Mid-Cap Value

Market Commentary

Period ended June 30, 2018
 

MARKET COMMENTARY

After a small decline in the first quarter of 2018, the Russell Midcap Index returned +2.8% in the second quarter and is now up +2.3% 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.  Russell Midcap earnings grew an impressive +25% year-over-year in the most recently reported quarter, with more than 75% of companies beating consensus estimates.  More than 175 of the ~800 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. 

The Russell Midcap Growth Index returned +3.2% during the quarter, compared to +2.4% for the Russell Midcap Value Index.  Mid cap growth has outperformed value in 11 of the past 15 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 was offset by value’s larger exposure to financials which was among the market’s worst-performing sectors, and value’s smaller exposure to technology which outperformed the market.  Within sectors growth outperformed value.  This was most pronounced in the consumer discretionary sector, where Russell Midcap Growth stocks rose +7.1% but Russell Midcap Value stocks rose just +0.8%. 

Since the beginning of the year, we have increased the weight in real estate and industrials modestly while trimming the weight in energy.  In real estate, we have identified an eclectic mix of unique opportunities even though we continue to find the broad sector richly valued.  In industrials we have identified attractive opportunities in cyclical businesses that are unrelated and have very different end markets.  While we are still partial to opportunities in energy, we trimmed our overweight position as the stocks have outperformed. 

The mid cap 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.  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 across 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 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 6.9x normal earnings compared to 17.9x and 15.6x for the Russell Midcap and Russell Midcap Value, respectively.  The price-to-book value of the portfolio is 1.1x vs. 2.6x and 1.9x for the Russell Midcap and Russell Midcap Value, respectively. 

ATTRIBUTION: 2Q 2018

The Hotchkis & Wiley Mid-Cap Value portfolio (gross and net of management fees) outperformed the Russell Midcap Value Index in the second quarter of 2018.  Positive stock selection drove the outperformance, and was particularly positive in real estate, healthcare, and financials. The overweight and outperformance in energy, a high returning sector, also helped performance.  Stock selection in technology and utilities, combined with an underweight allocation to REITs detracted from performance.  The largest individual contributors to relative performance were Whiting Petroleum, Kosmos Energy, GEO Group, Ericsson, and Discovery; the largest detractors were Hewlett Packard Enterprise, ARRIS International, Goodyear Tire, CNO Financial, and Ophir Energy. 

LARGEST NEW PURCHASES: 2Q 2018

Amerco, through its primary subsidiary U-Haul, offers truck, trailer, and self-storage rentals across its 22,000 locations in the US and Canada.  U-Haul is over 10x larger than its next largest competitor and has more locations than all US rental car companies combined.  In addition, the company has significant optionality in its self-storage business and real estate assets.  These advantages, combined with Amerco’s attractive valuation, make the stock compelling.

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 than 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.

CBS is a mass media company that operates in four segments: Entertainment (National CBS network, ~50% of EBIT), Cable Networks (mostly Showtime, ~30% of EBIT), Local TV Broadcasting, and Publishing (Simon & Schuster). CBS’s multiple is depressed relative to other media companies even though it does not face any material risk from disruptions to Pay TV and will take share of distribution fees for many years. A fundamental change in TV’s share of ad spend appears unlikely. Thus, as ad spend in the US recovers and vertical integration to TV production continues, CBS should enjoy increasing revenue with high conversion to EBIT and higher margins on syndication revenue.

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. 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 Mid-Cap Value strategy may prevent or limit investment in major stocks in the Russell Midcap and Russell Midcap 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.
 
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 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. 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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