Capital Income

Market Commentary

Period ended June 30, 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 returned +3.4% and the ICE BofAML US High Yield Index returned +1.0% in the second quarter of 2018 as strong corporate earnings prevailed over trade war risks and geopolitical tensions.   

S&P 500 earnings grew an impressive +20% year-over-year in the most recently reported quarter, with more than 81% of companies beating consensus estimates.  More than 100 of the ~500 companies in the index reported earnings growth of more than 50% from a year ago.  Interestingly, the composition of this fastest-growing cohort was broadly distributed across sectors even though stock performance across sectors has varied significantly.  Going forward, consensus expectations are for earnings growth in the high teens, even with the looming threat of a global trade war. 

The Russell 3000 Growth Index returned +5.9% during the quarter, compared to +1.7% for the Russell 3000 Value Index.  The Russell 3000 Growth has outperformed its value counterpart in 14 of the past 20 quarters, including each of the past six.  Energy was the top-performing sector, and because it is a larger weight in the value index, this helped value’s relative performance.  This exception aside, large differences in index sector weights generally worked to growth’s advantage.  Technology and consumer discretionary were the second and third best-performing sectors, respectively, and are much larger constituents of the growth index.  The primary reason value lagged was financials, which comprised 26.9% of the value index and just 3.7% of the growth index—financials declined in the quarter, making it among the worst performing sectors in the market.  Even within sectors, however, growth outperformed value.  This was most pronounced in technology, where Russell 3000 Growth stocks rose +8.6% but Russell 3000 Value stocks fell -0.5%. 

The equity market’s valuation appears above average, but this is heavily influenced by certain market segments that we view as considerably overvalued.  Excluding these segments, market valuations appear more reasonable.  Also, because growth has outperformed value to such a large extent, the price of select value stocks remains attractive.  We are often asked what would serve as the catalyst to bring value back into vogue; unfortunately we do not have a definitive answer.  A rise in interest rates should favor value stocks, which are shorter duration instruments than growth stocks.  An economic slowdown could favor value if the revenue/earnings projections for growth stocks fail to live up the rosy expectations embedded in the elevated valuation multiples.  Perhaps the “catalyst”, as has often been the case, is merely investors’ recognition of the wide valuation disparity across equity markets.  Whatever and whenever it may be, we are confident that the cycle will shift in favor of value once again, and our clients are well positioned to benefit. 

In the high yield market, lower rated credits outperformed higher rated credits.  The Fed raised its Fed Funds target rate which now stands at 2.0%.  Short rates rose slightly more than long rates, flattening the yield curve which is now quite flat though not inverted.  Lower rated high yield credits absorbed the rate hike while the BB rated cohort saw a modest rise in yields and spreads.  The net effect on the broad high yield market was a modest increase in the yield-to-worst which finished the quarter at 6.54%, and a negligible change in spreads which finished the quarter at 372 basis points.  Deviations in sector performance were modest during the quarter with about 3 percentage points separating the best- and worst-performing sectors—13 sectors rose while 5 fell.  Energy now comprises about 16% of the index and is not only the largest sector, but was also its top-performer in the quarter.  WTI and Brent crude prices rose +13% and +17% in the quarter, respectively.  Banking was the largest laggard, falling about 1.5% in the quarter despite the rise in interest rates. 

While valuations are not overly exciting, the high yield market continues to demonstrate signs of good health.  There were only 3 defaults across the entire market during the quarter; two in April, one in May, and zero in June—the first month with no defaults since January of 2014.   The trailing 12 month default rate closed just above 2% at quarter end. Revenue and profits continue to grow at a modest yet decidedly positive pace.  The overall market has shrunk as fund flows have been negative, particularly in high yield ETFs, and most new issuance coming to market has been for refinancing.  Leverage has shown nascent signs of rising but this has not worried rating agencies, whose upgrades have considerably outpaced downgrades.  Also, despite lower inventories at primary dealers—the byproduct of a more stringent regulatory environment—liquidity across the market has continued to improve. 

The lowest rated cohort of the investment grade credit market has grown much quicker than the rest of the US credit market and has shown signs of deteriorating credit quality.  While far from inevitable, this has the potential to flood the high yield market with additional supply should there be a large downgrade cycle.  Consequently, we are cautious in both investment grade credits where we have almost no exposure, and also in the BB-rated cohort where we are underweight both the broad and BB/B benchmarks.  Our CCC exposure is also modest, and underweight the broad benchmark, leaving us with a disproportionate exposure to single B credits where nearly half the portfolio is invested. 

The strategy remains focused on the most compelling risk-adjusted valuation opportunities in companies of all sizes and in all parts of the capital structure.   

ATTRIBUTION AND MANAGEMENT DISCUSSION: 2Q 2018

The Hotchkis & Wiley Capital Income portfolio (gross and net of management fees) outperformed the 50/50 blended benchmark in the second quarter of 2018.  The average equity weight was 56% and the average high yield bond weight was 44% over the course of the quarter, similar to its average over the first quarter.  The equity overweight helped considerably as equities outperformed bonds, and the portfolio’s equity exposure performed particularly well.    

The equity portion of the portfolio outperformed the S&P 500 Index during the quarter, despite growth outperforming value.  The growth cycle has been a notable performance headwind but positive stock selection was enough to overcome the challenge.  The lone consumer staples position outperformed, and both the overweight and positive stock selection in energy helped relative performance.  Stock selection in consumer discretionary and healthcare were also modest positive contributors.  Stock selection in technology detracted from relative performance in the quarter, along with the overweight position in industrials.  The largest positive contributors to relative performance were Whiting Petroleum, Energy XXI Gulf Coast, Discovery, GEO Group, and Ericsson; the largest detractors were WestJet Airlines, Hewlett Packard Enterprise, Credito Valtellinese, Barclays, and Ophir Energy.  

The high yield bond portion of the portfolio outperformed the ICE BofAML US Corporate, Government & Mortgage Index as high yield bonds outperformed investment grade bonds.  The portfolio performed in line with the ICE BofAML US High Yield Index.  Overall credit selection and allocation were about neutral in the quarter.  Positive credit selection in retail was offset by negative credit selection in energy.  The overweight position in energy helped relative performance but this was offset by the underweight position in telecommunications which hurt relative performance.  

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 attribution is based on a 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 3000 Growth, Russell 3000 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 June 30, 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