Small Cap Value (Limited Availability)

Market Commentary

Period ended December 31, 2018
 

MARKET COMMENTARY

The Russell 2000 Index was up more than +11% through the first nine months of the year before posting its worst calendar quarter in 7 years, falling -20.2% in Q4.  The end result was a -11.0% return for calendar year 2018.  In the fourth quarter, robust corporate earnings and strong economic indicators were no longer enough to fuel equity returns.  Suddenly, Fed tightening, a slight uptick in inflation, trade tensions, and a concern that tax stimulus had run its course all conspired to reverse equity gains in an abrupt risk off sell off. Small cap stocks bore the brunt of this correction due to their economic sensitivity and less defensive nature.  Meanwhile, real GDP growth in the US was a healthy +3.4% in the most recent quarter and the unemployment rate remains below 4%.  The forward P/E ratio for the Russell 2000 Index declined from 20.6x at the beginning of the year to 14.3x at the end of the year.  The index’s median P/E since 1995 is 16.7x, so it went from well above average to comfortably below average over the course of the year. 

Based on historical pre-recession peak to trough returns, the typical Russell 2000 decline is about -32% with the Global Financial Crisis being the lone exception.  By way of comparison, the peak to trough decline in the Russell 2000 during 2018 was -27%. Commodity securities were among the worst-performers of the year, with the small cap energy (-37%) and materials sectors
(-26%) leading the decline.  Non-cyclical utilities performed best, returning +4% during the year—the only sector in the Russell 2000 Value with a positive return.  The performance dispersion and resulting valuation differentials among stocks that are economically sensitive compared to those that are not suggests the market has begun to price in a recession scenario.  Economic metrics do not yet verify a meaningful change from positive economic growth.  At present, while acknowledging the uncertain economic outlook, we view the valuation support of cyclical stocks as vastly superior to non-cyclicals.  This valuation discrepancy provides a margin of safety in the long run almost irrespective of near term economic growth.

The portfolio trades at a substantial valuation discount to the index, which makes us optimistic about its prospects irrespective of market direction or temperament.  The portfolio trades at 6.2x normal earnings compared to 12.5x for the Russell 2000 Value and 14.4x for the Russell 2000.  The portfolio’s price-to-book ratio is 1.0x compared to 1.2x and 1.8x for the Russell 2000 Value and the Russell 2000, respectively.  

ATTRIBUTION: 2018

The Hotchkis & Wiley Small Cap Value portfolio (gross and net of management fees) underperformed the Russell 2000 Value Index in 2018.  The portfolio’s average energy weight was about double the benchmark’s average weight (14% vs. 7%) which detracted from performance.  Energy was the worst-performing sector in the Russell 2000 Value during the year by a large margin, as crude oil prices fell 25% in the year.  The portfolio’s energy stocks held up considerably better than the index’s energy stocks, but not enough to compensate for the overweight allocation.  Stock selection in communication services and consumer discretionary also detracted from performance.  Positive stock selection in technology and healthcare, along with the underweight position in materials helped relative performance.  The largest individual detractors to relative performance were C&J Energy Services, Masonite International, WestJet Airlines, MDC Partners, and CNO Financial; the largest positive contributors were ARRIS International, Popular, Hanger, Whiting Petroleum, and Matson.

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 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 2000 Value Index. Other securities may have been the best and worst performers on an absolute basis. 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 Small Cap Value strategy may prevent or limit investment in major stocks in the Russell 2000 and Russell 2000 Value 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, 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.
 

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