Small Cap Diversified Value

Market Commentary

Period ended September 30, 2018
 

MARKET COMMENTARY

The Russell 2000 Index returned +3.6% in the third quarter and is now up +11.5% 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 two-thirds of Russell 2000 companies beat consensus earnings estimates in the most recent quarter; the median positive surprise was 16% above consensus estimates. 

Small cap growth outperformed small 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 healthcare which outperformed and less exposure to energy which underperformed.  Sector weights aside, however, stocks with high valuations outperformed stocks with low valuations.  The Russell 2000 Growth Index has outperformed the Russell 2000 Value Index by more than 8 percentage points since the beginning of the year, after outperforming by more than 14 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 2000 Growth was 36.1x compared to 19.7x for the Russell 2000 Value, for a difference of 16.4x (“growth premium”).  Since the year 2000, the median growth premium has been 11.6x, so three years ago spreads were wider than average.  Today, however, the forward P/E ratio for the Russell 2000 Growth has expanded to 47.8x while the Russell 2000 Value has declined to 18.8x.  The current growth premium, therefore, is 29.0x (47.8x – 18.8x), 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 industrials and energy compared to the Russell 2000 Value, though we have taken capital out of energy since the beginning of the year.  Our portfolio holdings in energy have outperformed and so we have shifted capital to more compelling valuation opportunities.  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 9.7x normal earnings compared to 15.2x for the Russell 2000 Value and 17.3x for the Russell 2000.      

ATTRIBUTION: 3Q 2018

The Hotchkis & Wiley Small Cap Diversified Value portfolio (gross and net of management fees) underperformed the Russell 2000 Value Index in the third quarter of 2018.  Relative to the benchmark the portfolio has nearly twice the exposure to stocks with a market cap of less than $1 billion, which lagged the rest of the small cap market in the quarter considerably.  Stock selection in consumer discretionary, healthcare, and consumer staples also detracted from performance.  Positive stock selection in energy, real estate, and materials helped relative performance.  The overweight position in industrials also helped as the sector outperformed the market.

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 Small Cap Diversified 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 (Russell 2000 Value Index), is calculated using daily holding information and does not reflect management fees and other transaction costs and expenses.  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 Small Cap Diversified Value strategy may prevent or limit investment in major stocks in the Russell 2000, Russell 2000 Value an Russell 2000 Growth indices and returns may not be correlated to the indexes.  Quarterly characteristics and portfolio holdings are available on the Characteristics and Literature tabs. 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 smaller and/or newer companies involves greater risks than those associated with investing in larger companies, 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