Small Cap Value (Limited Availability)

Market Commentary

Period ended September 30, 2018
 

MARKET COMMENTARY

The Russell 2000 Index returned +3.6% in the third quarter and is now up +11.5% since the beginning of the year.  Failed Brexit negotiations and the threat of a global trade war have triggered short-lived bouts of equity market volatility, but positive economic data and strong corporate earnings growth has overwhelmed those concerns.  Despite Wall Street having revised estimates upward rather persistently, nearly two-thirds of Russell 2000 companies beat consensus earnings estimates in the most recent quarter; the median positive surprise was 16% above consensus estimates. 

Small cap growth outperformed small cap value in the quarter, extending its considerable lead in recent years.  Given value’s multi-year underperformance, some investors are wondering if the value phenomena has taken a permanent hiatus.  Our answer is no.  The 10 year underperformance is not without historical precedent as small growth led small value by an equivalent magnitude in the 10 years that ended with the internet bubble’s burst.  While that period was also unusually long, value ultimately made a comeback as the valuation premium grew too wide. The current growth premium is more than double the long term average. Some of the performance disparity was due to differences in sector exposures: the growth index has more exposure to healthcare which outperformed and less exposure to energy which underperformed.  Sector weights aside, however, stocks with high valuations outperformed stocks with low valuations.  Ultimately, the primary drive of valuation premium was due to multiple expansion, not earnings growth.  We do not believe that this valuation gap can widen indefinitely, and consequently we are optimistic about the prospects of value relative to growth as we look forward.  

We remain overweight industrials and energy compared to the Russell 2000 Value, though we have taken capital out of energy since the beginning of the year.  Our portfolio holdings in energy have outperformed and so we have shifted capital to more compelling valuation opportunities.  Portfolio changes have been modest in 2018, however, with year-to-date turnover about 19% by weight and 14% by name. 

The portfolio’s valuation discount relative to the market has moved from wide to wider, which gets us excited about the portfolio going forward.  The portfolio trades at 7.9x normal earnings compared to 15.2x for the Russell 2000 Value and 17.3x for the Russell 2000.  The portfolio’s price-to-book ratio is 1.3x compared to 1.5x and 2.2x for the Russell 2000 Value and the Russell 2000, respectively.  

ATTRIBUTION: 3Q 2018

The Hotchkis & Wiley Small Cap Value portfolio (gross and net of management fees) outperformed the Russell 2000 Value Index in the third quarter of 2018.  Stock selection was positive in 7 of the 11 GICS sectors during the quarter and was particularly helpful in real estate, financials, healthcare, and technology.   Small value underperformed small growth, which is a general headwind for our value focused approach.  Stock selection in industrials, consumer discretionary, and communication services also detracted from performance.  The largest positive contributors to relative performance were Hanger, Seritage Growth Properties, WestJet Airlines, Office Depot, and KBR; the largest detractors were Embraer, LSC Communications, TRI Pointe Group, Masonite International, and First Hawaiian.

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 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 2000 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. The value discipline used in managing accounts in the Small Cap 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. 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 September 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.
 

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