Small Cap Diversified Value

Market Commentary

Period ended March 31, 2019
 

MARKET COMMENTARY

After falling -20.2% in 4Q 2018, the Russell 2000 Index returned +14.6% 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 2000 sectors were positive in the first quarter, with the best returning +23% (technology) and the worst returning +7% (consumer staples).  The Russell 2000’s forward P/E ratio increased from 22.6x at the end of 2018 to 24.0x at the end of the first quarter.  The index’s median valuation over the past ~25 years is 24.2x; while it is now in line with its median, it is considerably lower than the 35x level where it began 2018. 

While the overall small 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.  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.  Conversely, “defensive” stocks such as regulated utilities trade at nearly twice the valuation of more economically sensitive stocks such as industrials or banks.  Many of these defensive industries have increased financial leverage over the last decade. 

The Russell 2000 Growth Index outperformed the Russell 2000 Value Index in the quarter by more than 5 percentage points (+17.1% vs. +11.9%); since the beginning of 2017, growth has outperformed value by 25 percentage points (+30% vs. +5%).  The performance difference is entirely explained by changes in price multiples, as opposed to differences in earnings growth.  The P/E ratio for the Value index has contracted by about 40% while the P/E ratio for the Growth index has actually expanded by a small amount.  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 9.4x compared to 13.4x and 20.0x for the Russell 2000 Value and Russell 2000 Growth, respectively.  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 Small Cap Diversified Value portfolio (gross and net of management fees) outperformed the Russell 2000 Value Index in the first quarter of 2019.  Positive stock selection in 7 of the 11 GICS sectors drove the outperformance in the quarter.  Stock selection in energy, industrials, and utilities were particularly helpful.  The overweight position in energy and underweight position in healthcare were modest positive contributors.  The large underweight allocation to REITs hurt relative performance as the sector outperformed the overall index.  Stock selection in communication services and healthcare were modest detractors.

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 and 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 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 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.
 

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