Value Opportunities Fund (HWAIX)

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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 -13.5% in 4Q 2018, the S&P 500 Index returned +13.7% 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 an 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 S&P 500 sectors were positive in the first quarter, with the best returning +20% (technology) and the worst returning +7% (healthcare).  The S&P 500’s forward P/E ratio increased from 15.4x at the end of 2018 to 17.1x at the end of the first quarter.  The index’s median valuation over the past ~30 years is 16.4x; while it is now slightly above median, it is considerably lower than the 20x level where it began 2018. 

While the overall market appears fairly valued, we continue to find opportunities because there is a large valuation disparity between certain segments of the market—some are attractively valued, some richly valued.  The S&P Banks Industry Group trades at 9.9x forward earnings.  The median multiple for banks over the last 30 years is 12.0x, so the group currently trades at about 80% of its historical average.  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.  The portfolio’s banks trade at an even lower valuation (9.3x consensus earnings and 8.1x normal earnings) with a payout yield of 10% (dividends + share repurchases as a percentage of total equity).  Conversely, the S&P Utilities Industry Group trades at 18.8x forward earnings, or double the valuation of banks.  The median multiple for utilities over the last 30 years is 14.4x, so the group currently trades at about 130% of its historical average.  Opposite of banks, utilities have added financial leverage, increasing net debt to EBITDA by 50% over the past decade from 3.4x to 5.1x.  Utilities can support higher debt levels than most other businesses, but paying high multiples for slow growing businesses with increased leverage is not an attractive proposition in our view.  Recognizing the considerable valuation dispersion across sectors, the portfolio exhibits larger-than-normal sector deviations from the benchmark. 

The Russell 3000 Growth Index outperformed the Russell 3000 Value Index in the quarter by about 4 percentage points (+16% vs. +12%); since the beginning of 2017, growth has outperformed value by about 31 percentage points (+47% vs. +16%).  Interestingly, the combination of earnings growth plus dividends paid has been similar for the underlying growth and value companies over this period.  The performance difference, therefore, is almost entirely explained by changes in price multiples.  The P/E ratio for the Value index has contracted by more than 20% while the P/E ratio for the Growth index has expanded by about 9%.  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 7.4x compared to 14.1x and 23.3x for the Russell 3000 Value and Russell 3000 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 Value Opportunities Fund (Class I) outperformed the Russell 3000 Value Index in the first quarter of 2019.  The overweight position in industrials and underweight position in healthcare were positive contributors to relative performance in the quarter.  Positive security selection REITs, energy, and consumer staples also helped.  Security selection in materials, healthcare, and communication services detracted from performance.  The largest positive contributors to relative performance in the quarter were General Electric (equity and preferred), Seritage Growth Properties, Apache, Goldman Sachs, and Hewlett Packard Enterprise; the largest detractors were Iracore bonds, Royal Mail, National Oilwell Varco, Vodafone, and Wells Fargo.   

LARGEST NEW PURCHASES: 1Q 2019

Medtronic PLC is one of the world’s largest medical technology companies with operations in over 150 countries and a highly diversified product portfolio.  Medtronic boasts a #1 or #2 market position in 75% of its businesses and its significant scale provides substantial benefits in negotiations with a consolidating healthcare industry.  The company benefits from numerous secular trends, including an aging population in developed markets and increasing healthcare spend in fast-growing emerging markets.  Medtronic also has a strong new device pipeline which should underpin the company’s ability to deliver mid single digit top line growth for years to come.  We believe Medtronic trades at a compelling valuation of normal earnings given the company’s growth profile.

The GEO Group is a diversified owner and operator of state and federal penitentiaries, immigration detention, reentry services and electronic monitoring.  The GEO 5 7/8 2024 bond fell in price due to political commentary to a point that the bond yield was comparable to GEO’s equity dividend yield.  The GEO bonds trade at very attractive multiples of current cash flow, a significant discount to replacement cost and has lease terms that extend beyond the maturity of the bond.

JC Penney Corp. operates over 800 department stores in the US and Puerto Rico including 400 stores that are owned.  The JCP 5 7/8 2023 bond is secured by over 280 stores and distribution centers with an appraised value that well exceeds debt at our bond level.  The market continues to discount department store assets due to more sales moving online to the point that we are able to buy security in real estate assets at a large discount to intrinsic value. 

Mutual fund investing involves risk. Principal loss is possible.  Investing in non-diversified funds and/or smaller and/or medium-sized companies involves greater risks than those associated with investing in diversified funds and/or large company stocks, such as business risk, significant stock price fluctuations, sector concentration and illiquidity. The Fund is non-diversified, meaning it may concentrate its assets in fewer individual holdings than a diversified fund.  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. 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.

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 3000 Value Index. Securities’ absolute performance may reflect different results. The “Largest New Purchases” section includes the three largest new security positions during the quarter based on the security’s quarter-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 during the quarter, 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.

 

Index definitions

Glossary of financial terms