Small Cap Value Fund (HWSIX) - Limited Availability

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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, 2019

 
MARKET COMMENTARY

After falling -20.2% in 4Q 2018, the Russell 2000 Index returned +14.6% in the first quarter of 2019.  The swift decline and equally rapid recovery were both triggered by changes in investor sentiment as opposed to changes in underlying economic or business fundamentals.  Investor concerns emerged late in 2018 regarding trade tensions and a hawkish Fed; this combination created fears of impending global economic recession.  These concerns appeared to fade during the first quarter of 2019 due to positive progress on US/China trade talks and dovish comments from the Federal Reserve. Throughout this period we have witnessed a significant decline in longer maturity Treasury yields and a flattening of the yield curve.  After reaching 3.2% in late 2018, the 10-year note yield fell below 2.4% in March, its lowest level in more than a year despite the Fed’s four 2018 rate hikes.  In response to these changes, all Russell 2000 sectors were positive in the first quarter, with the best returning +23% (technology) and the worst returning +7% (consumer staples).  The Russell 2000’s forward P/E ratio increased from 22.6x at the end of 2018 to 24.0x at the end of the first quarter.  The index’s median valuation over the past ~25 years is 24.2x; while it is now in line with its median, it is considerably lower than the 35x level where it began 2018. 

While the overall small cap market appears fairly valued, we find solace in the large valuation disparity between certain segments of the market—some are attractively valued, some richly valued.  The portfolio’s banks trade at 10x consensus earnings and offer a payout yield of more than 6%.  Considering that banks’ balance sheets are as strong as they have been in decades, and nearly 80% of earnings are being returned to shareholders via dividends and share repurchases, we view banks’ risk/reward tradeoff as especially compelling.  Conversely, “defensive” stocks such as regulated utilities trade at nearly twice the valuation of more economically sensitive stocks such as industrials or banks.  Many of these defensive industries have increased financial leverage over the last decade.  Given this considerable valuation dispersion across sectors, the portfolio exhibits large sector deviations from the benchmark. 

The Russell 2000 Growth Index outperformed the Russell 2000 Value Index in the quarter by more than 5 percentage points (+17.1% vs. +11.9%); since the beginning of 2017, growth has outperformed value by 25 percentage points (+30% vs. +5%).  The performance difference is entirely explained by changes in price multiples, as opposed to differences in earnings growth.  The P/E ratio for the Value index has contracted by about 40% while the P/E ratio for the Growth index has actually expanded by a small amount.  This repricing has contributed to not only the large valuation differences across sectors but also to notable spreads within sectors.  In response to this backdrop our Value approach led to a portfolio that trades at a large discount to the Value index and an exceptional discount to the Growth index.  The portfolio’s price-to-normal earnings ratio is 6.9x compared to 13.4x and 20.0x for the Russell 2000 Value and Russell 2000 Growth, respectively.  As active investors with a commitment to long-term fundamental valuation, we view this environment as conducive to our approach and we are optimistic about the portfolio’s prospects.     

ATTRIBUTION: 1Q 2019

The Hotchkis & Wiley Small Cap Value Fund underperformed the Russell 2000 Value Index in the first quarter of 2019.  Overall stock selection was positive, but this was countered by unfavorable sector allocation.  Positive stock selection in financials, REITs, consumer discretionary, and energy helped relative performance in the quarter.  The overweight position in energy and underweight position in consumer discretionary were also modestly positive. The overweight position and stock selection in technology detracted from performance in the quarter.  The overweight position in financials and underweight position in materials also detracted from performance along with stock selection in communication services.  The largest individual detractors to relative performance in the quarter were Embraer, Global Indemnity, Hanger, Enstar, and Casa Systems; the largest positive contributors were Seritage Growth Properties, Office Depot, Kosmos Energy, Avnet, and First Hawaiian.

Mutual fund investing involves risk. Principal loss is possible. Investing in smaller and/or newer companies involves greater risks than those associated with investing in larger companies, such as business risk, significant stock price fluctuations and illiquidity. The Fund may invest in ETFs, which are subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of an ETF’s shares may trade at a discount to its net asset value ("NAV"), an active secondary trading market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact a Fund’s ability to sell its shares.  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 3/31/19 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 Russell 2000 Value 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.

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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