Capital Income

Market Commentary

Period ended December 31, 2018
 

INVESTMENT STRATEGY

The Hotchkis & Wiley Capital Income portfolio 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 was up more than +10% through the first nine months of the year before posting its worst calendar quarter in 7 years, falling -13.5% in Q4.  The end result was a -4.4% return for calendar year 2018.  The ICE BofAML US High Yield Index returned -2.3% in 2018, just the 7th negative return since its 1986 inception; the index had been up +3.5% over the year’s first three quarters before declining -4.7% in Q4. 

Until the most recent quarter, robust corporate earnings growth had overcome political unrest across the globe. In the fourth quarter, however, ongoing trade tensions came to the forefront.  Markets began pricing in slowing economic growth in several major economies that are important trading partners with the US.   In contrast to this however, real GDP growth in the US was a healthy +3.4% in the most recent quarter and the unemployment rate remains below 4%.  Both the Federal Reserve and the European Central Bank implemented and spoke of future restrictive monetary policy.  This appears to have added to equity investor apprehension.  The forward P/E ratio for the S&P 500 declined from 20.0x at the beginning of the year to 15.4x at the end of the year.  The index’s median P/E since 1990 is 16.4x, so it went from well above average to comfortably below average over the course of the year.  The high yield market’s yield-to-worst rose 2.1% in the year, closing at 8.0%.  The spread over treasuries widened 172 basis points, from 363 at the beginning of the year to 535 at year’s end.  The market’s median spread since 1995 has been about 500 basis points; consequently, the spread went from much tighter than average to slightly wider than average in 2018—from our perspective, a considerably more attractive entry point. 

Fears that slowing economic growth would weaken demand weighed heavily on oil prices.  WTI crude closed the year at $45/barrel, down 25% from the beginning of the year ($60) and more than 40% from its early October high ($76).  Commodity securities were among the worst-performers of the year, with the energy and materials leading the decline.  Non-cyclical securities outperformed cyclical securities.  The performance dispersion and resulting valuation differentials among securities that are economically sensitive compared to those that are not suggests the market has begun to price in a recession scenario.  Economic metrics do not yet verify a meaningful change from positive economic growth.  At present, while acknowledging the uncertain economic outlook, we view the valuation support of cyclical securities as vastly superior to non-cyclicals.  This valuation discrepancy provides a margin of safety in the long run almost irrespective of near term economic growth.

The Fed raised rates by 25 basis points four times in 2018, moving the Fed Funds target rate from 1.5% to 2.5% over the course of the calendar year.  Treasury rates rose accordingly, more so on the short end of the curve, thus the yield curve flattened.  As of year-end, the yield on the 10-year stood just 20 basis points higher than the yield on the 2-year, an ever so slightly positive sloping curve.  The par-weighted average price of a high yield bond went from more than $100 a year ago to slightly above $92 at the end of 2018.  CCC-rated bonds underperformed the broad market (-4.1% for the year), but interestingly single-B credits held up slightly better than BB’s (-1.5% vs. -2.5%, respectively). 

While it took a decline in markets to get here, we are more constructive on the both the equity and high yield market’s forward-looking prospects than we were a year ago due to the improvement in valuation.  The market is also providing pockets of opportunities that we view as especially compelling as an active manager.  As a result, the portfolio exhibits a large valuation discount in its equity positions and a large spread advantage in its credit positions—an uncommon opportunity.   

ATTRIBUTION AND MANAGEMENT DISCUSSION: 2018

The Hotchkis & Wiley Capital Income portfolio (gross and net of management fees) underperformed the 50/50 blended benchmark in 2018.  The average equity weight was 56% and the average high yield bond weight was 44% over the course of the year.  The equity overweight hurt as equities underperformed bonds. 

The equity portion of the portfolio underperformed the S&P 500 Index during the year.  More than 70% of the portfolio is invested in stocks with a price-to-book ratio of less than 2x compared to just 20% for the index; this hurt relative performance as value stocks lagged by a large margin.  Also, nearly half of the portfolio was invested in small and mid cap stocks compared to just 11% for the index.  This also hurt performance as small and mid cap stocks lagged large caps.  Positive stock selection in technology and healthcare partially offset these headwinds.  The largest individual detractors to relative performance were AIG, Sanchez Energy, WestJet Airlines, Adient, and Ophir Energy; the largest positive contributors were Popular, Ericsson, Hewlett Packard Enterprise, ARRIS International, and Energy XXI. 

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.  The overweight position and credit selection in energy detracted from relative performance as crude prices fell 25% over the year.  The underweight position in telecommunications was also a detractor.  Positive credit selection in retail, basic industry, banking, and healthcare were relative performance contributors during the year.

Unless otherwise noted, the "high yield" or "broad" market refers to the ICE BofAML US High Yield Index. 

 
Composite performance for the strategy is located on the Performance tab. Returns discussed can differ from actual portfolio returns due to intraday trades, cash flows, corporate actions, accrued/miscellaneous income, and trade price and closing price difference of any given security. Portfolio characteristics and attribution based on representative Capital Income portfolio. Certain client portfolio(s) may or may not hold the securities discussed due to each account’s guideline restrictions, cash flow, tax and other relevant considerations. Fixed Income performance attribution is an analysis of the portfolio's return relative to the ICE BofAML US High Yield Index and is calculated using trade information, does not reflect cash flow transactions and the payment of transaction costs, fees and expenses. Equity performance attribution is an analysis of the portfolio's return relative to a selected benchmark, is calculated using daily holding information and does not reflect management fees and other transaction costs and expenses.  Specific securities identified are the largest contributors (or detractors) to the portfolio’s performance relative to the S&P 500 Index. Other securities may have been the best and worst performers on an absolute basis. Securities identified do not represent all of the securities purchased or sold for advisory clients, and are not indicative of current or future holdings or trading activity.  H&W has no obligation to disclose purchases or sales of the securities.  No assurance is made that any securities identified, or all investment decisions by H&W were or will be profitable. The Capital Income strategy may prevent or limit investments in major bonds or stocks in the S&P 500, Russell 1000 Value, ICE BofAML US Corporate, Government & Mortgage and ICE BofAML US High Yield indices and returns may not be correlated to the indexes. Indices provided as benchmarks are for reference only and are not directly comparable to the Capital Income strategy’s performance.  Quarterly characteristics and portfolio holdings are available on the Characteristics and Literature tabs. For a list showing every holding’s contribution to the overall account’s performance and portfolio activity for a given time period, please contact H&W at hotchkisandwiley@hwcm.com.  Portfolio information is subject to the firm’s portfolio holdings disclosure policy.
 
The commentary is for information purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.  Portfolio managers’ opinions and data included in this commentary are as of December 31, 2018 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. Certain information presented is based on proprietary or third-party estimates, which are subject to change and cannot be guaranteed. Equity securities may have greater risks and price volatility than US Treasuries and bonds, where the price of these securities may decline due to various company, industry and market factors. 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.  High yield bonds and other asset classes have different risk-return profiles, which should be considered when investing.  Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during a given period. All investments contain risk and may lose value.
 
Past performance is no guarantee of future results.
 

Index definitions