Mid-Cap Value

Market Commentary

Period ended March 31, 2019
 

MARKET COMMENTARY

After falling -15.4% in 4Q 2018, the Russell Midcap Index returned +16.5% in the first quarter of 2019.  The swift decline and equally rapid recovery were both triggered by changes in investor sentiment as opposed to changes in underlying economic or business fundamentals.  Investor concerns emerged late in 2018 regarding trade tensions and a hawkish Fed; this combination created fears of impending global economic recession.  These concerns appeared to fade during the first quarter of 2019 due to positive progress on US/China trade talks and dovish comments from the Federal Reserve. Throughout this period we have witnessed a significant decline in longer maturity Treasury yields and a flattening of the yield curve.  After reaching 3.2% in late 2018, the 10-year note yield fell below 2.4% in March, its lowest level in more than a year despite the Fed’s four 2018 rate hikes.  In response to these changes, all Russell Midcap sectors were positive in the first quarter, with the best returning +24% (technology) and the worst returning +8% (communication services).  The Russell Midcap’s forward P/E ratio increased from 15.9x at the end of 2018 to 18.1x at the end of the first quarter.  The index’s median valuation over the past ~25 years is 17.1x; while it is now slightly above median, it is considerably lower than the 21x level where it began 2018. 

While the overall mid cap market appears fairly valued, we find solace in the large valuation disparity between certain segments of the market—some are attractively valued, some richly valued.  The S&P Banks Industry Group trades at 9.9x forward earnings.  The median multiple for banks over the last 30 years is 12.0x, so the group currently trades at about 80% of its historical average.  Considering that banks’ balance sheets are as strong as they have been in decades, and nearly 80% of earnings are being returned to shareholders via dividends and share repurchases, we view banks’ risk/reward tradeoff as especially compelling.  The portfolio’s banks trade at an even lower valuation (9.0x consensus earnings and 8.7x normal earnings) with a payout yield of 7% (dividends + share repurchases as a percentage of total equity).  Conversely, the S&P Utilities Industry Group trades at 18.8x forward earnings, or double the valuation of banks.  The median multiple for utilities over the last 30 years is 14.4x, so the group currently trades at about 130% of its historical average.  Opposite of banks, utilities have added financial leverage, increasing net debt to EBITDA by 50% over the past decade from 3.4x to 5.1x.  Utilities can support higher debt levels than most other businesses, but paying high multiples for slow growing businesses with increased leverage is not an attractive proposition in our view.  Recognizing the considerable valuation dispersion across sectors, the portfolio exhibits larger-than-normal sector deviations from the benchmark. 

The Russell Midcap Growth Index outperformed the Russell Midcap Value Index in the quarter by more than 5 percentage points (+19.6% vs. +14.4%); since the beginning of 2017, growth has outperformed value by 29 percentage points (+43% vs. +14%).  Interestingly, the combination of earnings growth plus dividends paid has been similar for the underlying growth and value companies over this period.  The performance difference, therefore, is almost entirely explained by changes in price multiples.  The P/E ratio for the Value index has contracted by more than 20% while the P/E ratio for the Growth index has expanded by about 9%.  This repricing has contributed to not only  the large valuation differences across sectors but also to notable spreads within sectors.  In response to this backdrop our Value approach leads to a portfolio that trades at a large discount to the Value index and an exceptional discount to the Growth index.  The portfolio’s price-to-normal earnings ratio is just 37% of the Russell Midcap Value’s P/E compared to the long term average of 56%; the portfolio’s price-to-normal earnings ratio is just 23% of the Russell Midcap Growth’s P/E compared to the long term average of 38%.  As active investors with a commitment to long-term fundamental valuation, we view this environment as conducive to our approach and we are optimistic about the portfolio’s prospects. 

ATTRIBUTION: 1Q 2019

The Hotchkis & Wiley Mid-Cap Value portfolio (gross and net of management fees) outperformed the Russell Midcap Value Index in the first quarter of 2019.  The overweight position and positive stock selection in energy was the largest contributor to relative performance in the quarter.  Positive stock selection in financials and healthcare, along with the underweight position in utilities and overweight position in technology also helped.  The underweight position and stock selection in REITs detracted from performance in the quarter.  Stock selection in industrials and consumer staples also hurt.  The largest individual positive contributors to relative performance were Kosmos Energy, Ophir Energy, Office Depot, Bed Bath & Beyond, and CIT Group; the largest detractors were Royal Mail, Goodyear Tire, Embraer, Adient, and GEO Group.  

LARGEST NEW PURCHASES: 1Q 2019

Fluor Corp. is one of the largest E&C companies in the world, with global scale in engineering, construction, and fabrication. More than half of its normal revenue is in the relatively cyclical Energy, Chemicals, & Mining (ECM) segment, while ~30% of normal revenue is from the stable Government and Services businesses.  Fluor is a high-quality professional services company with a medium-risk business model that grows with no reinvested capital in an industry with few threats of disruption. Valuation is good on cyclically depressed earnings that should improve with spending cycles in Oil & Gas and Mining. Volatility from recent projects execution has depressed current margins thus created an attractive entry point.

Harley-Davidson is the market leader in its class and has impressive worldwide brand loyalty trading at an attractive valuation. It earns high returns on equity and returns large amounts of capital to shareholders.  While still supported by its legacy demographic, management has ramped up its focus and its investment in new international markets while cutting costs and expanding target market segments in the domestic market. 

KeyCorp is a conservatively managed large-cap regional bank based in Cleveland. The bank is well capitalized and has returned significant amounts of capital through both dividends and buybacks in recent years. Currently trading at ~10x normal earnings for a solid franchise with strong market share in its key markets of Ohio and Washington, KeyCorp is an attractive position.

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 March 31, 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