Mid-Cap Value

Market Commentary

Period ended March 31, 2018
 

MARKET COMMENTARY

In the first quarter of 2018, the Russell Midcap Index fell -0.5%.  The Russell Midcap Growth Index returned +2.2% while the Russell Midcap Value Index fell -2.5%, extending growth’s recent performance advantage.  Over the last 10 years, the mid value index has returned +155% cumulatively compared to +174% for the growth index (+9.8% and +10.6% annualized, respectively).  The only other period that favored growth to such an extent was the internet bubble of the late 1990s.  While the broad market’s valuation today is much less extreme than it was in 1999, a number of mid cap growth stocks exhibit rich valuation multiples.  We believe this poses risks for passive investors because they are, either consciously or naively, allocating capital to excessively valued securities.  Very few people would buy a new house, car, or even a meal without regard to price, but this frame of mind seems to breakdown at times when buying stocks.  In our view, to justify the current valuations of today’s most richly valued stocks, many things have to go perfectly right for a very long period.  In our experience, such unbridled optimism rarely materializes.

Fortunately for active investors, some segments of the mid cap market offer attractive valuations for the risks at hand.  Energy represents the portfolio’s largest sector weight in both absolute terms and relative to the benchmark.  We believe oil prices have been unsustainably low and that a rise in commodity prices will be necessary to bring global supply in line with global demand growth.  Accordingly, we have positions in predominantly upstream energy companies that are positively exposed to changes in crude prices.  We have a strong preference for companies with good balance sheets so that we are not exposed to shareholder dilution in the event the reversion in oil prices takes longer than we anticipate. 

Financials represent the second largest sector weight in the portfolio, though our exposure is close to that of the benchmark.  Despite healthy stock price appreciation in recent years, banks continue to trade at valuations well below their historical averages.  Critics argue that lower valuations are justified because banks will be unable to earn the same returns on capital they have earned in the past due to more stringent capital requirements.  We agree, but competitively advantaged banks like the ones we own should be able to earn above cost-of-capital returns.  Accordingly, we view 11x normal earnings and a small premium to book value as compelling valuations, particularly considering that the excess capital on their balance sheets reduce the risk profiles dramatically. 

Over long periods, value has outperformed growth, and we have no reason to believe we have entered a paradigm shift that would change this going forward.  Style shifts can occur quickly and powerfully, and we believe we are well positioned for such a reversion.  We continue to be encouraged by the portfolio’s valuation discount relative to the value benchmark and the broad benchmark. The portfolio trades at 6.3x normal earnings and 1.0x book value, a notable discount to the Russell Midcap Value Index (15.4x and 1.9x, respectively) and an even larger discount to the Russell Midcap Index (17.8x and 2.6x, respectively).  We remain committed to maintaining our unwavering dedication to the principals of long-term, fundamental value investing, and that while fads can drive short term performance fundamentals prevail in the long run. 

ATTRIBUTION: 1Q 2018

The Hotchkis & Wiley Mid-Cap Value portfolio (gross and net of management fees) outperformed, by declining less than, the Russell Midcap Value Index in the first quarter of 2018.  The portfolio’s considerable overweight to technology helped performance as it was the top performing sector in the quarter by a considerable margin.  The underweight in REITs and positive stock selection in industrials, consumer staples, and utilities also helped performance.  Stock selection in healthcare and consumer discretionary hurt performance along with the overweight position in energy.  The largest individual positive contributors to performance were Hewlett-Packard Enterprise, Whiting Petroleum, Popular, Royal Mail, and Kohl’s; the largest detractors were Office Depot, Weatherford International, Mallinckrodt, Ophir Energy, and Goodyear Tire. 

LARGEST NEW PURCHASES: 1Q 2018

KBR is a global engineering and construction services company focusing on the government and energy sectors. KBR traded down recently due to misunderstood cost overruns at one of its large construction projects. We find KBR’s current valuation attractive and valuation becomes very attractive if KBR benefits from a cyclical recovery in LNG investment.

SLM Corporation, or Sallie Mae, is the leading provider of private student loans in the United States with ~55% market share. Private student loans continue to be a high growth area of lending, with SLM increasing its loan book 23% y/y to $18.8B and management guiding to $5.0B in new originations for 2018, equally split between market share gain and overall growth in the space. Private student loans are relatively high yielding assets and the overall book has a net interest margin of ~6% despite SLM’s wholesale funding model. The risk of loan charge-offs are also lower than one might expect for a non-collateralized class of loans given the inability to receive forgiveness for student loans in bankruptcy. Despite the high level of growth and attractive return profile of the loan book, SLM trades at an attractive multiple of earnings when normalized for mid-cycle provisions and remains well-capitalized, allowing the company to absorb future growth.

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 pays an attractive ~6% 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 attribution is based on a 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 at year-end, 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. 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 March 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.
 

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