Small Cap Value (Limited Availability)

Market Commentary

Period ended March 31, 2018


In the first quarter of 2018, the Russell 2000 Index fell -0.1%.  The Russell 2000 Growth Index returned +2.3% while the Russell 2000 Value Index fell -2.6%, extending growth’s recent performance advantage.  Over the last 10 years, the small value index has returned +128% cumulatively compared to +182% for the small growth index (+8.6% and +10.9% annualized, respectively).  The only other period that favored growth to such an extent was the internet bubble of the late 1990s.  While the broad market’s valuation today is much less extreme than it was in 1999, many small growth stocks exhibit rich valuation multiples.  We believe this poses risks for passive investors because they are, either consciously or naively, allocating capital to excessively valued securities.  Very few people would buy a new house, car, or even a meal without regard to price, but this frame of mind seems to breakdown at times when buying stocks.  In our view, to justify the current valuations of today’s most richly valued stocks, many things have to go perfectly right for a very long period.  In our experience, such unbridled optimism rarely materializes.

Fortunately for active investors, some segments of the small cap market offer attractive valuations for the risks at hand.  In recent years we have been partial to industrials.  Our focus has been on attractively valued, well-managed companies with strong balance sheets and good prospects for growth.  The sector is composed of mostly cyclical businesses but with different end markets.  Different industries experience cyclical troughs at different times and therefore exhibit compelling valuation opportunities at different times.  Thus, we have been overweight industrials for an extended period but our investment mix has changed through time. 

Financials represents the largest sector weight in the portfolio, though our exposure is close to that of the benchmark.  Despite healthy stock price appreciation in recent years, banks continue to trade at valuations well below their historical averages.  Critics argue that lower valuations are justified because banks will be unable to earn the same returns on capital they have earned in the past due to more stringent capital requirements.  We agree, but competitively advantaged banks like the ones we own should be able to earn above cost-of-capital returns.  Accordingly, we view 11x normal earnings and a small premium to book value as compelling valuations, particularly considering that the excess capital on their balance sheets reduce the risk profiles dramatically. 

We have also increased energy, and are now modestly overweight relative to the index.  We believe oil prices have been unsustainably low and that a rise in commodity prices will be necessary to bring global supply in line with global demand growth.  Accordingly, we have positions in predominantly upstream energy companies that are positively exposed to changes in crude prices.  We have a strong preference for companies with good balance sheets so that we are not exposed to shareholder dilution in the event the reversion in oil prices takes longer than we anticipate. 

Over long periods, value has outperformed growth, and we have no reason to believe we have entered a paradigm shift that would change this going forward.  Style shifts can occur quickly and powerfully, and we believe we are well positioned for such a reversion.  We continue to be encouraged by the portfolio’s valuation discount relative to the value benchmark and the broad benchmark. The portfolio trades at 6.7x normal earnings and 1.2x book value, a notable discount to the Russell 2000 Value Index (14.9x and 1.5x, respectively) and an even larger discount to the Russell 2000 Index (17.3x and 2.2x, respectively).  We remain committed to maintaining our unwavering dedication to the principals of long-term, fundamental value investing, and that while fads can drive short term performance fundamentals prevail in the long run.   


The Hotchkis & Wiley Small Cap Value portfolio (gross and net of management fees) underperformed the Russell 2000 Value Index in the quarter.  Stocks that exhibit more cyclicality, have higher market capitalization, and trade at lower valuation multiples tended to lag the value benchmark.  The portfolio has higher exposure to cyclical industries and the average market cap is larger than the benchmark.  With respect to valuation, nearly 25% of the portfolio trades at a discount to book value compared to less than 9% for the index; this deeply discounted group underperformed in the quarter.  Stock selection in consumer discretionary and industrials, along with the overweight position in energy also detracted from performance.  Stock selection was positive or neutral in 8 of the 11 GICS sectors during the quarter which helped relative performance.  The largest individual detractors to relative performance in the quarter were Office Depot, Masonite, Seritage Growth Properties, Frank’s International, and WestJet Airlines; the largest positive contributors were Whiting Petroleum, Popular, Bank of NT Butterfield & Son, LSC Communications, and Embraer.   

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 attribution is based on a 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.  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  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, 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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