Large Cap Diversified Value

Market Commentary

Period ended June 30, 2018
 

MARKET COMMENTARY

After a small decline in the first quarter of 2018, the S&P 500 Index returned +3.4% in the second quarter and is now up +2.7% for the year.  The positive performance from equities suggests that for the time being, investors are choosing to focus on strong corporate earnings as opposed to 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 global trade war concerns. 

The Russell 1000 Growth Index returned +5.8% during the quarter, compared to +1.2% for the Russell 1000 Value Index.  Growth has outperformed value in 15 of the past 20 quarters, including each of the past six.  A large part of the performance difference this quarter stems from significant variations in sector performance.  Energy, consumer discretionary, and technology were the best performing sectors, in that order. While energy is overrepresented in the value index, technology and consumer discretionary are much larger constituents in the growth index.   In addition, the financial sector, among the worst performing sectors in the quarter with a negative quarterly return, is much larger in the value index; financials represent 26.6% of the value index versus just 3.5% of the growth index.  Further, within sectors, growth outperformed value.  This was most pronounced in technology, where Russell 1000 technology Growth stocks rose +8.6% but Russell 1000 technology Value stocks fell -1.0%. 

Since the beginning of the year, we have increased the weight in consumer staples and energy while trimming the weight in technology.  Consumer staples has been the market’s worst-performer year-to-date and thus valuations have improved, particularly relative to the rest of the market.  Energy has outperformed, but stock price increases have not kept pace with the rise in oil prices, which have approached equilibrium levels.  At current commodity prices, our energy holdings reflect highly compelling valuation opportunities, particularly given the broad equity market appears fully/fairly valued.  In technology, we trimmed select positions that had outperformed in lieu of valuation opportunities elsewhere. 

The equity market’s valuation appears above average, but this is heavily influenced by certain market segments that we view as considerably overvalued.  Valuation spreads are wide. In light of value’s underperformance, 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.  A global economic slowdown could favor value if the revenue/earnings projections for growth stocks fail to live up to the rosy expectations embedded in the elevated valuation multiples.  Perhaps the “catalyst”, will be investors’ eventual recognition of the wide valuation disparity across equity markets, as has often been the case.  While the timing is uncertain, we are confident that the cycle will shift in favor of value once again.

The portfolio continues to trade at a considerable valuation discount to both the broad index and the value index, which is why we believe our clients should be rewarded if/when the growth/value cycle turns.  The portfolio trades at 9.6x normal earnings compared to 17.5x and 14.6x for the S&P 500 and the Russell 1000 Value, respectively.  The price-to-book value of the portfolio is 1.6x vs. 3.2x and 2.0x for the S&P 500 and Russell 1000 Value, respectively.  

ATTRIBUTION: 2Q 2018

The Hotchkis & Wiley Large Cap Diversified Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the second quarter of 2018.   Positive stock selection drove all of the outperformance, and was most positive in energy, healthcare, and consumer staples.  Stock selection in industrials along with an underweight allocation to real estate hurt relative performance.  The largest positive contributors to relative performance were Marathon Oil, Hess, Apache, Ericsson, and Discovery; the largest detractors were Hewlett Packard Enterprise, Cummins, CNH Industrial, Vodafone, and Travelers.  

LARGEST NEW PURCHASES: 2Q 2018

AXA Equitable Holdings is a large domestic life insurance company that underwrites and distributes annuities, retirement products, life insurance, and asset management services. It owns a 65% economic interest in AllianceBernstein, a full service, global asset manager that serves both retail and institutional clients. As one of the largest sellers of variable annuities in the US, annuities account for more than 50% of the company’s earnings. AXA is well capitalized and is expected to return a significant amount of its earnings to shareholders. Further, the company trades at a very low level of normalized earnings, both on an absolute basis and relative to peers.

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 Large Cap Diversified Value 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. 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 Russell 1000 Value Index. Other securities may have been the best and worst performers on an absolute basis. 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 at quarter-end, all new security positions are included.  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 value disciplines used in managing accounts in the Large Cap Diversified Value strategy may prevent or limit investment in major stocks in the S&P 500 and Russell 1000 Value indices and returns may not be correlated to the indexes. 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.
 
Past performance is no guarantee of future results.
 

Index definitions