Value Opportunities

Market Commentary

Period ended December 31, 2019
 

MARKET COMMENTARY

The S&P 500 Index returned an impressive +31.5% in 2019.  There have been only 16 calendar years since 1926 that have been better.  The economy was strong with real GDP modestly positive, inflation range-bound around 2%, and unemployment at a 50-year low.   These economic factors proved more consequential to the market than the contentious political environment which included a trade war between the US and China and a vote along party lines in the House of Representatives to impeach the President.

The S&P 500’s forward P/E ratio went from 15.4x at the beginning of the year to 19.8x at the end of the year; the 28% multiple expansion explains nearly all of the market’s performance.  The market’s average P/E over the past 30 years is 17.1x, so it went from about 10% below average to about 15% 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 by a large margin, returning +50% over the 12 months.  Energy was the worst-performing sector for the third year in a row, returning +12%.  All other S&P 500 sectors returned between +20% and +33%. 

For the third year in a row, the Russell 3000 Growth Index outperformed the Russell 3000 Value Index (+35.8% vs. 26.3%). Growth outperformed value in 7 of the last 10 calendar years with cumulative outperformance of +306% vs. +203%, or +15.0% vs. +11.7% 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 25 years, the average forward P/E for the Russell 3000 Growth has been 21.1x compared to 15.9x for the Russell 3000 Value, which represents an average valuation spread of 5.2x.  As of 12/31/19, the forward P/E for the growth and value indices were 26.6x and 16.9x, respectively, or a spread of 9.7x. This valuation gap has only been wider 7% of the time, all of which came during the tech/internet bubble from 1999 to 2001.   Using price-to-book instead of price-to-earnings, the current valuation gap has been exceeded only 3% 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.  The S&P 500 Low Volatility Index is composed of the 100 index stocks that exhibited the lowest volatility in the previous 12 months (i.e. the least volatile quintile of the S&P 500).  Over the last decade, the low volatility index’s forward P/E averaged about 1.0x multiple points higher than the broad index (18.8x vs. 17.8x).  The average premium over the first 8 years was 0.4x multiple points.  Over the last 2 years, the premium gapped out to 3.1x multiple points (the spread as of 12/31/19 was also 3.1x). 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 S&P 500 utilities has risen by more than 60% over the last decade; the forward P/E ratio for S&P 500 banks has fallen by 5% over the same period. No surprisingly, the portfolio is significantly underweight utilities and staples, given their high valuations.   

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 8.0x normal earnings (historical average of 7.4x) compared to the Russell 3000 Value at 15.3x (historical average of 13.6x) and the Russell 3000 Growth at 26.4x (historical average of 19.2x). 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 Value Opportunities portfolio (gross of management fees) slightly outperformed the Russell 3000 Value Index in 2019 (underperformed net of fees). Over the course of the year, there was an unusually strong correlation between company size and performance, with larger market cap companies outperforming smaller market cap companies. Russell 3000 Value stocks that began the year with a market cap of less than $5 billion returned +15% over the year while index stocks with a market cap of more than $100 billion returned +27%.  The portfolio’s average weight to the smaller group (<$5 billion) averaged 18% throughout the year compared to 10% for the index; the portfolio’s average weight to the larger group (>$100 billion) averaged 25% throughout the year compared to 37% for the index.  The smaller cap bias had a large negative effect on relative performance along with stock selection in consumer discretionary. Fortunately, positive security selection more than offset this brisk stylistic headwind. Positive security selection in industrials and financials were the most meaningful contributors, along with the overweight positions in industrials and technology. The largest positive contributors to relative performance in the year were WestJet Airlines, Microsoft, General Electric, Goldman Sachs, and AIG; the largest detractors were National Oilwell Varco, Tesla put options, Motors Liquidation Trust, Danieli, and Royal Mail.     

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 Value Opportunities 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 holdings 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 3000 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 duriong 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 Value Opportunities strategy may prevent or limit investment in major stocks in the Russell 3000 Value, Russell 3000 Growth, S&P 500, S&P 500 Low Volatility, S&P 500 Bank and S&P 500 Utilities 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. The strategy may be exposed to more individual stock volatility than a more diversified strategy and may also invest in smaller and/or medium-sized companies, foreign securities, and debt securities. All investments contain risk and may lose value. 
 
Past performance is no guarantee of future results.
 

Index definitions