MARKET COMMENTARY: Despite macroeconomic and geopolitical uncertainties, U.S. equities climbed in the third quarter with the S&P 500 Index returning +6.4% and the Russell 1000 Value Index returning +6.5%. Investors appeared to take notice of Corporate America's improving health. Of the S&P 500 constituents reporting earnings during the quarter, more than 70% beat Wall Street estimates and one out of four beat estimates by more than ten percent. Strong cash flows, which had been predominantly retained in an effort to improve balance sheets, are now being returned to shareholders with increased regularity via dividends and share repurchases.
European economic woes and the subsequent policy responses continue to be debated in full public view. While the drama roiled U.S. equity markets in the second quarter, signs of progress transpired in the third quarter. Indications of Eurozone cohesion, like the European Central Bank's unlimited bond purchasing program announced in September, have been well-received by investors. European sovereign debt yields fell and equity markets rose following the announcement. In the U.S., the elephant in the room has been the so-called "fiscal cliff"—the combination of tax cut expirations and sequestration (i.e. forced spending cuts) set to take place in 2013. If the fiscal situation remains status quo, the fallout would have a negative effect on GDP growth next year and could pose a recession threat. Consensus expectation, however, is for some form of transitory relief which would buy the newly-elected government additional time to configure a longer-term resolution. This appears to be the expectation regardless of the November election outcomes. Meanwhile, housing and employment have continued to show subtle signs of improvement.
We continue to observe strong demand for low volatility assets such as 10-Year Treasury notes, which currently offer investors a yield of 1.6% per annum. Given expected inflation is 2.8% over the next decade1, we view an investment in treasuries with skepticism. As investment managers, our primary objective is to increase our clients' purchasing power. Accordingly, we believe the negative real yields offered by treasuries and other high-rated bonds represent deficient investment opportunities. Conversely, we find equities an interesting alternative. Our Large Cap Diversified Value portfolio offers investors a dividend yield of 2.5%, which represents 25% of the earnings generated. The other 75% of earnings can be reinvested to grow profits or be returned to shareholders with dividend increases or share repurchases. Granted, equities are not backed by the full faith and credit of the U.S. Government and its ability to print currency to ensure repayment. It is important to recognize, however, that the government is not promising investors growth, or even stability of purchasing power. We are confident that most investors would view a decade of eroding purchasing power as a disappointing outcome—we certainly would. Given the compelling characteristics of the portfolio, our sights are set considerably higher.
ATTRIBUTION: Q3 2012
The Hotchkis & Wiley Large Cap Diversified Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index for the quarter. An overweight and stock selection in technology was the largest performance detractor over the quarter. Stock selection in industrials and energy also detracted from performance. The largest individual detractors were Hewlett-Packard (HPQ, Financial), Cobalt International Energy (CIE, Financial), and Microsoft (MSFT, Financial). Positive stock selection in financials, healthcare, and utilities contributed to performance in the quarter. The largest individual contributors were Citigroup (C, Financial), NRG Energy (NRG, Financial), and Gap (GSP).
1 Based on University of Michigan Survey 5-10 Year Ahead Inflation Expectations Index
Composite performance is available at www.hwcm.com, located on the strategy's Performance tab. The attribution in this commentary is based on a representative Large Cap Diversified Value portfolio. Equity performance attribution is an analysis of the portfolio's return relative to a selected benchmark and is calculated using daily holding information. Returns calculated using this buy-and-hold methodology can differ from actual portfolio returns due to intraday trades, cash flows, corporate actions, accrued/miscellaneous income, and trade price and closing price difference of any given security. 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 9/30/12 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.
Equities, bonds, and U.S. Treasuries have different risk profiles. U.S. Treasuries are generally considered "risk free" securities. Equity securities may have greater risks and price volatility than U.S. Treasuries and bonds, where the price of these securities may decline due to various company, industry and market factors. The dividend yield of securities held in the portfolio is calculated by annualizing the last quarterly dividend paid and dividing it by the current share price. Past performance is no guarantee of future results.
European economic woes and the subsequent policy responses continue to be debated in full public view. While the drama roiled U.S. equity markets in the second quarter, signs of progress transpired in the third quarter. Indications of Eurozone cohesion, like the European Central Bank's unlimited bond purchasing program announced in September, have been well-received by investors. European sovereign debt yields fell and equity markets rose following the announcement. In the U.S., the elephant in the room has been the so-called "fiscal cliff"—the combination of tax cut expirations and sequestration (i.e. forced spending cuts) set to take place in 2013. If the fiscal situation remains status quo, the fallout would have a negative effect on GDP growth next year and could pose a recession threat. Consensus expectation, however, is for some form of transitory relief which would buy the newly-elected government additional time to configure a longer-term resolution. This appears to be the expectation regardless of the November election outcomes. Meanwhile, housing and employment have continued to show subtle signs of improvement.
We continue to observe strong demand for low volatility assets such as 10-Year Treasury notes, which currently offer investors a yield of 1.6% per annum. Given expected inflation is 2.8% over the next decade1, we view an investment in treasuries with skepticism. As investment managers, our primary objective is to increase our clients' purchasing power. Accordingly, we believe the negative real yields offered by treasuries and other high-rated bonds represent deficient investment opportunities. Conversely, we find equities an interesting alternative. Our Large Cap Diversified Value portfolio offers investors a dividend yield of 2.5%, which represents 25% of the earnings generated. The other 75% of earnings can be reinvested to grow profits or be returned to shareholders with dividend increases or share repurchases. Granted, equities are not backed by the full faith and credit of the U.S. Government and its ability to print currency to ensure repayment. It is important to recognize, however, that the government is not promising investors growth, or even stability of purchasing power. We are confident that most investors would view a decade of eroding purchasing power as a disappointing outcome—we certainly would. Given the compelling characteristics of the portfolio, our sights are set considerably higher.
ATTRIBUTION: Q3 2012
The Hotchkis & Wiley Large Cap Diversified Value portfolio (gross and net of management fees) underperformed the Russell 1000 Value Index for the quarter. An overweight and stock selection in technology was the largest performance detractor over the quarter. Stock selection in industrials and energy also detracted from performance. The largest individual detractors were Hewlett-Packard (HPQ, Financial), Cobalt International Energy (CIE, Financial), and Microsoft (MSFT, Financial). Positive stock selection in financials, healthcare, and utilities contributed to performance in the quarter. The largest individual contributors were Citigroup (C, Financial), NRG Energy (NRG, Financial), and Gap (GSP).
1 Based on University of Michigan Survey 5-10 Year Ahead Inflation Expectations Index
Composite performance is available at www.hwcm.com, located on the strategy's Performance tab. The attribution in this commentary is based on a representative Large Cap Diversified Value portfolio. Equity performance attribution is an analysis of the portfolio's return relative to a selected benchmark and is calculated using daily holding information. Returns calculated using this buy-and-hold methodology can differ from actual portfolio returns due to intraday trades, cash flows, corporate actions, accrued/miscellaneous income, and trade price and closing price difference of any given security. 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 9/30/12 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.
Equities, bonds, and U.S. Treasuries have different risk profiles. U.S. Treasuries are generally considered "risk free" securities. Equity securities may have greater risks and price volatility than U.S. Treasuries and bonds, where the price of these securities may decline due to various company, industry and market factors. The dividend yield of securities held in the portfolio is calculated by annualizing the last quarterly dividend paid and dividing it by the current share price. Past performance is no guarantee of future results.
