Value Opportunities

Market Commentary

Period ended September 30, 2019
 

MARKET COMMENTARY

The S&P 500 Index returned +1.7% in the third quarter of 2019, and is now up more than +20% since the beginning of the year.  The Federal Reserve’s FOMC lowered the Fed Funds rate by 25 basis points for the second time this year, which now stands at 2.0% (upper bound).  With inflation benign and economic growth modest, albeit positive, the rate cut was widely expected and triggered little reaction from equity markets.  The price of crude oil spiked following the drone attacks on Saudi refineries, but this was short-lived and WTI crude finished the quarter down -8%.  Energy was the S&P 500’s worst-performing sector, declining -6% in the quarter.  It has been the index’s worst-performing sector over the past year returning -19% (WTI has declined -27% over the past year), and has been the worst-performing sector in three of the past four calendar quarters.  Utilities +9%, real estate +8%, and consumer staples +6% were the best-performing sectors in the quarter.  These are also the top three sectors, by far, over the past year.  The S&P 500 is up 4% over the past 12 months but these three sectors are up considerably more: utilities +27%, real estate +25%, and consumer staples +17%. 

Concerns about slowing economic growth and a possible recession have become increasingly pervasive amid erratic trade negotiations and geopolitical uncertainty (e.g. Brexit in the UK, potential impeachment proceedings in the US).  As a result, treasuries rallied during the quarter with the yield on the 10 year note falling below 1.5% in late August—for about a week, the 2-year treasury yield exceeded the 10-year treasury yield.  This caught investors’ attention because contemporary recessions have been preceded by similar 10-year/2-year yield curve inversions.  The time between inversion and recession has varied significantly, from several months to more than 2 years. 

The timing of the next economic slowdown and/or recession is unclear but it is certainly possible in the near to intermediate term, and we acknowledge this as a legitimate risk.  In periods leading into economic slowdowns, intuition would suggest that equity investors should gravitate toward stocks with less economic sensitivity.  For the most part, this was a winning strategy during the early 2000s recession.  During that period, richly valued internet, telecom, and media stocks cratered and many less cyclical stocks outperformed.  In today’s market, however, the richly valued stocks are the non-cyclicals, which suggests that an economic slowdown is already priced in—perhaps overly priced in.  As noted above, utilities, real estate, and consumer staples—non-cyclical sectors—have outperformed more cyclical areas significantly.  Consequently, the valuation dispersion between certain market segments is uncommonly wide. 

To illustrate our approach given the current state of affairs, consider banks (the portfolio’s largest industry weight) versus utilities (the portfolio has no exposure).  The S&P 500 Bank Index trades at 10.9x consensus earnings, which is 9% below its long term average of 12.0x.  The S&P 500 Utilities Index trades at 21.0x consensus earnings, which is 45% above its long term average of 14.5x.  Returns-on-equity for the two indexes are similar1.  Dividend yields are also similar but because valuations are so different, utilities have to pay out about 2/3 of their earnings in dividends while banks pay out about 1/3 of their earnings to arrive at similar yields2.  Because banks retain more of their earnings, it has allowed them to amass capital and strengthen their balance sheets, and in recent years, buyback their own stock.  Given the information above, for the two indexes to generate equivalent returns going forward, one of several things would need to occur.  The valuation gap would need to widen even further, utilities would need to accelerate earnings growth, or banks would need to suffer a major destruction of capital.  To us these seem like unlikely scenarios because the valuation gap is already near an all-time wide, organic growth prospects for utilities are limited, and banks have accumulated near record levels of excess capital on their balance sheets to protect against a downturn.  Thus, we view banks as superior risk-adjusted investments irrespective of near-term economic growth. 

The portfolio continues to trade at a large discount to the market.  The portfolio trades at 7.3x normal earnings compared to 14.5x for the Russell 3000 Value Index and 18.8x for the S&P 500 Index.  It trades at 1.2x book value compared to 1.9x and 3.2x for the same indices, respectively.  This valuation discount combined with healthy balance sheets and good underlying businesses has us confident about the portfolio’s prospects as we look forward.  

ATTRIBUTION: 3Q 2019

The Hotchkis & Wiley Value Opportunities portfolio (gross and net of management fees) underperformed the Russell 3000 Value Index in the third quarter of 2019.  The strategy’s all cap nature worked against it in the quarter, as the overweight allocation to small caps and underweight allocation to mega caps hurt relative performance—index stocks below $3 billion in market capitalization declined -3.8% while those above $100 billion rose +2.2%.  Security selection in industrials and real estate, along with the underweight allocation to consumer staples and utilities, also hurt performance.  Positive security selection in healthcare, financials, materials, and energy helped relative performance.  The largest individual detractors to relative performance in the period were General Electric, Discovery, CBS, Corning, and Frank’s International; the largest positive contributors were Vodafone, Wells Fargo, Microsoft, AIG, and Cairn Energy.    

LARGEST NEW PURCHASES: 3Q 2019

Alphabet (GOOGL) is the parent of Google, which dominates many of the most important services Internet users rely on.  Current valuation is near the market multiple in spite of better growth prospects, an overcapitalized balance sheet, and significant options in Cloud services and new advertising.   

Ascena Retail (bonds).  Ascena owns a collection of retail brands that include Ann Taylor, LOFT, Lou & Grey, Dressbarn, Lane Bryant, Cacique, Catherines, and Justice.  While some of these brands have struggled, the company’s premium Ann Taylor and Loft brands supply around 90% of free cash flow and have positive comp store sales.  The company has significant near-term liquidity and is also in the process of selling some of its lower tier brands.  At current valuations for these bonds we are more than compensated for the value of the company’s profitable and more valuable Ann Taylor and Loft brands.

 

________________________

111.6% ROE for banks, 10.9% ROE for utilities, based on FY1 consensus estimates.
2 2.9% dividend yield for banks, 3.1% dividend yield for utilities.  32% dividend payout ratio for banks, 64% payout ratio for utilities.

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 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 Russell 3000 Value 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 quarter based on the security’s quarter-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 duriong the quarter, 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. The value discipline used in managing accounts in the Value Opportunities strategy may prevent or limit investment in major stocks in the S&P 500, Russell 3000 Value, S&P 500 Bank and S&P 500 Utilities 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, 2019 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.
 

Index definitions