Value Opportunities

Market Commentary

Period ended March 31, 2018
 

MARKET COMMENTARY

In the first quarter of 2018, the S&P 500 Index fell -0.8%. The Russell 3000 Growth Index returned +1.5% while the Russell 3000 Value Index fell -2.8%, extending growth’s recent performance advantage.  Over the last 10 years, the value index has returned +113% cumulatively compared to +192% for the growth index (+7.8% and +11.3% annualized, respectively).  The only other period that favored growth to such an extent was the internet bubble of the late 1990s.  While the broad market’s valuation today is much less extreme than it was in 1999, a number of popular stocks exhibit exorbitant valuation multiples akin to internet bubble levels.  We believe this poses risks for passive investors because they are, either consciously or naively, allocating capital to excessively valued securities.  Very few people would buy a new house, car, or even a meal without regard to price, but this frame of mind seems to breakdown at times when buying stocks.  In our view, to justify the current valuations of today’s most richly valued stocks, many things have to go perfectly right for a very long period.  In our experience, such unbridled optimism rarely materializes.

Fortunately for active investors, some segments of the market offer attractive valuations for the risks at hand.  Financials continue to represent the largest sector weight in the portfolio and largest overweight relative to the S&P 500.  Despite healthy stock price appreciation in recent years, banks continue to trade at valuations well below their historical averages.  Critics argue that lower valuations are justified because banks will be unable to earn the same returns on capital they have earned in the past due to more stringent capital requirements.  We agree, but competitively advantaged banks like the ones we own should be able to earn above cost-of-capital returns.  Accordingly, we view 11x normal earnings and a small premium to book value as compelling valuations, particularly considering that the excess capital on their balance sheets reduce the risk profiles dramatically. 

In recent years we have found interesting opportunities in technology even though parts of the sector are overvalued.  Our focus has been on attractively valued, well-managed companies with sticky customers, strong balance sheets, and good prospects for growth.  As the adoption of cloud technology proliferates, the mix of IT spending is likely to shift with some competitors gaining share at the expense of others.  In our view, several of our large tech holdings stand to benefit from this transition.  These companies offer cloud products that have been well-received by the marketplace, and as existing customers transition to the cloud they become more valuable to the company.  Customers are sticky because switching costs are onerous.  Many customers store critical business data in, and have built business processes around these products. Additionally, these companies have great balance sheets, are good stewards of capital, and are growing. 

We have also increased our weight in energy as the sector has underperformed the broad market in a big way.  We believe oil prices have been unsustainably low and that a rise in commodity prices will be necessary to bring global supply in line with global demand growth.  Accordingly, we have positions in predominantly upstream energy companies that are positively exposed to changes in crude prices.  We have a strong preference for companies with good balance sheets so that we are not exposed to shareholder dilution in the event the reversion in oil prices takes longer than we anticipate.  

Over long periods, value has outperformed growth, and we have no reason to believe we have entered a paradigm shift that would change this going forward.  Style shifts can occur quickly and powerfully, and we believe we are well positioned for such a reversion.  We continue to be encouraged by the portfolio’s valuation discount relative to the benchmark. The portfolio trades at 6.6x normal earnings and 1.2x book value, a notable discount to the S&P 500 Index (17.4x and 3.1x, respectively).  We remain committed to maintaining our unwavering dedication to the principals of long-term, fundamental value investing, and that while fads can drive short term performance fundamentals prevail in the long run.  

ATTRIBUTION: 1Q 2018

The Hotchkis & Wiley Value Opportunities portfolio (gross and net of management fees) underperformed the S&P 500 Index in the first quarter of 2018.  The underperformance of value relative to growth was a performance headwind for our valuation-focused approach relative to the broad benchmark.  Nearly 75% of the portfolio trades at less than 2x book value compared to about 20% of the S&P 500—these stocks underperformed the market which served as a brisk headwind.  Stock selection in consumer discretionary and the overweight position in energy also detracted from performance.  Positive stock selection in technology, consumer staples, and healthcare, along with the underweight position in staples, helped performance.  The largest individual detractors relative to the benchmark were Office Depot, Wells Fargo, Seritage Growth Properties, WestJet Airlines, and Cobalt convertible bonds; the largest positive contributors were Hewlett Packard Enterprise, Royal Mail, Whiting Petroleum, Popular, and Credito Valtellinese.  

LARGEST NEW PURCHASES: 1Q 2018

Credito Valtellinese is the 10th largest bank in Italy with ~$25B in assets. The majority of Italian banks are struggling with extremely high levels of non-performing loans, often with 20% to 30% of the gross loan book classified as non-performing. Credito Valtellinese recently initiated a $700M rights offering with plans to accelerate the disposal of its gross non-performing loans to ~10% of gross loans. Despite the improvement in the loan book quality, Credito Valtellinese continues to trade at a very low multiple of book and normalized earnings and in-line with peers with much unhealthier loan books.

GEO Group operates private prisons in the United States, which is a duopoly industry in a growing market.  After a slight decline in prison populations over the last six years, prison populations are expected to rise.  With state budgets severely constrained, states are turning to private prisons to support the rising populations.  Meanwhile, GEO trades below replacement cost and a low multiple of normal earnings despite the favorable backdrop.

Medtronic is one of the largest and most diversified medical device companies in the world. With its dominant market position in CRM, Spine, and Neuromodulation, the company has enjoyed best-in-class margins and free cash flow. Medtronic’s merger with Covidien is highly synergic by providing cost savings ($850MM or 3% of sales), expanding distribution, especially in emerging markets, diversifying product risk, and increasing scale in negotiating with the consolidating healthcare industry. In addition, it re-incorporated in Ireland, which provides greater financial flexibility in accessing global cash. Management has committed to a dividend payout of at least 50%. Medtronic is currently the #1 or #2 player in almost all of its businesses, with meaningful barriers to entry given the scale and expertise required to receive FDA approval for its products, and we expect management to leverage this and improve margins further.

     

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. 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 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 March 31, 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