Capital Income

Market Commentary

Period ended June 30, 2017
 

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 BofA Merrill Lynch 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 increased +3.1% and the BofA Merrill Lynch US High Yield Index returned +2.1% in the second quarter of 2017.  In equity markets, growth stocks outperformed value stocks in the quarter, with the Russell 1000 Growth Index returning +4.7% compared to the Russell 1000 Value Index’s return of +1.3%.  Year-to-date, the growth index has outperformed the value index by more than 9 percentage points, a reversal of value’s 10 percentage point advantage in 2016.  In the last few years, investors flocked to companies with high dividend payouts (i.e. bond surrogates) because interest rates have been persistently low.  In 2017, with GDP advancing at a positive but lackluster pace, investors have flocked to stocks that have exhibited above average growth.  This has not only led to growth’s outperformance but also produced a market with narrow leadership.  More than one-third of growth’s outperformance has come from just five mega cap stocks—Apple, Amazon, Facebook, Google, and Microsoft.

Financials represent the portfolio’s largest equity sector, and banks comprise a meaningful portion of that exposure.  In late June, the Federal Reserve Board completed its Comprehensive Capital Analysis and Review (“CCAR”) and did not object to the capital plans of the 34 participating companies1.  In its press release, the Fed noted that the common equity capital ratio of the 34 banks “has more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 percent in the first quarter of 2017”.  Of the 34 banks, 26 are public US companies.  These 26 banks were approved for returning 100% of earnings to shareholders on average, which equates to 7.5% of their equity value; i.e. a 7.5% payout yield—a handful have a payout yield of more than 10%.  We view this as a compelling dynamic for companies that have not had better balance sheets in our lifetime. 

In credit markets, higher quality credits performed best, which is moderately atypical in a market rally.  Spreads for the overall market tightened by 15 basis points but spreads on credits rated CCC or below actually widened by 21 basis points.  Every sector but one increased during the quarter, with financial market sectors leading the way.  Energy was the laggard, declining -1.3% during the quarter as oil prices declined 9% and 3 high yield energy issuers defaulted.  A little more than a year ago, spreads for commodity sectors were about 1,000 basis points wider than the market average before almost fully converging with the rest of the market.  After the notable widening during the second quarter, energy spreads are now about 150 basis points wider than the aggregate market. 

The Treasury yield curve flattened during the quarter.  Yields on the 2-year increased, yields on the 5-year were flat, and yields on the 10- and 30-year decreased.  The flattening was of modest magnitude, and the yield curve remains normal/upward sloping.  This is something we monitor closely; however, as an inverted yield curve has preceded all seven recessions of the past 50 years.  Revenue and EBITDA growth have recovered, and financial leverage remains in check.  Distressed debt accounts for less than 1% of the total high yield market; the default rate is 2%, about half the market’s historical average.  Excluding commodity defaults over the past year, the default rate is under 1%.  The market’s “excess spread”, or spread after adjusting for the default rate environment, is 257 basis points—just 36 basis points below the historical average.  The maturity calendar is termed out well, with little near term refinancing pressures.  The primary/new issue market has been well-behaved.  Most new issuance has been higher quality bonds and the proceeds have been predominantly used for refinancing—LBO activity remains muted. 

Both equity and credit valuations leave us somewhat guarded.  Valuations are above average, though a healthy corporate environment, an accommodating Federal Reserve, and a resilient consumer provide support.  Potential policy changes remain a looming uncertainty across markets.  The equity portion of the portfolio trades at a considerable discount to the market and the high yield portion of the portfolio contains a meaningful spread advantage relative to the broad high yield index. 

ATTRIBUTION AND MANAGEMENT DISCUSSION: 2Q 2017

The Hotchkis & Wiley Capital Income portfolio (gross and net of management fees) outperformed the 50/50 blended benchmark in the second quarter of 2017.  The equity portion averaged 57% of the portfolio over the year with the balance allocated to high yield bonds.  The overweight to equities helped as equities outperformed high yield bonds.  The high yield bond exposure, as opposed to investment grade fixed income, also helped relative performance as high yield outperformed high grade bonds. 

The equity portion of the portfolio underperformed the S&P 500 Index.  The overweight and stock selection in energy was the largest detractor by a wide margin.  On the positive side, stock selection in technology and the overweight position in industrials helped relative performance.  The largest individual detractors to relative performance were Energy XXI Gulf Coast, Whiting Petroleum, Bowleven, Hewlett-Packard Enterprise, and Cobalt; the largest positive contributors were Calpine, Koninklijke Philips, Office Depot, Danieli, and Vodafone.

The high yield bond portion of the portfolio outperformed the BofA Merrill Lynch US Corporate, Government & Mortgage Index and the BofA Merrill Lynch US High Yield Index.  Relative to the high yield index, the portfolio was helped by positive credit selection, particularly in energy and basic industry.  The overweight position in energy was a detractor.  
 

_______________________
1While the Fed did not object to its plan, Capital One is required to address weaknesses in its capital planning process and resubmit its plan.

Unless otherwise noted, the high yield market or "broad" index refers to the BofA Merrill Lynch 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 BofA Merrill Lynch 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.  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, 2017 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 given periods. All investments contain risk and may lose value.
 
Past performance is no guarantee of future results.
 

Index definitions