Geopolitical concerns dominated financial headlines and triggered extreme volatility during the third quarter. Macroeconomic uncertainty in the US, Europe, and emerging markets combined with skittish market sentiment translated into double-digit equity market losses. These apprehensions overshadowed individual company fundamentals, which have continued to become increasingly compelling.
In the US, the debt ceiling issue prompted a contentious debate entwined with political gamesmanship, which resulted in a loss of confidence in policymakers’ ability to reach effective resolution. Meanwhile in Europe, the European Commission, European Central Bank, and International Monetary Fund (coined the “Troika”) have been working with Greece to reach a compromise addressing its deteriorating fiscal situation. Investors appear most concerned about the ramifications of a disorderly Greek default that would result in Greece departing from the euro. This could destabilize existing contractual relationships within the Eurozone and test the euro’s long term sustainability. In addition, this could result in a mass exodus of bank deposits from peripheral Europe to healthier economies (e.g. Germany, France). This “run on banks” coupled with a Greek default would likely necessitate bank bailouts throughout Europe. An orderly default in which Greece remains part of the Eurozone, should allow these bailouts to occur in a more controlled fashion. The strongest Eurozone countries foot the bill in any of these scenarios.
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 Index 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 Midcap Value Index returned -18.5% 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 utilities and consumer staples held up better than the overall market, while energy was the largest laggard. 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 payout yields. We believe this should produce exceptional results for the diligent and patient investor.
The Hotchkis & Wiley Mid-Cap Value portfolio (gross and net of management fees) underperformed the Russell Midcap 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 utilities and consumer staples, which outperformed the overall market considerably. Stock selection in financials and staples also detracted from performance for the quarter. Positive stock selection in healthcare and an underweight in materials were the largest performance contributors.
PORTFOLIO ACTIVITY: 3Q11
We increased the weight in insurance by increasing the weight in Allstate (NYSE:ALL), which ended the quarter as a top ten holding. It is the second largest writer of auto and homeowners insurance policies in the US. We believe it is a highly profitable franchise with sustainable competitive advantages over its peers. We also increased our industrials weight by taking a new position in Paccar (NASDAQ:PCAR), a heavy-duty truck manufacturer trading at an attractive multiple of normal earnings. It earns a high return on capital, maintains a conservative balance sheet, and returns capital to shareholders. We exited the position in Hartford (NYSE:HIG) in lieu of better risk/return opportunities and we trimmed the position in Valassis (VCI) for diversification reasons.
The portfolio attribution in this commentary is based on a representative Mid-Cap 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.