Mid-Cap Value

Market Commentary

Period ended June 30, 2017
 

MARKET COMMENTARY

The Russell Midcap Index returned +2.7% in the second quarter.  Mid cap growth stocks outperformed mid cap value stocks in the quarter, with the Russell Midcap Growth Index returning +4.2% compared to the Russell Midcap Value Index’s return of +1.4%.  Year-to-date, the growth index has outperformed the value index by more than 6 percentage points, a reversal of value’s 13 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 75% of the Russell Midcap’s quarter return was generated by the tech and healthcare sectors. 

Financials have represented the portfolio’s largest sector since the end of the financial crisis, and banks have comprised 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. 

Equity valuation multiples 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 equity markets.  Investors have favored sectors with stable earnings and high dividend payouts, bidding them up to levels we view as excessive; we are underweight REITs, regulated utilities, and consumer staples.  We are overweight energy, technology, and consumer discretionary, which exhibit compelling valuations for the risks at hand.  The portfolio trades at a considerable discount to the market, largely due to this valuation dichotomy.  The portfolio trades at 7.2x normal earnings compared to 15.8x and 18.1x for the Russell Midcap Value and Russell Midcap Indices, respectively.  The portfolio trades at 1.1x book value compared to 1.9x and 2.6x for the two indices, respectively.

ATTRIBUTION: 2Q 2017

The Hotchkis & Wiley Mid-Cap Value portfolio (gross and net of management fees) underperformed the Russell Midcap Value Index in the second quarter.  The overweight and stock selection in energy detracted from performance along with stock selection in consumer discretionary.  Relative to the benchmark, the portfolio benefitted from its strong selection in utilities and financials.  The largest individual contributors to relative performance were Calpine, Office Depot, CIT Group, Willis Towers Watson, and Corning; the largest detractors were Whiting Petroleum, Bed Bath & Beyond, Weatherford International, Cairn Energy, and Discovery Communications.  

PORTFOLIO ACTIVITY: 2Q 2017

We increased our energy exposure by adding new positions in C&J Energy Services and Sanchez Energy, and adding to the existing position in Superior Energy Services.  This was partially offset by trimming the position in Marathon Oil.  We reduced our technology exposure by trimming positions that have performed well recently.    
 

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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.

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 Mid-Cap 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 Midcap Value 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 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 given periods. Investing in small and medium-sized companies involves greater risks than those associated with investing in large company stocks, such as business risk, significant stock price fluctuations and illiquidity. All investments contain risk and may lose value. 
 
Past performance is no guarantee of future results.
 

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