Mid-Cap Value

Market Commentary

Period ended December 31, 2019
 

MARKET COMMENTARY

For much of calendar year 2019, the United States engaged in a trade war with its largest global trading partner.  Near the end of the year, the House of Representatives impeached the President for just the third time in history. US equity markets shrugged off the tumultuous political environment and the S&P 500 Index returned an impressive +31.5%; there have been only 16 calendar years since 1926 that have been better. The Russell Midcap Index performed similarly, returning +30.5%. The economy has been supportive with real GDP modestly positive, inflation range-bound around 2%, and unemployment at a 50-year low.   

The Russell Midcap’s forward P/E ratio went from 15.9x at the beginning of the year to 20.7x at the end of the year; the 30% multiple expansion explains nearly all of the market’s performance.  The mid cap market’s average P/E over the past 25 years is 17.4x, so it went from about 9% below average to about 19% above average over the course of the year. Importantly, however, interest rates are considerably lower than they have been for most of that period—the 10-year treasury yield is just 1.9% compared to its 30-year average of 4.4%. Technology was the top-performing sector, returning +44% over the 12 months.  Energy was the worst-performing mid cap sector for the third year in a row, returning +8%. All other mid cap sectors returned between +22% and +37%. 

For the third consecutive year, the Russell Midcap Growth Index outperformed the Russell Midcap Value Index (+35.5% vs. 27.1%).  Mid cap growth outperformed value over the last decade by more than 50% (+278% vs. +222%, or +14.2% vs. +12.4% annualized), nearly all of which occurred in the last three years.  The lopsided performance has resulted in a wider-than-normal valuation spread between growth and value.  Over the past 20 years, the average forward P/E for the Russell Midcap Growth has been 21.7x compared to 16.7x for the Russell Midcap Value, which represents an average valuation spread of 5.0x.  As of 12/31/19, the forward P/E for the growth and value indices were 28.3x and 17.5x, respectively, or a spread of 10.8x.  This valuation gap has only been wider 8% of the time, all of which came during the tech/internet bubble. Using price-to-book instead of price-to-earnings, the current valuation gap has been exceeded only 6% of the time historically, with the tech/internet bubble again representing the lone exception. 

Investors’ increasing preference for low stock price volatility explains at least a portion of the valuation gap’s widening.  This has caused a substantial divergence between certain industries whereby many non-cyclicals exhibit rich risk-adjusted valuations relative to their cyclical counterparts.  As an example, the forward P/E ratio for utilities has risen by more than 60% over the last decade; the forward P/E ratio for banks has fallen by 5% over the same period. We have nothing against utilities, consumer staples, or REITs, other than the seemingly high prices currently required to purchase them.   

While the overall equity market appears fully valued compared to history, we believe the valuation disparities across the market create an investment environment highly conducive to long-term focused active management, particularly in relative terms. The spread between the growth and value indices is wide, suggesting a promising outlook for value.  The spread between the portfolio and the value index is also wide, suggesting a promising outlook for the portfolio. The portfolio trades at 5.6x normal earnings (historical average of 7.5x) compared to the Russell Midcap Value at 16.2x (historical average of 14.0x) and the Russell Midcap Growth at 27.1x (historical average of 21.1x). The considerable valuation advantage combined with good underlying businesses and healthy balance sheets leaves us confident about the portfolio’s prospects, particularly compared to passive alternatives.  

ATTRIBUTION: 2019

The Hotchkis & Wiley Mid-Cap Value portfolio (gross and net of management fees) underperformed the Russell Midcap Value Index in 2019. Over the course of the year, there was an unusually strong correlation between company size and performance within the mid cap market, as larger market cap companies outperformed smaller market cap companies. This had a large negative effect on relative performance. For example, Russell Midcap Value stocks that began the year with a market cap over $20 billion returned more than +40% while stocks that began the year with a market cap under $5 billion returned +3%. The portfolio’s average weight in the larger cap group was 12% compared to 29% for the index, while the portfolio’s average weight in the smaller group was 52% compared to 11% for the index—the smaller cap bias was an insurmountable headwind during the year. The overweight position and stock selection in energy, along with stock selection in industrials and technology also detracted from performance. The overweight and positive stock selection in financials helped relative performance. The largest detractors to relative performance were Whiting Petroleum, Mallinckrodt, Superior Energy Services, McDermott, and C&J Energy Services; the largest positive contributors were Ophir Energy, NexTier Oilfield Solutions, Bed Bath & Beyond, Citizens Financial, and Cairn Energy.      

LARGEST NEW PURCHASES: 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 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.

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 and created an attractive entry point.

Vistra Energy is a large integrated retail and power generation company with a 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/year based on the security’s quarter/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 during the quarter/year, 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 and S&P 500 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 December 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