Small Cap Diversified Value

Market Commentary

Period ended June 30, 2018
 

MARKET COMMENTARY

After a small decline in the first quarter of 2018, the Russell 2000 Index returned +7.8% in the second quarter and is now up +7.7% for the year.  Strong corporate earnings prevailed over trade war risks and geopolitical tensions.  Russell 2000 earnings grew an impressive +25% year-over-year in the most recently reported quarter.  Nearly 400 of the ~2,000 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. 

Unlike US large and mid cap stocks, value outperformed growth in small cap, albeit by a modest magnitude.  The Russell 2000 Value Index returned +8.3% during the quarter, compared to +7.2% for the Russell 2000 Growth Index.  Small growth maintains a considerable performance edge in recent years; however, having outperformed small value in 11 of the past 16 quarters.  Much of small value’s outperformance in the quarter was a sector story as energy, which comprised 7.3% of the value index and just 1.4% of the growth index, was the top-performing sector across the market by a wide margin. 

The small cap equity market’s valuation appears above average, but this is heavily influenced by the considerable overvaluation of small cap growth stocks.  Because small growth has outperformed small value to such a large extent, the price of select value stocks remains attractive.  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 should favor value stocks, which are shorter duration instruments than growth stocks.  An 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”, as has often been the case, is merely investors’ recognition of the wide valuation disparity across equity markets.  Whatever and whenever it may be, we are confident that the cycle will shift in favor of value once again, and our clients are well positioned to benefit. 

The portfolio continues to trade at a considerable valuation discount to both the broad small cap index and the small cap value index, which is why we believe our clients should be rewarded if/when the growth/value cycle turns.  The portfolio trades at 9.8x normal earnings compared to 17.2x and 15.2x for the Russell 2000 and Russell 2000 Value, respectively.      

ATTRIBUTION: 2Q 2018

The Hotchkis & Wiley Small Cap Diversified Value portfolio (gross and net of management fees) outperformed the Russell 2000 Value Index in the second quarter of 2018.  Positive stock selection drove the outperformance, and was most positive in energy, consumer staples, and real estate.  The overweight exposure to energy, the small cap market’s top performing sector by a wide margin, also helped.  About 45% of the portfolio was invested in stocks with a market capitalization of less than $1 billion compared to about 25% for the index, which helped performance as this group outperformed the rest of the index.  Stock selection in healthcare was the largest detractor, followed by the underweight position in REITs.  Stock selection in materials and technology were modest detractors.  

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. The value disciplines 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 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 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