Value Opportunities Fund (HWAIX)

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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, 2019

 
MARKET COMMENTARY

The S&P 500 Index returned +1.7% in the third quarter of 2019, and is now up more than +20% since the beginning of the year.  The Federal Reserve’s FOMC (Federal Open Market Committee) lowered the Fed Funds rate by 25 basis points for the second time this year, which now stands at 2.0% (upper bound).  With inflation benign and economic growth modest, albeit positive, the rate cut was widely expected and triggered little reaction from equity markets.  The price of crude oil spiked following the drone attacks on Saudi refineries, but this was short-lived and WTI (West Texas intermediate) crude finished the quarter down -8%.  Energy was the S&P 500’s worst-performing sector, declining -6% in the quarter.  It has been the index’s worst-performing sector over the past year returning -19% (WTI has declined -27% over the past year), and has been the worst-performing sector in three of the past four calendar quarters.  Utilities +9%, real estate +8%, and consumer staples +6% were the best-performing sectors in the quarter.  These are also the top three sectors, by far, over the past year.  The S&P 500 is up 4% over the past 12 months but these three sectors are up considerably more: utilities +27%, real estate +25%, and consumer staples +17%. 

Concerns about slowing economic growth and a possible recession have become increasingly pervasive amid erratic trade negotiations and geopolitical uncertainty (e.g. Brexit in the UK, potential impeachment proceedings in the US).  As a result, treasuries rallied during the quarter with the yield on the 10 year note falling below 1.5% in late August—for about a week, the 2-year treasury yield exceeded the 10-year treasury yield.  This caught investors’ attention because contemporary recessions have been preceded by similar 10-year/2-year yield curve inversions.  The time between inversion and recession has varied significantly, from several months to more than 2 years. 

The timing of the next economic slowdown and/or recession is unclear but it is certainly possible in the near to intermediate term, and we acknowledge this as a legitimate risk.  In periods leading into economic slowdowns, intuition would suggest that equity investors should gravitate toward stocks with less economic sensitivity.  For the most part, this was a winning strategy during the early 2000s recession.  During that period, richly valued internet, telecom, and media stocks cratered and many less cyclical stocks outperformed.  In today’s market, however, the richly valued stocks are the non-cyclicals, which suggests that an economic slowdown is already priced in—perhaps overly priced in.  As noted above, utilities, real estate, and consumer staples—non-cyclical sectors—have outperformed more cyclical areas significantly.  Consequently, the valuation dispersion between certain market segments is uncommonly wide. 

To illustrate our approach given the current state of affairs, consider banks (the portfolio’s largest industry weight) versus utilities (the portfolio has no exposure).  The S&P 500 Bank Index trades at 10.9x consensus earnings, which is 9% below its long term average of 12.0x.  The S&P 500 Utilities Index trades at 21.0x consensus earnings, which is 45% above its long term average of 14.5x.  Returns-on-equity for the two indexes are similar1.  Dividend yields are also similar but because valuations are so different, utilities have to pay out about 2/3 of their earnings in dividends while banks pay out about 1/3 of their earnings to arrive at similar yields2.  Because banks retain more of their earnings, it has allowed them to amass capital and strengthen their balance sheets, and in recent years, buyback their own stock.  Given the information above, for the two indexes to generate equivalent returns going forward, one of several things would need to occur.  The valuation gap would need to widen even further, utilities would need to accelerate earnings growth, or banks would need to suffer a major destruction of capital.  To us these seem like unlikely scenarios because the valuation gap is already near an all-time wide, organic growth prospects for utilities are limited, and banks have accumulated near record levels of excess capital on their balance sheets to protect against a downturn.  Thus, we view banks as superior risk-adjusted investments irrespective of near-term economic growth. 

The portfolio continues to trade at a large discount to the market.  The portfolio trades at 7.3x normal earnings compared to 14.5x for the Russell 3000 Value Index and 18.8x for the S&P 500 Index.  It trades at 1.2x book value compared to 1.9x and 3.2x for the same indices, respectively.  This valuation discount combined with healthy balance sheets and good underlying businesses has us confident about the portfolio’s prospects as we look forward.   

ATTRIBUTION: 3Q 2019

The Hotchkis & Wiley Value Opportunities Fund underperformed the Russell 3000 Value Index in the third quarter of 2019.  The fund’s all cap nature worked against it in the quarter, as the overweight allocation to small caps and underweight allocation to mega caps hurt relative performance—index stocks below $3 billion in market capitalization declined -3.8% while those above $100 billion rose +2.2%.  Security selection in industrials and real estate, along with the underweight allocation to consumer staples and utilities, also hurt performance.  Positive security selection in healthcare, financials, materials, and energy helped relative performance.  The largest individual detractors to relative performance in the period were General Electric, Discovery, CBS, Corning, and Frank’s International; the largest positive contributors were Vodafone, Wells Fargo, Microsoft, AIG, and Cairn Energy.

 

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1 11.6% ROE for banks, 10.9% ROE for utilities, based on FY1 consensus estimates.
2 2.9% dividend yield for banks, 3.1% dividend yield for utilities.  32% dividend payout ratio for banks, 64% payout ratio for utilities.

Mutual fund investing involves risk. Principal loss is possible.  Investing in non-diversified funds and/or smaller and/or medium-sized companies involves greater risks than those associated with investing in diversified funds and/or large company stocks, such as business risk, significant stock price fluctuations, sector concentration and illiquidity. The Fund is non-diversified, meaning it may concentrate its assets in fewer individual holdings than a diversified fund.  The Fund may invest in ETFs, which are subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of an ETF’s shares may trade at a discount to its net asset value ("NAV"), an active secondary trading market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact a Fund’s ability to sell its shares. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. 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.

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 9/30/19 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 Russell 3000 Value Index. Securities’ absolute performance may reflect different results. The “Largest New Purchases” section includes the three largest new security positions during the quarter based on the security’s quarter-end weight adjusted for its relative return contribution; does not include any security received as a result of a corporate action; if fewer than three new security positions during the quarter, all new security positions are included.  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.

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 period. Equities, bonds, and other asset classes have different risk profiles, which should be considered when investing. All investments contain risk and may lose value.

 

Index definitions

Glossary of financial terms