES: 2018

Amerco, through its primary subsidiary U-Haul, offers truck, trailer, and self-storage rentals across its 22,000 locations in the US and Canada.  U-Haul is over 10x larger than its next largest competitor and has more locations than all US rental car companies combined.  In addition, the company has significant optionality in its self-storage business and real estate assets.  These advantages, combined with Amerco’s attractive valuation, make the stock compelling.

AXA Equitable Holdings is a large domestic life insurance company that underwrites and distributes annuities, retirement products, life insurance, and asset management services. It owns a 65% economic interest in AllianceBernstein, a full service, global asset manager that serves both retail and institutional clients. As one of the largest sellers of variable annuities in the US, annuities account for more than 50% of the company’s earnings. AXA is well capitalized and is expected to return a significant amount of its earnings to shareholders. Further, the company trades at a very low level of normalized earnings, both on an absolute basis and relative to peers.

PPL Corporation is a utility holding company that, through its fully regulated subsidiaries, generates electricity from power plants in the Northeastern and Western portions of the United States and delivers electricity in Pennsylvania and the UK.  Following the spinoff of its non-regulated generation assets in 2015, the company is now a fully regulated utility. Annual earnings growth of around 6% is expected over the next several years, driven by rate base investments in aging utility infrastructure in Pennsylvania and Kentucky.  PPL exhibits an attractive dividend yield and has grown its dividend by ~2% over the last 5 years.

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 Mid-Cap 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 Midcap 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 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 Mid-Cap Value strategy may prevent or limit investment in major stocks in the Russell Midcap and Russell Midcap 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 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. Investing in small and medium-sized companies involves greater risks than those associated with investing in large company stocks, such as business risk, significant stock price fluctuations and illiquidity. All investments contain risk and may lose value. 
 
Past performance is no guarantee of future results.
 

Index definitions