International Value

Market Commentary

Period ended March 31, 2018
 

MARKET COMMENTARY

In the first quarter of 2018, the Russell Developed ex-US Index declined -1.6% in US Dollar terms.  The US Dollar weakened between 2% and 3% relative to other major currencies, so in local currency terms global index declined more.  International growth stocks outperformed international value stocks during the quarter, extending their recent advantage.  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.  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, some segments of the international market offer attractive valuations for the risks at hand.  Financials continue to represent the largest sector weight in the portfolio.  Despite healthy stock price appreciation in recent years, banks continue 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 been partial to industrials.  Our focus has been on attractively valued, well-managed companies with strong balance sheets and good prospects for growth.  The sector is composed of mostly cyclical businesses but with different end markets.  Different industries experience cyclical troughs at different times and therefore exhibit compelling valuation opportunities at different times.  Thus, we have been overweight industrials for an extended period but our investment mix has changed through time. 

We have gradually increase our energy weight as the sector has underperformed the market by a wide margin in recent years.  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. 

We remain underweight consumer staples but less so than we have been in recent years because we increased our weight recently.  The new positions possess great brands that are among the market share leaders, which enable them to earn good returns on capital. 

Over long periods, international value has outperformed international 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 7.4x normal earnings and 1.2x book value, a notable discount to the Russell Developed ex-US Index (14.2x and 1.6x, 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 International Value portfolio (gross and net of management fees) outperformed the Russell Developed ex-US Index in the first quarter of 2018.  The portfolio’s value approach was a considerable headwind as international growth stocks outpaced international value stocks.  About 75% of the portfolio trades at less than 2x book value compared to less than half of the index; this was a challenge to performance that was overcome by positive stock selection in a variety of sectors.  Positive stock selection in financials, consumer staples, and industrials helped relative performance.  The overweight in technology and underweight in materials also helped.  Stock selection in materials, consumer discretionary, and telecommunications detracted from performance.  The largest individual positive contributors to relative performance were Royal Mail, Credito Valtellinese, Danieli, Zurich Insurance Group, and Barclays; the largest detractors were WestJet Airlines, Frank’s International, Masonite International, Global Indemnity, and Vodafone. 

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 International 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 Developed ex-US 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 March 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 U.S. Treasuries and bonds, where the price of these securities may decline due to various company, industry and market factors.  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. The strategy invests in foreign as well as emerging market securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. All investments contain risk and may lose value. 
 
Past performance is no guarantee of future results.
 

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