Value Opportunities

Market Commentary

Period ended December 31, 2017


The S&P 500 Index returned +21.8% in 2017, and for the first time in its 91-year history generated positive performance in every month of a calendar year.  Large caps outperformed small caps and growth outperformed value.  The market was fueled by strong corporate earnings, a supportive economic environment, an accommodative central bank, and the passage of tax reform.  Following the rally, the overall market’s valuation appears above normal but not wildly so.  The S&P 500 trades at 20x next year’s consensus earnings and 3.2x book value, which is 0.8 and 0.6 standard deviations higher than historical averages, respectively1.  Valuations are reasonable despite the market’s 9 year rally because: 1) the market was significantly undervalued 9 years ago; 2) lower interest rates justify higher price multiples; 3) earnings growth has been resilient, and; 4) the market expects continued earnings growth in 2018.

The first three items above are relatively uncontroversial while the fourth is more uncertain.  Tax reform should provide a permanent earnings benefit to the market as a whole but not all companies will benefit equally.  The repatriation clause allows companies to bring cash held overseas back into the US at a more favorable rate than previously anticipated.  This creates an opportunity for management teams to add value for shareholders via productive investments, share repurchases, etc.  The reduction in the corporate tax rate from 35% to 21% should provide a broad near-term earnings boost but only companies with core competitive advantages, barriers to entry, and/or pricing power will retain this benefit permanently.  Companies operating in highly competitive industries with low barriers to entry and commodity-like products or services are likely to see this benefit competed away until earnings eventually reflect cost-of-capital returns.  Thus, when estimating a company’s earnings post tax reform, it is important to look beyond its current and projected effective tax rates and assess management’s skill at allocating capital effectively as well as the quality of the underlying franchise. 

Several attributes of the portfolio provide reason for optimism as we look to 2018 and beyond.  First, the portfolio trades at a large valuation discount to the market.  We have been able to identify interesting valuation opportunities on a selective basis, particularly in financials, technology, and energy—the portfolio’s largest sector exposures.  Second, we are reassured by the quality of the businesses across the portfolio.  While some holdings may be contending with temporary difficulties—the reason they are undervalued—most are well-capitalized companies with long-term competitive advantages that should translate into improved returns on capital in the future.  Third, the correlation among stocks across the market has moved from high (a macro-driven market) to low (a stock-driven market); the latter is a much more conducive environment for a fundamental, bottom-up value investor. 

The portfolio trades at 8.2x normal earnings and 1.2x book value, a notable discount to the S&P 500 Index (18.6x and 3.2x, respectively).  We continue to believe that markets can be driven by fads and temperament in the short run but fundamentals and valuation prevail in the long run.  Accordingly, we commit to maintaining our unwavering dedication to the principals of long-term, fundamental value investing.  


The Hotchkis & Wiley Value Opportunities portfolio (gross and net of management fees) underperformed the S&P 500 Index in 2017.  The portfolio invests in attractive value opportunities across the market cap spectrum.  In 2017, the market was led by mega cap growth stocks, which serves as a notable headwind for our investment approach.  Security selection in consumer discretionary and information technology, along with the overweight position in energy detracted from performance in the year.  Positive security selection in healthcare, materials, and telecommunications helped relative performance.  The largest individual detractors in the year were Energy XXI, Iracor bonds, AIG, Bed Bath & Beyond, and ARRIS International; the largest contributors were WestJet Airlines, WorleyParsons, Bank of America, Tri Pointe Group, and Masonite International.     


Seritage Growth Properties is a mall REIT with 230 wholly owned and 23 JV mall anchor properties across the United States.  After being spun off from Sears Holdings in 2015, Seritage is focused on redeveloping and re-leasing mall properties to new tenants, or redeveloping them to alternative uses.  The company receives high returns on capital for these projects, and valuation is especially attractive as investors remain focused on a potential Sears bankruptcy.

Apache Corporation is a global oil & gas exploration and production company. The company is among the largest acreage holders in the Permian, a large oil and natural gas basin in West Texas. The company has recently-discovered assets that could provide years of organic production growth. The company has a strong balance sheet and asset base. We expect the Permian assets to drive corporate returns higher in a normal oil price environment.

National Oilwell Varco (“NOV”) is a manufacturer of oilfield capital equipment and provider of related services and technologies.  Historically, a large portion of its business has been providing capital equipment for new rigs and this business is currently under pressure given reduced exploration and development spending by E&Ps and an overbuild of rigs prior to the downturn in oil prices. This has created a value opportunity. The market is currently overlooking the earnings power of NOV’s other businesses including rig aftermarket, wellbore technologies, and completion & production systems as oil prices rise. Meanwhile the rig business, where NOV is the market leader with 3x the market share of the number two competitor, is assigned no value in the marketplace but provides substantially higher earnings power should a new rig building cycle develop.


11990 through 2017

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 Value Opportunities 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 S&P 500 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 year based on the security’s year-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 year-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.  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  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, 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 a given period. The strategy may be exposed to more individual stock volatility than a more diversified strategy and may also invest in smaller and/or medium-sized companies, foreign securities, and debt securities. All investments contain risk and may lose value. 
Past performance is no guarantee of future results.

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