Capital Income Fund (HWIIX)

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The performance data quoted represents past performance and does not guarantee future results. Current performance may be lower or higher. Investment return and principal value of the fund will fluctuate, and shares may be worth more or less than their original cost when redeemed. Click quarter-end or month-end to obtain the most recent fund performance.

Manager Commentary
Period ended December 31, 2017

 

INVESTMENT STRATEGY

The Hotchkis & Wiley Capital Income Fund invests in both value equity securities and high yielding fixed income securities with an emphasis on income generation.  The long-term allocation target between value equities and high yielding fixed income securities is 50/50.  The portfolio has two benchmarks, the S&P 500 Index (“the equity benchmark”) and the ICE BofAML US Corporate, Government & Mortgage Index (“the fixed income benchmark”).  These benchmarks are averaged, using the portfolio’s long-term allocation targets, to produce a “50/50 blended benchmark” to help assess performance.

MARKET COMMENTARY

The ICE BofAML US High Yield Index posted a positive return in each calendar quarter of 2017, finishing the year up +7.5%.  The index has posted positive performance in 8 consecutive quarters.  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 cap equities outperformed small cap equities and growth outperformed value.  The market was fueled by strong corporate earnings, a supportive economic environment, an accommodative central bank, and then received an additional boost with 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.  We believe 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 we believe 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. 

The ICE BofAML US High Yield Index finished the year with a yield-to-worst of 5.8%, which is 0.3% lower than it was at the beginning of the year; the market’s spread over treasuries finished the year at 363 basis points, which represents a 59 basis point tightening over the course of the year (the interest rate on similar duration treasuries rose slightly).  The treasury yield curve flattened over the year.  The Federal Open Market Committee increased the Fed Funds target rate by 25 basis points three different times during 2017, moving the rate from 0.75% to 1.50% by year-end.  This precipitated a comparable rise in short-term treasury rates but long-term rates actually fell slightly.  We pay close attention to the yield curve because it has inverted prior to each of the past 7 recessions—while it has flattened, it remains upward sloping. 

Including distressed exchanges, the par-weighted high yield bond default rate in 2017 was 1.45%.  For perspective, the default rate in 2016 was 4.26%.  The primary reason for the decline in defaults was the energy sector; the sector’s default rate went from 15.6% in 2016 to 2.1% in 2017.  Across the market, revenue, earnings, and cash flow have grown, financial leverage has declined, liquidity has improved, and the maturities are well-termed.  Fortunately, these factors have led to low defaults; unfortunately, these factors have led to tight spreads. 

We continue to believe that equity and credit 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, and will invest in the part of the capital structure that provides the most attractive risk/return profile. 

ATTRIBUTION AND MANAGEMENT DISCUSSION: 2017

The Hotchkis & Wiley Capital Income Fund underperformed the 50/50 blended benchmark in 2017.  The average equity weight was 56% and the average high yield bond weight was 44% over the course of the year.  The equity overweight was a modest positive performance contributor because equities outperformed high yield bonds; the magnitude of this benefit was smaller than it should have been because the equity portion of the portfolio underperformed the equity benchmark.  High yield bonds outperformed investment grade bonds, which also worked in the Fund’s favor. 

The equity portion of the portfolio underperformed the S&P 500 Index during the year. The Russell 1000 Growth Index outperformed the Russell 1000 Value Index by more than 16 percentage points in the year, which is a major headwind for our value investment approach and the primary cause of the portfolio’s equity underperformance.  The overweight and stock selection in energy along with stock selection in technology and financials also detracted from performance.  This was partially offset by positive stock selection in utilities and telecommunications, and the underweight position in consumer staples.  The largest individual detractors to relative performance over the year were Energy XXI, AIG, Popular, Fifth Street Asset Management, and Cobalt International Energy; the largest contributors were Bowleven, WorleyParsons, NRG Energy, Vodafone, and Anthem. 

The high yield bond portion of the portfolio outperformed the ICE BofAML US Corporate, Government & Mortgage Index during the year as high yield bonds outperformed investment grade bonds.  The portfolio also outperformed the ICE BofAML US High Yield Index due to positive credit selection.  Credit selection was positive or neutral in 14 of the 18 BofAML sectors, and was particularly positive in basic industry, energy, and media credits.  This was partially offset by credit selection in retail and healthcare.   

 

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11990 through 2017

The ICE BofAML Indices were known as the BofA Merrill Lynch Indices prior to 10/23/17.

Mutual fund investing involves risk. Principal loss is possible. Investments in debt securities typically decrease in value when interest rates rise.  This risk is usually greater for longer-term debt securities.  Investment by the fund in lower-rated and non-rated securities presents a greater risk of loss to principal and interest than higher-rated securities.  The Fund may invest in derivative securities, which derive their performance from the performance of an underlying asset, index, interest rate or currency exchange rate.  Derivatives can be volatile and involve various types and degrees of risks.  Depending on the characteristics of the particular derivative, it could become illiquid.  Investment in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. The Fund may invest in foreign as well as emerging markets which involve greater volatility and political, economic and currency risks and differences in accounting methods.

Fund holdings and/or sector allocations are subject to change and are not buy/sell recommendations. Current and future portfolio holdings are subject to risk. Value stocks may underperform other asset types during a given period. Portfolio managers’ opinions and data included in this commentary are as of 12/31/17 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. Specific securities identified are the largest contributors (or detractors) on a relative basis to the S&P 500 Index. Securities’ absolute performance may reflect different results. The Fund may not continue to hold the securities mentioned and the Advisor has no obligation to disclose purchases or sales of these securities. Attribution is an analysis of the portfolio's return relative to a selected benchmark, is calculated using daily holding information and does not reflect the payment of transaction costs, fees and expenses of the Fund. Past performance is no guarantee of future results. Diversification does not assure a profit nor protect against loss in a declining market.

Credit Quality weights by rating were derived from the highest bond rating as determined by S&P, Moody's or Fitch. Bond ratings are grades given to bonds that indicate their credit quality as determined by private independent rating services such as Standard & Poor's, Moody's and Fitch. These firms evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest in a timely fashion. Ratings are expressed as letters ranging from 'AAA', which is the highest grade, to 'D', which is the lowest grade. In limited situations when none of the three rating agencies have issued a formal rating, the Advisor will classify the security as nonrated.

Investing in high yield securities is subject to certain risks, including market, credit, liquidity, issuer, interest-rate, inflation, and derivatives risks.  Lower-rated and non-rated securities involve greater risk than higher-rated securities.  Equities, bonds and other asset classes have different risk-return profiles, which should be considered when investing.  All investments contain risk and may lose value. 

The average annual total returns for the ICE BofAML US High Yield Index were 0.41%, 7.48%, 6.39%, 5.80%, and 6.94% for 4Q17, one-year, three-year, five-year and Since 12/31/10 periods ended December 31, 2017, respectively.
 

Index definitions

Glossary of financial terms