Mid-Cap Value

Market Commentary

Period ended September 30, 2019
 

MARKET COMMENTARY

The Russell Midcap Index returned a modest +0.5% in the third quarter of 2019, and is now up more than +21% 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 Russell Midcap’s worst-performing sector, declining -12% in the quarter.  It has been the index’s worst-performing sector over the past year returning -35% (WTI has declined -27% over the past year), and has been the worst-performing sector in three of the past four calendar quarters.  Real estate +8% and utilities +7% were the best-performing sectors in the quarter.  These are also the top two sectors, by far, over the past year.  The Russell Midcap is up 3% over the past 12 months but these sectors are up considerably more: utilities +22% and real estate +19%. 

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 and real estate—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 banks (a large absolute and relative weight in the portfolio) versus utilities (a large underweight in the portfolio).  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 4.7x normal earnings compared to 15.3x for the Russell Midcap Value Index and 26.4x for the Russell Midcap Growth Index.  It trades at 0.9x book value compared to 1.9x and 5.9x for the value and growth indices, respectively. 

ATTRIBUTION: 3Q 2019

The Hotchkis & Wiley Mid-Cap Value portfolio (gross and net of management fees) underperformed the Russell Midcap Value Index in the third quarter of 2019.  The overweight allocation and stock selection in energy was the largest performance detractor in the quarter.  Stock selection in industrials and technology also hurt performance, along with the underweight position in real estate and utilities.  Positive stock selection in utilities and the underweight exposure to healthcare and materials helped.  The largest individual detractors to relative performance were Whiting Petroleum, McDermott International, Mallinckrodt, Embraer, and Flour; the largest positive contributors were Tri Pointe Group, Vistra Energy, Cairn Energy, Colony Capital, and NRG Energy.    

LARGEST NEW PURCHASES: 3Q 2019

CNH Industrial (CNH) is the world’s second largest agricultural machinery manufacturer, with presence in every major global market. It also has decent positions in construction equipment and commercial vehicle markets. CNH is improving its high cost manufacturing footprint and, through significant organizational changes, is unlocking value in what has been a misunderstood and underappreciated business. Management’s plans to address excess manufacturing capacity, unneeded complexity in both product lines and management structure, and bolster recent under-investment in a few key, new-tech areas offer a meaningful amount of earnings benefit. Finally management plans to spin off the On-Highway businesses to investors at the end of next year as a means to unlock value.  

Evercore Inc. (EVR) is an investment banking boutique that provides advisory services to multinational corporations.  Over the past few years, it has increased its market share by adding a large number of investment bankers and expanding its service offerings.  EVR has a clean balance sheet and given the business model should be able to return most of its net income to shareholders.  The stock pays a healthy dividend and the Company has bought back ~10% of its market cap in the past year, all while trading at a low multiple of normal earnings.

 

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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.

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, Russell Midcap Growth, S&P 500 Bank and S&P 500 Utilities 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 September 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.
 

Index definitions