Mid-Cap Value Fund (HWMRX)

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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 March 31, 2018

 
MARKET COMMENTARY

In the first quarter of 2018, the Russell Midcap Index fell -0.5%.  The Russell Midcap Growth Index returned +2.2% while the Russell Midcap Value Index fell -2.5%, extending growth’s recent performance advantage.  Over the last 10 years, the mid value index has returned +155% cumulatively compared to +174% for the growth index (+9.8% and +10.6% 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, a number of mid cap 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 mid cap market offer attractive valuations for the risks at hand, in our opinion.  Energy represents the portfolio’s largest sector weight in both absolute terms and relative to the benchmark.  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. 

Financials represent the second 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 continued 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. 

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 6.3x normal earnings and 1.0x book value, a notable discount to the Russell Midcap Value Index (15.4x and 1.9x, respectively) and an even larger discount to the Russell Midcap Index (17.8x and 2.6x, 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.   

ATTRIBUTION: 1Q 2018

The Hotchkis & Wiley Mid-Cap Value Fund (Class I) outperformed, by declining less than, the Russell Midcap Value Index in the first quarter of 2018.  The portfolio’s considerable overweight to technology helped performance as it was the top performing sector in the quarter by a considerable margin.  The underweight in REITs and positive stock selection in industrials, consumer staples, and utilities also helped performance.  Stock selection in healthcare and consumer discretionary hurt performance along with the overweight position in energy.  The largest individual positive contributors to performance were Hewlett Packard Enterprise, Whiting Petroleum, Popular, Royal Mail, and Kohl’s; the largest detractors were Office Depot, Weatherford International, Mallinckrodt, Ophir Energy, and Goodyear Tire.  

LARGEST NEW PURCHASES: 1Q 2018

KBR is a global engineering and construction services company focusing on the government and energy sectors. KBR traded down recently due to misunderstood cost overruns at one of its large construction projects. We find KBR’s current valuation attractive and valuation becomes very attractive if KBR benefits from a cyclical recovery in LNG investment.

SLM Corporation, or Sallie Mae, is the leading provider of private student loans in the United States with ~55% market share. Private student loans continue to be a high growth area of lending, with SLM increasing its loan book 23% year-over-year to $18.8B and management guiding to $5.0B in new originations for 2018, equally split between market share gain and overall growth in the space. Private student loans are relatively high yielding assets and the overall book has a net interest margin of ~6% despite SLM’s wholesale funding model. The risk of loan charge-offs are also lower than one might expect for a non-collateralized class of loans given the inability to receive forgiveness for student loans in bankruptcy. Despite the high level of growth and attractive return profile of the loan book, we believe SLM trades at an attractive multiple of earnings when normalized for mid-cycle provisions and remains well-capitalized, allowing the company to absorb future growth.

PPL Corporation is a utility holding company that, through its fully regulated subsidiaries, generates electricity from power plants in the Northeastern and Western portions of the United States and delivers electricity in Pennsylvania and the UK.  Following the spinoff of its non-regulated generation assets in 2015, the company is now a fully regulated utility. Annual earnings growth of around 6% is expected over the next several years, driven by rate base investments in aging utility infrastructure in Pennsylvania and Kentucky.  PPL pays an attractive 5.8% dividend yield and has grown its dividend by ~2% over the last 5 years.   

Mutual fund investing involves risk. Principal loss is possible. Investing in medium-sized companies involves greater risks than those associated with investing in large company stocks, such as business risk, significant stock price fluctuations and illiquidity. The Fund may invest in foreign securities 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. Certain information presented based on proprietary or third-party estimates are subject to change and cannot be guaranteed.  Portfolio managers’ opinions and data included in this commentary are as of 3/31/18 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 Russell MidcapValue Index. Securities’ absolute performance may reflect different results.  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 at year-end, all new security positions are included.  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.

Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform other asset types during a given period. Equities, bonds, and other asset classes have different risk profiles, which should be considered when investing. All investments contain risk and may lose value. 
 

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