Mid-Cap Value

Market Commentary

Period ended June 30, 2019
 

MARKET COMMENTARY

The Russell Midcap Index returned +4.1% in the second quarter and is now up +21.3% 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 Russell Midcap sectors were positive except energy and consumer staples, the latter of which declined only -0.3%.  Crude oil prices declined by 3% in the quarter and mid cap energy stocks fell 8% as a result.  Growth again outpaced value, further widening the valuation gap.  Over the past five years, the Russell Midcap Growth Index has outperformed the Russell Midcap Value Index by a large margin, returning +69% compared to +38%, cumulatively. 

We continue to view the overall mid cap 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 mid cap companies within energy, consumer discretionary, and communication services 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 5.1x normal earnings compared to 15.5x for the Russell Midcap Value Index and 24.7x for the Russell Midcap Growth Index.  It trades at less than 1.0x book value compared to 1.9x and 5.9x for the mid value and mid 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 Mid-Cap Value portfolio (gross and net of management fees) underperformed the Russell Midcap Value Index in the second quarter of 2019.  The overweight position and stock selection in energy was the largest performance detractor in the quarter, as energy was the market’s worst-performing sector.  Stock selection in consumer discretionary, healthcare, and industrials also hurt relative performance.  Positive stock selection in real estate and consumer staples, along with the overweight position in financials helped relative performance in the quarter.  The largest individual detractors to relative performance were Whiting Petroleum, Office Depot, Superior Energy Services, Mallinckrodt, and Bed Bath & Beyond; the largest positive contributors were Adient, McDermott International, Discovery, CIT Group, and Citizens Financial.  

LARGEST NEW PURCHASES: 2Q 2019

Arrow Electronics is one of the largest global distributors of electronic components and enterprise computing solutions to industrial and commercial customers, operating in a two or three player market in many parts of the world. The stock sold off significantly in the most recent quarter after management provided EPS guidance below consensus expectations, creating a compelling valuation. Longer-term, Arrow’s positioning as a value-added distributor serves as a competitive differentiator.

JetBlue Airways Corporation is a provider of passenger flights focused primarily on east coast routes. We expect margin improvement in JetBlue as the company shifts their fleet to aircraft that operates at the same cost per hour as their legacy fleet while providing more passenger capacity per flight. We view management’s shift in focus toward cost control as material and likely to position the company favorably in the highly competitive passenger airline industry. JetBlue trades at a notable discount to competitors.

Vistra Energy is a large integrated retail and power generation company with portfolio of power generation plants paired with a competitive retail business. Vistra is favorably exposed to the Texas retail markets, operating the largest retail business in the state. The company plans to reduce debt in the next couple years combined with share repurchases of $500MM annually. The company is attractively valued.

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 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 Mid-Cap Value strategy may prevent or limit investment in major stocks in the Russell Midcap, Russell Midcap Value and Russell Midcap Growth 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 June 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. 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.
 

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