Equity and fixed income market prices reflect mounting pessimism that an orderly compromise will transpire. The price-to-forward earnings multiple of the S&P 500 is lower today than it was at the end of the first quarter in 2009 during the depths of the financial crisis; high yield bond spreads have also ballooned to mid/late 2009 levels. Predicting political outcomes is difficult, but a result that does not involve a disorderly default should provide a tailwind for depressed equity and high yield bond prices. Corporate America has laid a solid foundation from which to build—it has generated robust earnings, strong free cash flows, and put hoards of cash on its balance sheets.
The S&P 500 Index returned -13.9% and the Russell 1000 Value Index returned -16.2% during the third quarter of 2011. As was the case in the second quarter, the market remains overtly focused on the macroeconomic environment rather than corporate performance. As such, the market exhibited many of the same “themes” it exhibited last quarter. Non-cyclical sectors held up better than the overall market (utilities, staples, telecom, healthcare), while financials and energy were among the worst performers. The highest valued stocks (using any common metric) outperformed the lowest valued stocks by a tremendous margin. This environment is conducive to momentum strategies but is quite challenging for fundamental value strategies—even while it produces opportunities that should benefit our investors in the long run. Without doubt, it has been a more volatile path than we anticipated, but we believe the portfolio has strong valuation support with compelling dividend and payout yields. We believe this should produce exceptional results for the diligent and patient investor.
The Hotchkis & Wiley Large Cap Diversified Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index for the quarter. The largest detractor from performance for the quarter was an overweight to stocks with low valuations. Depending on the metric used (P/E, P/B, etc.) this explains all, or nearly all of the underperformance. The portfolio was also underweight in three of the four non-cyclical sectors (healthcare, staples, and telecommunications), which detracted from performance slightly. Stock selection in financials and technology also detracted from performance for the quarter. Positive stock selection in energy, telecommunications, and healthcare was the largest performance contributor for the quarter. An overweight in utilities and an underweight in materials also helped.
PORTFOLIO ACTIVITY: 3Q11
We exited our position in Chevron (CVX) as it approached our valuation target and trimmed some other large integrated oil companies in favor of Total (TOT), but the net effect was a reduction in the portfolio’s energy weight. We reduced the materials exposure by exiting our position in specialty chemical producer Celanese (CE), which also approached our valuation target—we are underweight materials. We exited our position in IBM (IBM) due to valuation but added to Oracle (ORCL) and took a new position in Corning (GLW)—the net effect was an increase in the technology weight. Corning is a materials sciences company (primarily display glass and specialty materials) that we believe has a track record of outstanding performance and has exhibited a sustainable margin advantage over its competitors. We also increased the healthcare exposure, where we took a new position in global pharmaceutical company Sanofi-Aventis (SNY). Sanofi is attractively valued based on its existing drug portfolios and conservative estimates of their pipelines.
The portfolio attribution in this commentary is based on a representative Large Cap Diversified Value portfolio. Certain client portfolio(s) may or may not contain the securities discussed in this commentary due to the account’s guideline restrictions, cash flow, tax and other relevant considerations. The commentary is for information purposes only and is not intended to be, and should not be, relied on for investment advice. The opinions expressed are those of the portfolio managers as of September 30, 2011 and may not be accurate reflections of their opinions after that date. There is no guarantee that any forecasts made will come to pass. Accounts may not continue to hold the securities mentioned and H&W has no obligation to disclose purchases or sales of these securities.
Past performance is no guarantee of future results.