The S&P 500 Index finished the first quarter of 2014 with a +1.81% return but experienced some turbulence along the way. In early February, the S&P was down nearly 6% for the year, fueled by developments in several of the largest emerging market economies. Chinese manufacturing slowed and the country’s banking regulator signaled increased credit scrutiny. Also, Argentina devalued its peso triggering a selloff in several other emerging market currencies, revealing that contagion is alive and well. This rattled US equity investors, sending the VIX Index from 14 at the beginning of the year to 21 in early February.
Earnings season progressed convincingly, however, and U.S. equities began to recover. More than 73% of S&P 500 Index companies met or exceeded consensus earnings estimates even though these estimates have risen consistently in recent years. Harsh winter weather across much of the country affected certain segments of the market (e.g. retail, housing) but we believe should not pose lasting effects. Consumer confidence climbed to a six-year high in March, an important factor considering personal consumption comprises roughly two-thirds of US GDP.
Performance dispersion by sector was sizeable during the quarter, and largely a reverse of calendar year 2013. Consumer discretionary went from first-to-worst, and was one of only two S&P sectors with a negative return during the quarter (Telecom was the other). Utilities went from second worst-to-first, returning +10% during the quarter. In general, non-cyclical stocks outperformed cyclical stocks, which is a more common occurrence when equity markets are negative.
The housing market has improved, the labor market has improved, corporate earnings have been robust, and balance sheets are strong. Also, the yield curve is normal-to-steep, which has been a constructive signal for economic growth historically. Understandably, these factors have served as a springboard for equity markets which have posted astounding returns over the past five years. This has extended broad equity valuations and tempered our outlook accordingly. We continued to find interesting opportunities selectively, though the valuation opportunities available several years ago have been at least partly exhausted. Nevertheless, we remain optimistic about the risk/return prospects of the portfolio. At 11.3x price/normal earnings, the portfolio trades at an 18% discount to the Russell 1000 Value Index and a 28% discount to the S&P 500 Index.
The Hotchkis & Wiley Large Cap Value Fund (Class I) outperformed the Russell 1000 Value Index during the quarter. Two-thirds of the outperformance was due to positive stock selection, which was particularly strong in technology, industrials, energy, and utilities. Within technology, Corning (3.3%)*, Hewlett-Packard (3.0%)*, and Microsoft (3.1%)* each returned more than +10%. The largest two individual contributors were both utilities, as Public Service Enterprise Group (2.9%)* and Exelon (1.8%)* each returned more than +20% for the quarter. Stock selection in telecommunications and financials detracted from performance over the quarter. The largest individual detractors were Vodafone (2.9%)*, Citigroup (3.8%)*, and Johnson Controls (2.0%)*.
Sector changes during the quarter were modest. Financials increased by about one percentage point as we added to existing positions in Wells Fargo (2.9%)*, American International Group (4.7%)*, and Citigroup (3.8%)*. New positions during the quarter include Eli Lilly (1.0%)*, McDonald’s (0.7%)*, and Time Warner Cable (0.5%)* — we believe each represents attractive risk/return profiles. We exited positions in pharmaceutical companies AstraZeneca (0.0%)* and Merck (0.0%)* due to valuations.