Value Opportunities

Market Commentary

Period ended Decemebr 31, 2018
 

MARKET COMMENTARY

The S&P 500 Index was up more than +10% through the first nine months of the year before posting its worst calendar quarter in 7 years, falling -13.5% in Q4.  The end result was a -4.4% return for calendar year 2018.  The Russell 3000 Value Index returned -8.6% as value lagged growth and small caps lagged large caps.  Until the most recent quarter, robust corporate earnings growth had overcome political unrest across the globe. In the fourth quarter, however, ongoing trade tensions came to the forefront.  Markets began pricing in slowing economic growth in several major economies that are important trading partners with the US.   In contrast to this however, real GDP growth in the US was a healthy +3.4% in the most recent quarter and the unemployment rate remains below 4%.  Both the Federal Reserve and the European Central Bank implemented and spoke of future restrictive monetary policy.  This appears to have added to equity investor apprehension.  The forward P/E ratio for the S&P 500 declined from 20.0x at the beginning of the year to 15.4x at the end of the year.  The index’s median P/E since 1990 is 16.4x, so it went from well above average to comfortably below average over the course of the year. 

Fears that slowing economic growth would weaken demand weighed heavily on oil prices.  WTI crude closed the year at $45/barrel, down 25% from the beginning of the year ($60) and more than 40% from its early October high ($76).  Commodity securities were among the worst-performers of the year, with the energy (-18%) and materials sectors (-15%) leading the decline.  Industrials and financials, also cyclical sectors, each declined -13% and lagged the market by a wide margin.  The non-cyclical healthcare and utilities sectors performed best, returning +6% and +4% during the year, respectively.  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.

To illustrate the stark contrast in valuation between sectors, consider banks relative to utilities.  Five years ago, S&P 500 banks traded at 12.5x consensus earnings while S&P 500 utilities traded at 15.5x.  Since then, bank earnings have grown 53% compared to 36% for utilities, but bank stocks have lagged utility stocks.  Utilities’ total return outpaced its earnings growth considerably, while banks’ total return lagged its earnings growth substantially.  As a result, bank P/Es compressed while utility P/Es expanded.  Today, S&P 500 banks trade at just 9.9x consensus earnings while S&P 500 utilities trade at 17.1x.  This translates into an earnings yield of more than 10% for banks and just 5.8% for utilities—a rich valuation for an industry with modest growth prospects. 

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 6.6x normal earnings compared to 13.0x for the Russell 3000 Value and 16.1x for the S&P 500.  The portfolio’s price-to-book ratio is 1.1x compared to 1.8x and 2.9x for the Russell 3000 Value and the S&P 500, respectively.  

ATTRIBUTION: 2018

The Hotchkis & Wiley Value Opportunities portfolio (gross and net of management fees) underperformed the Russell 3000 Value Index in 2018.  The strategy’s focus on valuation and its ability to invest across the market cap spectrum are two important contributors to its long term outperformance.  However, both of these characteristics detracted from relative performance in 2018 as value lagged growth and small caps lagged large caps.  The overweight to small caps (24% vs. 6%), and corresponding underweight to mega caps (20% vs. 37%), hurt relative performance.  An even larger factor was the valuation bias.  More than 70% of the portfolio was invested in stocks with a price-to-book ratio of less than 2x compared to about 43% for the index—this cohort underperformed the market significantly.  Combined, these factors explain all of the underperformance in the year.  An overweight and positive security selection in technology helped relative performance.  Positive security selection in consumer staples, and materials also helped.  The largest individual detractors to relative performance in the year were WestJet Airlines, AIG, Goldman Sachs, Vodafone, and Apache; the largest positive contributors were ARRIS International, Microsoft, Popular, Ericsson, and National Oilwell Varco.  

LARGEST NEW PURCHASES: 2018

Amerco, through its primary subsidiary U-Haul, offers truck, trailer, and self-storage rentals across its 22,000 locations in the US and Canada.  U-Haul is over 10x larger than its next largest competitor and has more locations than all US rental car companies combined.  In addition, the company has significant optionality in its self-storage business and real estate assets.  These advantages, combined with Amerco’s attractive valuation, make the stock compelling.

CBS’s multiple is depressed along with other media companies.  It is exposed to cyclical risk in ad spending but with little impact on long run normal earnings power. The most important risk is fundamental change in TV’s share of ad spend, which appears unlikely. The biggest opportunities are reversion in US ad spend, which would boost revenue and EBIT, and continued vertical integration into TV production, which would dramatically boost margins on syndication revenue.

General Electric has leading positions in power turbines, jet engines, diesel locomotives, and diagnostic imaging systems.  The stock trades at an attractive valuation considering it has a high quality set of businesses with interesting future prospects.  Shares have underperformed due to disappointing earnings in its power business, weak corporate cash flow, and concerns about its balance sheet.  While the power business is earning returns below normal and it will face ongoing challenges in the near term, its earnings decline is more than reflected in its current share price.  The market also misses that GE has great market positions in its aviation, healthcare, and other businesses, with a dominant installed base to service and sell equipment.  Concerns about its balance sheet are overblown because the company has great assets well in excess of the company’s debt levels.

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 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 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 year based on the security’s 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 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 S&P 500 and Russell 3000 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. 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.
 

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