Mid-Cap Value

Market Commentary

Period ended September 30, 2018
 

MARKET COMMENTARY

The Russell Midcap Index returned +5.0% in the third quarter and is now up +7.5% since the beginning of the year.  Failed Brexit negotiations and the threat of a global trade war have triggered short-lived bouts of equity market volatility, but positive economic data and strong corporate earnings growth has overwhelmed those concerns.  Despite Wall Street having revised estimates upward rather persistently, nearly 75% of Russell Midcap companies beat consensus earnings estimates in the most recent quarter.  The median positive surprise was 7% above consensus estimates.  In technology and healthcare, the two top-performing sectors in the quarter, more than 80% of companies reported an earnings beat. 

Mid cap growth outperformed mid cap value in the quarter, extending its considerable lead in recent years.  Some of the disparity was due to differences in sector exposures: the growth index has more exposure to technology which outperformed, and less exposure to REITs and financials which underperformed.  Sector weights aside, however, stocks with high valuations outperformed stocks with low valuations.  The Russell Midcap Growth Index has outperformed the Russell Midcap Value Index by more than 10 percentage points since the beginning of the year, after outperforming by nearly 12 percentage points in 2017.  As a result, the valuation gap between growth stocks and value stocks has widened.  Three years ago, the forward P/E for the Russell Midcap Growth was 20.5x compared to 17.5x for the Russell Midcap Value, for a difference of 3.0x (“growth premium”).  Since the year 2000, the median growth premium has been 3.3x, so three years ago spreads were modestly narrower than average.  Today, however, the forward P/E ratio for the Russell Midcap Growth has expanded to 24.4x while the Russell Midcap Value has declined to 16.5x.  The current growth premium, therefore, is 7.9x (24.4x – 16.5x), or more than double the long term average.  Earnings growth between the two indices has been comparable, thus the primary cause of the outperformance has been the repricing of growth stocks, i.e. multiple expansion.  We do not believe that this valuation gap can widen indefinitely, and consequently we are optimistic about the prospects of value relative to growth as we look forward.  

We remain overweight technology and energy compared to the Russell Midcap Value, though we have taken capital out of technology since the beginning of the year.  The sector overall, and our portfolio holdings in particular, have outperformed and so we have shifted capital to more compelling valuation opportunities.  Portfolio changes have been modest in 2018, however, with year-to-date turnover about 25% by weight and 14% by name. 

The portfolio’s valuation discount relative to the market has moved from wide to wider, which gets us excited about the portfolio going forward.  The portfolio trades at 6.9x normal earnings compared to 16.0x for the Russell Midcap Value and 18.4x for the Russell Midcap.  The portfolio’s price-to-book ratio is 1.2x compared to 2.0x and 2.7x for the Russell Midcap Value and the Russell Midcap, respectively. 

ATTRIBUTION: 3Q 2018

The Hotchkis & Wiley Mid-Cap Value portfolio performed in-line (gross of management fees; underperformed net of fees) compared to the Russell Midcap Value Index in the third quarter of 2018.  Positive stock selection in healthcare, utilities, and financials helped relative performance.  The overweight allocation to technology and underweight allocation to materials and real estate also helped returns.  This was offset by stock selection in industrials, real estate, and consumer discretionary.  The overweight exposure to energy and underweight exposure to healthcare were also modest detractors.  The largest positive contributors to relative performance were Mallinckrodt, Office Depot, Popular, Hewlett Packard Enterprise, and NRG Energy; the largest detractors were TRI Pointe Group, Ophir Energy, Bed Bath & Beyond, Weatherford International, and Cairn Energy. 

LARGEST NEW PURCHASES: 3Q 2018

Interpublic Group of Companies is the world’s fourth largest advertising agency holding company with revenues of ~$8B and close to 15% of the worldwide ad-agency market. Interpublic is an above-average business selling at a discount to the market due to misunderstood risks as the advertising industry changes.

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 at quarter-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. 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 September 30, 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