Small Cap Diversified Value

Market Commentary

Period ended June 30, 2017
 

MARKET COMMENTARY

The Russell 2000 Index returned +2.5% in the second quarter.  Small cap growth stocks outperformed small cap value stocks in the quarter, with the Russell 2000 Growth Index returning +4.4% compared to the Russell 2000 Value Index’s return of +0.7%.  Year-to-date, the growth index has outperformed the value index by more than 9 percentage points, a reversal of value’s 20 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 2000’s quarter return was generated by the tech and healthcare sectors. 

Financials represent the portfolio’s second largest sector exposure (after industrials), and banks comprise 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. 

Small cap 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 and utilities.  We are overweight industrials, consumer discretionary, and financials, 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 11.7x normal earnings compared to 15.4x and 18.0x for the Russell 2000 Value and Russell 2000 Indices, respectively.   

ATTRIBUTION: 2Q 2017

The Hotchkis & Wiley Small Cap Diversified Value portfolio (gross and net of management fees) outperformed the Russell 2000 Value Index in the second quarter.  Stock selection was positive or neutral in 8 of the 11 GICS sectors.  Positive stock selection in financials and energy were the most notable positive contributors.  Stock selection in industrials and technology were modest detractors.  The strategy’s overweight to microcaps also worked in its favor during the quarter.  
 

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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 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. 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 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 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.
 

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