Value Opportunities Fund (HWACX)

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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 S&P 500 Index fell -0.8%.  The Russell 3000 Growth Index returned +1.5% while the Russell 3000 Value Index fell -2.8%, extending growth’s recent performance advantage.  Over the last 10 years, the value index has returned +113% cumulatively compared to +192% for the growth index (+7.8% and +11.3% 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 popular stocks exhibit exorbitant valuation multiples akin to internet bubble levels.  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, we believe some segments of the market offer attractive valuations for the risks at hand.  Financials continue to represent the largest sector weight in the portfolio and largest overweight relative to the S&P 500.  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. 

In recent years we have found interesting opportunities in technology even though parts of the sector are overvalued.  Our focus has been on attractively valued, well-managed companies with sticky customers, strong balance sheets, and good prospects for growth.  As the adoption of cloud technology proliferates, the mix of IT spending is likely to shift with some competitors gaining share at the expense of others.  In our view, several of our large tech holdings stand to benefit from this transition.  These companies offer cloud products that have been well-received by the marketplace, and as existing customers transition to the cloud they become more valuable to the company.  Customers are sticky because switching costs are onerous.  Many customers store critical business data in, and have built business processes around these products. Additionally, these companies have great balance sheets, are good stewards of capital, and are growing. 

We have also increased our weight in energy as the sector has underperformed the broad market in a big way.  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. 

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 benchmark. The portfolio trades at 6.6x normal earnings and 1.2x book value, a notable discount to the S&P 500 Index (17.4x and 3.1x, 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 Value Opportunities Fund underperformed the S&P 500 Index in the first quarter of 2018.  The underperformance of value relative to growth was a performance headwind for our valuation-focused approach relative to the broad benchmark.  Nearly 75% of the portfolio trades at less than 2x book value compared to about 20% of the S&P 500—these stocks underperformed the market which served as a brisk headwind.  Stock selection in consumer discretionary and the overweight position in energy also detracted from performance.  Positive stock selection in technology, consumer staples, and healthcare, along with the underweight position in staples, helped performance.  The largest individual detractors relative to the benchmark were Office Depot, Wells Fargo, Seritage Growth Properties, WestJet Airlines, and Cobalt convertible bonds; the largest positive contributors were Hewlett Packard Enterprise, Royal Mail, Whiting Petroleum, Popular, and Credito Valtellinese.  

LARGEST NEW PURCHASES: 1Q 2018

Credito Valtellinese is the 10th largest bank in Italy with ~$25B in assets. The majority of Italian banks are struggling with extremely high levels of non-performing loans, often with 20% to 30% of the gross loan book classified as non-performing. Credito Valtellinese recently initiated a $700M rights offering with plans to accelerate the disposal of its gross non-performing loans to ~10% of gross loans. Despite the improvement in the loan book quality, Credito Valtellinese continues to trade at a very low multiple of book and normalized earnings and in-line with peers with much unhealthier loan books.

GEO Group operates private prisons in the United States, which is a duopoly industry in a growing market.  After a slight decline in prison populations over the last six years, prison populations are expected to rise.  With state budgets severely constrained, states are turning to private prisons to support the rising populations.  Meanwhile, GEO trades below replacement cost and a low multiple of normal earnings despite the favorable backdrop.

Medtronic is one of the largest and most diversified medical device companies in the world. With its dominant market position in CRM, Spine, and Neuromodulation, the company has enjoyed best-in-class margins and free cash flow. Medtronic’s merger with Covidien is highly synergic by providing cost savings ($850MM or 3% of sales), expanding distribution, especially in emerging markets, diversifying product risk, and increasing scale in negotiating with the consolidating healthcare industry. In addition, it re-incorporated in Ireland, which provides greater financial flexibility in accessing global cash. Management has committed to a dividend payout of at least 50%. Medtronic is currently the #1 or #2 player in almost all of its businesses, with meaningful barriers to entry given the scale and expertise required to receive FDA approval for its products, and we expect management to leverage this and improve margins further.

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 3/31/18 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 “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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