Capital Income Fund (HWIAX)

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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 September 30, 2018

 

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 S&P 500 Index returned +7.7% and the ICE BofAML US High Yield Index returned +2.4% in the third quarter of 2018. Failed Brexit negotiations and the threat of a global trade war have triggered short-lived bouts of 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 stocks outperformed value stocks in the quarter, extending its considerable lead in recent years.  The Russell 1000 Growth Index has outperformed the Russell 1000 Value Index by more than 13 percentage points since the beginning of the year, after outperforming by nearly 17 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 1000 Growth was 18.6x compared to 15.3x for the Russell 1000 Value, for a difference of 3.3x (“growth premium”).  Excluding the internet bubble, the average growth premium over that last 20 years has been 4.0x, so three years ago spreads were modestly narrower than average.  Today, however, the forward P/E ratio for the Russell 1000 Growth has expanded to 22.9x while the Russell 1000 Value trades at 15.3x, the same multiple as three years ago.  The current growth premium, therefore, is 7.6x (22.9x – 15.3x), or nearly 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.  

The FOMC raised the Fed Funds Target Rate by another quarter point to 2.25%, its third such raise of the year.  Consequently, government bonds declined while spread sectors outperformed.  Investment grade corporates were slightly positive (about +1%) and high yield corporates were slightly more positive (+2.4%).  Treasury yields with maturities between 2 and 30 years rose between 20 and 30 basis points, with an ever-so-slight flattening of the yield curve.  The high yield market absorbed the rate hike and then some, experiencing a decline in the yield-to-worst of 0.24% during the quarter, which finished at 6.30%.  Spreads tightened by 43 basis points, closing the quarter at 329 basis points over comparable duration treasuries.  BB-rated and single B-rated credits performed similarly, while CCC-rated (and below) outperformed slightly—yields declined and spreads narrowed disproportionately for this lowest-rated cohort.  Performance variation among sectors was modest: healthcare returned +3.4%, retail returned +1.1%, and all other sectors where somewhere in between. 

A primary reason for high yield’s outperformance relative to other fixed income asset classes has been the market’s overall health.  Only 2 high yield bonds defaulted in the quarter, following just 3 in the previous quarter—this represents the fewest defaults over a six month period in more than 7 years.  The trailing 12 month default rate, including distressed exchanges, now stands at 2.0% which is well below long term averages.  A meager 0.5% of the market trades at 50% of par or less, implying that the market believes the docile environment will persist.  Recovery rates over the past 12 months averaged 46%, which is also slightly better than long term averages, though the sample size is small due to the low number of defaults.  Rating agencies have agreed with the market’s assessment of tranquility, and have upgraded 5 credits for every 4 they have downgraded.  

The strategy remains focused on the most compelling risk-adjusted valuation opportunities in companies of all sizes and in all parts of the capital structure.  The portfolio’s equities trade at a large discount to the broad equity market.  The portfolio’s bonds are focused in single-B rated credits across the cap spectrum with strong/quality asset coverage and a spread advantage relative to the high yield market.  

ATTRIBUTION AND MANAGEMENT DISCUSSION: 3Q 2018

The Hotchkis & Wiley Capital Income Fund underperformed the 50/50 blended benchmark in the third quarter of 2018.  The average equity weight was 56% and the average high yield bond weight was 44% over the course of the quarter, similar to its average over the course of the year.  The equity overweight helped as equities outperformed bonds, but it helped less than it should have because the portfolio’s equities underperformed. 

The equity portion of the portfolio underperformed the S&P 500 Index during the quarter.  Growth outperformed value, which is a difficult environment for our value focused approach. The portfolio lacks exposure to some large benchmark constituents that performed well in the quarter (e.g. Apple, Amazon).  The overweight and stock selection in energy also hurt, along with stock selection in industrials and consumer discretionary.  Positive stock selection in communication services and technology helped relative performance.  The largest individual detractors to relative performance were Sanchez Energy, Ophir Energy, General Motors, Vodafone, and AIG; the largest positive contributors were WestJet Airlines, Office Depot, Corning, Discovery, and Popular.  

The high yield bond portion of the portfolio outperformed the ICE BofAML US Corporate, Government & Mortgage Index as high yield bonds outperformed investment grade bonds.  The portfolio underperformed the ICE BofAML US High Yield Index.  Positive credit selection in the basic industry and healthcare sectors was offset by negative credit selection in energy.  The underweight exposure to telecommunications was a modest performance detractor.

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 9/30/18 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 2.44%, 2.94%, 8.19%, 5.54%, and 6.59% for 3Q18, one-year, three-year, five-year and Since 12/31/10 periods ended September 30, 2018, respectively.
 

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