Small Cap Diversified Value

Market Commentary

Period ended December 31, 2018
 

MARKET COMMENTARY

The Russell 2000 Index was up more than +11% through the first nine months of the year before posting its worst calendar quarter in 7 years, falling -20.2% in Q4.  The end result was a -11.0% return for calendar year 2018.  Until the most recent quarter, robust corporate earnings growth had overcome political unrest across the globe. In the fourth quarter, however, ongoing trade tensions came to the forefront.  While small caps are more domestic-focused than large caps, and should be insulated from global disruptions relative to large caps, this suppressed investor risk appetite and small caps sold off disproportionately.  Markets began pricing in slowing economic growth in several major economies that are important trading partners with the US.   In contrast to this however, real GDP growth in the US was a healthy +3.4% in the most recent quarter and the unemployment rate remains below 4%.  Both the Federal Reserve and the European Central Bank implemented and spoke of future restrictive monetary policy.  This appears to have added to equity investor apprehension.  The forward P/E ratio for the Russell 2000 Index declined from 20.6x at the beginning of the year to 14.3x at the end of the year.  The index’s median P/E since 1995 is 16.7x, so it went from well above average to comfortably below average over the course of the year. 

Fears that slowing economic growth would weaken demand weighed heavily on oil prices.  WTI crude closed the year at $45/barrel, down 25% from the beginning of the year ($60) and more than 40% from its early October high ($76).  Commodity securities were among the worst-performers of the year, with the small cap energy (-37%) and materials sectors (-26%) leading the decline.  Non-cyclical utilities performed best, returning +4% during the year—the only sector in the Russell 2000 Value with a positive return.  The performance dispersion and resulting valuation differentials among stocks that are economically sensitive compared to those that are not suggests the market has begun to price in a recession scenario.  Economic metrics do not yet verify a meaningful change from positive economic growth.  At present, while acknowledging the uncertain economic outlook, we view the valuation support of cyclical stocks as vastly superior to non-cyclicals.  This valuation discrepancy provides a margin of safety in the long run almost irrespective of near term economic growth.

The portfolio trades at a substantial valuation discount to the index, which makes us optimistic about its prospects irrespective of market direction or temperament.  The portfolio trades at 7.2x normal earnings compared to 12.5x for the Russell 2000 Value and 14.4x for the Russell 2000.  The portfolio’s price-to-book ratio is 1.1x compared to 1.2x and 1.8x for the Russell 2000 Value and the Russell 2000, respectively.      

ATTRIBUTION: 2018

The Hotchkis & Wiley Small Cap Diversified Value portfolio (gross and net of management fees) underperformed the Russell 2000 Value Index in 2018.  The portfolio’s average energy weight was slightly more than 9% for the year compared to just 7% for the index, which detracted from performance.  Energy was the worst-performing sector in the Russell 2000 Value during the year by a large margin, as crude oil prices fell 25% in the year.  The portfolio’s energy stocks held up considerably better than the index’s energy stocks which more than made up for the modest overweight position.  The underweight position in real estate, healthcare, and utilities were modest detractors, along with stock selection in healthcare, industrials, and consumer discretionary.  This was partially offset by positive stock selection in financials and materials.

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 characteristics and attribution based on representative Small 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 (Russell 2000 Value Index), is calculated using daily holding information and does not reflect management fees and other transaction costs and expenses.  No assurance is made that any securities identified, or all investment decisions by H&W were or will be profitable. The value discipline used in managing accounts in the Small Cap Diversified Value strategy may prevent or limit investment in major stocks in the Russell 2000 and Russell 2000 Value indices and returns may not be correlated to the indexes.  Quarterly characteristics and portfolio holdings are available on the Characteristics and Literature tabs. 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 December 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. Investing in smaller and/or newer companies involves greater risks than those associated with investing in larger companies, 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.
 

Index definitions