Capital Income Fund (HWIIX)

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The performance data quoted represents past performance and does not guarantee future results. Current performance may be lower or higher. Investment return and principal value of the fund will fluctuate, and shares may be worth more or less than their original cost when redeemed. Click quarter-end or month-end to obtain the most recent fund performance.

Manager Commentary
Period ended December 31, 2018

 

INVESTMENT STRATEGY

The Hotchkis & Wiley Capital Income Fund invests in both value equity securities and high yielding fixed income securities with an emphasis on income generation.  The long-term allocation target between value equities and high yielding fixed income securities is 50/50.  The portfolio has two benchmarks, the S&P 500 Index (“the equity benchmark”) and the ICE BofAML US Corporate, Government & Mortgage Index (“the fixed income benchmark”).  These benchmarks are averaged, using the portfolio’s long-term allocation targets, to produce a “50/50 blended benchmark” to help assess performance..

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 ICE BofAML US High Yield Index returned -2.3% in 2018, just the 7th negative return since its 1986 inception; the index had been up +3.5% over the year’s first three quarters before declining -4.7% in Q4. 

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.  The high yield market’s yield-to-worst rose 2.1% in the year, closing at 8.0%.  The spread over treasuries widened 172 basis points, from 363 at the beginning of the year to 535 at year’s end.  The market’s median spread since 1995 has been about 500 basis points; consequently, the spread went from much tighter than average to slightly wider than average in 2018—from our perspective, a considerably more attractive entry point. 

Fears that slowing economic growth would weaken demand weighed heavily on oil prices. West Texas Intermediate 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 and materials leading the decline.  Non-cyclical securities outperformed cyclical securities.  The performance dispersion and resulting valuation differentials among securities 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 securities as vastly superior to non-cyclicals.  We believe this valuation discrepancy provides a “margin of safety” in the long run almost irrespective of near term economic growth.

The Fed raised rates by 25 basis points four times in 2018, moving the Fed Funds target rate from 1.5% to 2.5% over the course of the calendar year.  Treasury rates rose accordingly, more so on the short end of the curve, thus the yield curve flattened.  As of year-end, the yield on the 10-year stood just 20 basis points higher than the yield on the 2-year, an ever so slightly positive sloping curve.  The par-weighted average price of a high yield bond went from more than $100 a year ago to slightly above $92 at the end of 2018.  CCC-rated bonds underperformed the broad market (-4.1% for the year), but interestingly single-B credits held up slightly better than BB’s (-1.5% vs. -2.5%, respectively). 

While it took a decline in markets to get here, we are more constructive on the both the equity and high yield market’s forward-looking prospects than we were a year ago due to the improvement in valuation.  The market is also providing pockets of opportunities that we view as especially compelling as an active manager.  As a result, the portfolio exhibits a large valuation discount in its equity positions and a large spread advantage in its credit positions—an uncommon opportunity.   

ATTRIBUTION AND MANAGEMENT DISCUSSION: 2018

The Hotchkis & Wiley Capital Income Fund underperformed the 50/50 blended benchmark in 2018.  The average equity weight was 56% and the average high yield bond weight was 44% over the course of the year.  The equity overweight hurt as equities underperformed bonds. 

The equity portion of the portfolio underperformed the S&P 500 Index during the year.  More than 70% of the portfolio is invested in stocks with a price-to-book ratio of less than 2x compared to just 20% for the index; this hurt relative performance as value stocks lagged by a large margin.  Also, nearly half of the portfolio was invested in small and mid cap stocks compared to just 11% for the index.  This also hurt performance as small and mid cap stocks lagged large caps.  Positive stock selection in technology and healthcare partially offset these headwinds.  The largest individual detractors to relative performance were AIG, Sanchez Energy, WestJet Airlines, Adient, and Ophir Energy; the largest positive contributors were Popular, Ericsson, Hewlett Packard Enterprise, ARRIS International, and Energy XXI. 

The high yield bond portion of the portfolio underperformed the ICE BofAML US Corporate, Government & Mortgage Index and the ICE BofAML US High Yield Index.  The overweight position and credit selection in energy detracted from relative performance as crude prices fell 25% over the year.  The underweight position in telecommunications was also a detractor.  Positive credit selection in retail, basic industry, banking, and healthcare were relative performance contributors during the year.

Mutual fund investing involves risk. Principal loss is possible. Investments in debt securities typically decrease in value when interest rates rise.  This risk is usually greater for longer-term debt securities.  Investment by the fund in lower-rated and non-rated securities presents a greater risk of loss to principal and interest than higher-rated securities.  The Fund may invest in derivative securities, which derive their performance from the performance of an underlying asset, index, interest rate or currency exchange rate.  Derivatives can be volatile and involve various types and degrees of risks.  Depending on the characteristics of the particular derivative, it could become illiquid.  Investment in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. The Fund may invest in foreign as well as emerging markets which involve greater volatility and political, economic and currency risks and differences in accounting methods.

Fund holdings and/or sector allocations are subject to change and are not buy/sell recommendations. Current and future portfolio holdings are subject to risk. Value stocks may underperform other asset types during a given period. Portfolio managers’ opinions and data included in this commentary are as of 12/31/18 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. Specific securities identified are the largest contributors (or detractors) on a relative basis to the S&P 500 Index. Securities’ absolute performance may reflect different results. The Fund may not continue to hold the securities mentioned and the Advisor has no obligation to disclose purchases or sales of these securities. Attribution is an analysis of the portfolio's return relative to a selected benchmark, is calculated using daily holding information and does not reflect the payment of transaction costs, fees and expenses of the Fund. Past performance is no guarantee of future results. Diversification does not assure a profit nor protect against loss in a declining market.

Credit Quality weights by rating were derived from the highest bond rating as determined by S&P, Moody's or Fitch. Bond ratings are grades given to bonds that indicate their credit quality as determined by private independent rating services such as Standard & Poor's, Moody's and Fitch. These firms evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest in a timely fashion. Ratings are expressed as letters ranging from 'AAA', which is the highest grade, to 'D', which is the lowest grade. In limited situations when none of the three rating agencies have issued a formal rating, the Advisor will classify the security as nonrated.

Investing in high yield securities is subject to certain risks, including market, credit, liquidity, issuer, interest-rate, inflation, and derivatives risks.  Lower-rated and non-rated securities involve greater risk than higher-rated securities.  Equities, bonds and other asset classes have different risk-return profiles, which should be considered when investing.  All investments contain risk and may lose value. 

The average annual total returns for the ICE BofAML US High Yield Index were -4.67%, -2.26%, 7.27%, 3.82% and 5.75% for 4Q18, one-year, three-year, five-year and Since 12/31/10 periods ended December 31, 2018, respectively.
 

Index definitions

Glossary of financial terms