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 June 30, 2019

 

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 +4.3% in the second quarter and is now up +18.5% since the beginning of the year, fully recouping its losses from the fourth quarter of 2018.  An increasingly dovish tone from central banks, most notably the US Federal Reserve, contributed to positive equity markets.  Fed Chairman Jay Powell indicated a readiness to lower interest rates for the first time in more than a decade, and the futures market is pricing in a high likelihood of a rate cut during the Fed’s next meeting. In addition, geopolitical tensions subsided, as the US reached a deal with Mexico to halt proposed tariffs, and US-China trade talks resumed.  All equity and high yield sectors were positive except energy, as crude prices declined by 3% in the quarter. 

Growth equities again outpaced value, further widening the valuation gap.  Over the past five years, the Russell 1000 Growth Index has more than doubled the Russell 1000 Value Index, returning +87% compared to +43%, cumulatively.  A top-down view would suggest that the global equity markets are fairly valued.  However, this is far from a normal market; significant valuation differences exist within and between sectors, geographies and even asset classes.  On the one hand, the market’s valuation suggests that investors have a reasonably healthy risk appetite.  On the other hand, certain attributes imply that investors are exceptionally risk averse.  A glaring example is the negative yield on some country’s government debt, like German bunds, where investors are guaranteed to lose money if held to maturity.  A preference for a small, yet certain loss over a wider range of outcomes exemplifies extreme risk aversion.  This risk aversion is borne out in equity markets through a comparison of different sectors.  Sectors with low economic sensitivity and stable earnings streams have outperformed sectors believed to be more cyclical.  Regulated utilities, for example, are largely insulated from economic slowdowns and exhibit more stable earnings than most other businesses.  This has appealed to risk averse equity investors, which have flooded the sector with capital.  As a result, utilities’ P/E multiples are now close to 20x, an increase of 20% over the past five years.  We view this as a rich price to pay for a sector with modest prospects for growth, and do not view this as a safe investment.  While it does not represent a certain loss, the long-term upside potential at these valuations are paltry at best.  Most REITs, consumer staples, and healthcare companies exhibit a similarly unappealing long-term risk-reward tradeoff. 

In many cases, banks and other financials trade at half the valuation of the non-cyclical markets segments.  Select companies within industrials, energy, and consumer discretionary also trade at substantial discounts to their intrinsic values.  These sectors may have a higher correlation with economic cycles than non-cyclicals, but valuations render the long-term return prospects more appealing irrespective of near-term economic growth. Businesses with strong balance sheets that are well-positioned competitively should be able to sustain and grow their value through the full economic cycle. Some may even enhance their value at the expense of weaker peers during times of economic volatility. In our view, these types of businesses represent compelling investment opportunities.

The high yield default environment remains benign relative to average.  The default rate, including distressed exchanges, is 1.55% which is less than half of the 20-year average.  This is down 0.34% since the beginning of the year and down 0.50% year-over-year.  During the first half of 2019, 13 high yield bonds defaulted and 2 went through a distressed exchange, for a total par value of about $14 billion ($8 billion occurred during the second quarter).  The market’s average post-default recovery rate stands at 36%, slightly less than the long-term average of 41%.  This is a bit misleading, however, considering that defaults have been few and far between.  About one-third of this year’s default activity was in the energy sector.  Less than 1% of the market trades for under 50% of par value and less than 5% trades for under 70% of par value, reflecting the market’s view that fundamentals remain sound.  The new issue market has picked up from 2018’s slowdown, and remains on a pace slightly lighter than average for the past decade.  About two-thirds of all issuance has been for refinancing and less than 20% for leveraged buyout/acquisition activity. Just 10% of new issuance was CCC-rated debt and more than two-thirds of that was for refinancing. 

Both the high yield and equity markets are close to fairly valued, but both also provide opportunities for active managers.  We view the ability to invest across companies of all sizes and across the capital structure as a considerable advantage in such environments.  We have identified interesting opportunities across both spectrums and are optimistic about the portfolio’s prospects as we look forward.    

ATTRIBUTION AND MANAGEMENT DISCUSSION: 2Q 2019

The Hotchkis & Wiley Capital Income Fund underperformed the 50/50 blended benchmark in the second quarter of 2019.  The average equity weight was 56% and the average high yield bond weight was 44% over the course of the quarter.  The equity overweight helped modestly as equities outperformed bonds. 

The equity portion of the portfolio underperformed the S&P 500 Index during the quarter.  Growth again outperformed value which represents a headwind for our value focused investment approach.  Small and mid cap stocks lagged large caps, which was another stylistic headwind as the strategy invests across the cap spectrum.  From a sector standpoint, the overweight position and stock selection in energy was the largest detractor.  The overweight position in financials, underweight position in healthcare, and positive stock selection in industrials helped relative performance.  The largest individual detractors to relative performance were Whiting Petroleum, Office Depot, Royal Mail, Quintana Energy Services, and Credito Valtellinese; the largest positive contributors were WestJet Airlines, AIG, Adient, Discovery, and Fifth Street Asset Management.  

The high yield bond portion of the portfolio underperformed the ICE BofAML US Corporate, Government & Mortgage Index and the ICE BofAML US High Yield Index.  The overweight position in mid and small cap credits hurt relative performance as larger credits outperformed.  Credit selection in basic industry, consumer goods, and retail hurt performance along with the underweight position in telecommunications.  The overweight position in energy also hurt but this was offset by positive credit selection in the sector.

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 6/30/19 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 ICE BofAML index data referenced is the property of ICE Data Indices, LLC (“ICE BofAML”) and/or its licensors and has been licensed for use by Hotchkis & Wiley. ICE BofAML and its licensors accept no liability in connection with its use. See Index definitions for full disclaimer.

The average annual total returns for the ICE BofAML US High Yield Index were 2.56%, 7.58%, 7.54%, 4.70% and 6.61% for 2Q19, one-year, three-year, five-year and Since 12/31/10 periods ended June 30, 2019, respectively.
 

Index definitions

Glossary of financial terms