Value Opportunities

Market Commentary

Period ended September 30, 2018
 

MARKET COMMENTARY

The S&P 500 Index returned +7.7% in the third quarter and is now up +10.6% since the beginning of the year.  Contentious 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, 84% of S&P 500 companies beat consensus earnings estimates in the most recent quarter.  The median positive surprise was 6% above consensus estimates.  In technology and healthcare, the two top-performing sectors in the quarter, more than 90% of companies reported an earnings beat. 

Growth outperformed value in the quarter, extending its considerable lead in recent years.  Some of the disparity was due to differences in sector exposures: the growth index has more exposure to technology which outperformed, and less exposure to energy and financials which underperformed.  Sector weights aside, however, stocks with high valuations outperformed stocks with low valuations.  The Russell 3000 Growth Index has outperformed the Russell 3000 Value Index by nearly 13 percentage points since the beginning of the year, after outperforming by more than 16 percentage points in 2017.  As a result, the valuation gap between growth stocks and value stocks has widened.  Three years ago, the forward P/E for the Russell 3000 Growth was 19.3x compared to 15.5x for the Russell 3000 Value, for a difference of 3.8x (“growth premium”).  The average growth premium over that last 20 years has been 4 multiple points, so three years ago spreads were slightly narrower than average.  Today, however, the forward P/E ratio for the Russell 3000 Growth has expanded to 23.9x while the Russell 3000 Value trades at 15.5x, the same multiple as three years ago.  The current growth premium 8.4 multiple points (23.9x – 15.5x), more than double the long term average.  Earnings growth between the two indices has been comparable, thus the primary cause of the outperformance has been the repricing of growth stocks, i.e. multiple expansion.  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.  

Financials represent the portfolio’s largest sector weight, followed by energy and technology.  We have reduced our exposure to energy and technology since the beginning of the year as these sectors have performed well.  The sectors were among the best performers this year, and so we have shifted capital to more compelling valuation opportunities.  We have added capital to the industrials, consumer discretionary, and financial sectors as they have underperformed and now exhibit improved valuations without a commensurate change in risk.

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 8.0x normal earnings compared to 18.3x for the S&P 500 (more than double the portfolio).  The portfolio’s price-to-book ratio is 1.3x compared to 3.4x for the S&P 500.  

ATTRIBUTION: 3Q 2018

The Hotchkis & Wiley Value Opportunities portfolio (gross and net of management fees) underperformed the S&P 500 Index in the third quarter of 2018.  The concentrated, growth-led market was not a conducive environment for our value-focused approach.  Not owning Apple and Amazon, for example, detracted nearly 1 percentage point from our performance relative to the index.  The overweight position and security selection in financials also detracted from performance, along with security selection in consumer discretionary.  Positive security selection in materials, healthcare, communication services, and technology helped performance in the quarter.  The largest individual detractors to relative performance were General Motors, Vodafone, Wells Fargo, Goldman Sachs, and AIG; the largest positive contributors were GHW Holdco, Hanger, WestJet Airlines, Oracle, and Seritage Growth Properties.  

LARGEST NEW PURCHASES: 3Q 2018

CBS Corp’s multiple is depressed with other media companies even though it does not face material risk from disruptions to Pay TV. CBS is exposed to cyclical risk in ad spending with little impact on normal earnings. The most important risk is fundamental change in TV’s share of ad spend, which appears unlikely. The biggest opportunities are reversion in US ad spend and continued vertical integration into TV production, which would boost margins on syndication revenue.

News Corp’s valuation is supported by its real-estate advertising businesses alone.  It also has a mature Pay TV national media business and a regional newspaper business, though the latter is in secular decline.

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 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 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 at quarter-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. 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 and Russell 3000 Growth 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. 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