Capital Income Fund (HWIAX)

I SHARES    A SHARES   

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, 2019

 

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 returned an impressive +31.5% in 2019.  There have been only 16 calendar years since 1926 that have been better. The ICE BofAML US High Yield Index also did well, returning +14.4% in 2019.  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. 

Yields for the broad high yield market fell by 2.44% and spreads narrowed by 173 basis points.  At year end, the yield-to-worst for the ICE BofAML US High Yield Index was 5.41%, which represented a spread over treasuries of 360 basis points.  Yields and spreads declined less for lower rated issues than for higher rated issues, widening the valuation gap.  Yields and spreads also declined less for large cap credits than for small/mid caps, further extending small/mid caps’ yield/spread advantage. The high yield market’s default rate, including distressed exchanges, was 2.86% in 2019, an increase of about one percentage point from 2018 but below the long-term average of 3.44%.  The default rate would have been just 1.26% without the energy and metals & mining sectors, which comprised about half of all 2019 defaults by volume.  The default rate for the energy sector was about 11% in 2019, by far the highest among all sectors. Unsurprisingly, energy was the worst-performing high yield sector by a large margin.

Overall, both equity and high yield valuations appear about average considering the risks at hand.  There seems to be a wide valuation dispersion within both markets, which we believe provides a conducive environment for active, bottom-up research.  The research has facilitated a portfolio with a considerable valuation/spread advantage relative to the market, in part due to our proclivity for small/mid cap equities and credits.  Accordingly, we remain optimistic about the portfolio’s prospects and look forward to 2020.   

ATTRIBUTION AND MANAGEMENT DISCUSSION: 2019

The Hotchkis & Wiley Capital Income Fund underperformed the 50/50 blended benchmark in 2019.  The average equity weight was 56% and the average high yield bond weight was 44% over the course of the quarter. The equity overweight helped relative performance effect as equities outperformed bonds performed in the year.   

The equity portion of the portfolio underperformed the S&P 500 Index during the year. Value underperformed growth substantially, which hurt our value focused approach relative to the core benchmark. Smaller cap stocks underperformed larger cap stocks significantly, which was another stylistic headwind for the equity portion of the portfolio.  From a sector perspective, stock selection in energy, technology, real estate, and communication services hurt relative performance. Positive stock selection in financials, industrials, healthcare, and staples helped relative performance. The largest individual detractors to relative performance in the year were Whiting Petroleum, Danieli, GEO Group, Motors Liquidation Trust, and Royal mail; the largest positive contributors were WestJet Airlines, General Electric, Ophir Energy, Fifth Street Asset Management and Citigroup. 

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.  Relative to the high yield index, the overweight position in small and mid cap credits hurt performance as larger cap credits outperformed considerably. The overweight position and credit selection in energy was a major detractor in the year, while credit selection in basic industry and consumer goods also hurt. Positive credit selection in healthcare, leisure, and capital goods helped relative performance.    

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 12/31/19 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 ICE BofAML index data referenced is the property of ICE Data Indices, LLC (“ICE BofAML”) and/or its licensors and has been licensed for use by Hotchkis & Wiley. ICE BofAML and its licensors accept no liability in connection with its use. See Index definitions for full disclaimer.

The average annual total returns for the ICE BofAML US High Yield Index were 2.61%, 14.41%, 6.32%, 6.13% and 6.67% for 4Q19, one-year, three-year, five-year and Since 12/31/10 periods ended December 31, 2019, respectively.

Index definitions

Glossary of financial terms