Small Cap Diversified Value Fund (HWVIX)

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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, 2018

 
MARKET COMMENTARY

The Russell 2000 Index was up more than +11% through the first nine months of the year before posting its worst calendar quarter in 7 years, falling -20.2% in Q4.  The end result was a -11.0% return for calendar year 2018.  Until the most recent quarter, robust corporate earnings growth had overcome political unrest across the globe. In the fourth quarter, however, ongoing trade tensions came to the forefront.  While small caps are more domestic-focused than large caps, and should be insulated from global disruptions relative to large caps, this suppressed investor risk appetite and small caps sold off disproportionately.  Markets began pricing in slowing economic growth in several major economies that are important trading partners with the US.   In contrast to this however, real GDP growth in the US was a healthy +3.4% in the most recent quarter and the unemployment rate remains below 4%.  Both the Federal Reserve and the European Central Bank implemented and spoke of future restrictive monetary policy.  This appears to have added to equity investor apprehension.  The forward P/E ratio for the Russell 2000 Index declined from 20.6x at the beginning of the year to 14.3x at the end of the year.  The index’s median P/E since 1995 is 16.7x, so it went from well above average to comfortably below average over the course of the year. 

Fears that slowing economic growth would weaken demand weighed heavily on oil prices.  WTI crude closed the year at $45/barrel, down 25% from the beginning of the year ($60) and more than 40% from its early October high ($76).  Commodity securities were among the worst-performers of the year, with the small cap energy (-37%) and materials sectors (-26%) leading the decline.  Non-cyclical utilities performed best, returning +4% during the year—the only sector in the Russell 2000 Value with a positive return.  The performance dispersion and resulting valuation differentials among stocks that are economically sensitive compared to those that are not suggests the market has begun to price in a recession scenario.  Economic metrics do not yet verify a meaningful change from positive economic growth.  At present, while acknowledging the uncertain economic outlook, we view the valuation support of cyclical stocks as vastly superior to non-cyclicals.  We believe this valuation discrepancy provides a “margin of safety” in the long run almost irrespective of near term economic growth.

The portfolio trades at a substantial valuation discount to the index, which makes us optimistic about its prospects irrespective of market direction or temperament.  The portfolio trades at 7.2x normal earnings compared to 12.5x for the Russell 2000 Value and 14.4x for the Russell 2000.  The portfolio’s price-to-book ratio is 1.1x compared to 1.2x and 1.8x for the Russell 2000 Value and the Russell 2000, respectively.     

ATTRIBUTION: 2018

The Hotchkis & Wiley Small Cap Diversified Value Fund underperformed the Russell 2000 Value Index in 2018.  The portfolio’s average energy weight was slightly more than 9% for the year compared to just 7% for the index, which detracted from performance.  Energy was the worst-performing sector in the Russell 2000 Value during the year by a large margin, as crude oil prices fell 25% in the year.  The portfolio’s energy stocks held up considerably better than the index’s energy stocks which more than made up for the modest overweight position.  The underweight position in real estate, healthcare, and utilities were modest detractors, along with stock selection in healthcare, industrials, and consumer discretionary.  This was partially offset by positive stock selection in financials and materials.

Mutual fund investing involves risk. Principal loss is possible. Investing in smaller and/or newer companies involves greater risks than those associated with investing in larger companies, such as business risk, significant stock price fluctuations and illiquidity. The Fund may invest in foreign securities 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. Certain information presented based on proprietary or third-party estimates are subject to change and cannot be guaranteed. Portfolio managers’ opinions and data included in this commentary are as of 12/31/18 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. 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.

Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform other asset types during a given periods. Equities, bonds, and other asset classes have different risk profiles, which should be considered when investing. All investments contain risk and may lose value. 
 

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