Following six years of positive returns, the S&P 500 Index opened 2015 with a modest +1.0% return in the first quarter. The unprecedented corporate cost-cutting measures and general economic recovery following the financial crisis has fueled impressive earnings growth. Over the last six years, the S&P 500 is up +194% cumulatively. While such a rampant appreciation of market prices would normally give us pause, equity valuations are scarcely higher than historical averages due to these robust earnings.
After six years of zero interest rate policy, investors are acutely focused on the Federal Reserve’s plan to taper its lax monetary policy. Equity investors are not fully insulated from such actions, however, we believe the effect on equities should be more subdued than many investors expect. Firstly, increasing interest rates are often correlated with positive economic developments, which is good for corporate cash flows. Secondly, long bond rates are a component of the cost of capital used to discount corporate cash flows. Fed tapering should impact short term interest rates disproportionately to long term rates, which already reflect expectations of a less intrusive Fed. Finally, the premium equity investors require above treasuries is considerably higher than historical averages. If interest rates rise, we may see a reversion of the equity premium back to normal levels, resulting in equity prices remaining stable despite higher interest rates.
In commodity markets, crude oil prices continued to fall during the quarter, particularly WTI crude. Long term supply and demand dynamic are the primary drivers of oil prices over time. Current crude prices appear well below long term equilibrium levels. Global demand growth is about +1% annually while the natural decline rate in oil supply is about 6% annually. Given this decline rate, oil production needs to continue to grow in order to keep pace with demand. Over the last five years, most of the global production growth has come from the US and Canada, particularly US shale regions. First year decline rates for these regions are estimated between 60% and 75%, which could result in a meaningful production decline if new wells are not drilled. Capex budgets for 2015 have been slashed due to low crude prices so new wells appear to be on the decline. Other regions around the globe appear unlikely to increase production as well; many regions did not increase production when oil was over $100/barrel, so it seems unlikely they would increase production after crude prices halved. Our analysis suggests that oil prices around $70 to $80 per barrel are required for marginal producers to supply the market. The path to equilibrium can by rocky but we see opportunities to generate returns for patient investors.
The US dollar strengthened relative to other major currencies during the quarter. The US dollar index, which compares the dollar relative to a weighted basket of other major currencies, has appreciated by 23% since mid-2014. We receive many perceptive questions on how this affects equity valuations; the answer is somewhat complex as there are many moving pieces. A stronger dollar in and of itself would generally result in lower earnings for companies that generate more revenue than costs overseas (a prevalent occurrence). It is important to remember, however, the reason that the dollar has appreciated. An improved US economy, easy monetary policies overseas (e.g. quantitative easing in Europe), and heightened geopolitical risks have each contributed to a stronger dollar—and each justify higher US equity valuations.
Overall, compelling valuation opportunities with acceptable risk profiles are more difficult to find in today’s market than five years ago. In such environments, our experience has taught us that stressing risk controls is of paramount importance. We remain partial to companies with strong balance sheets, sustainable cash flows, sound capital allocation policies, and of course, attractive valuations. While it has become more challenging to find new opportunities that exhibit such traits, the current portfolio exemplifies these characteristics and exhibits an attractive risk/return profile. The portfolio trades at 10.8x our normal earnings estimate compared to 13.8x for the Russell 1000 Value Index and 16.2x for the S&P 500 Index.
ATTRIBUTION: 1Q 2015
The Hotchkis & Wiley Large Cap Diversified Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the first quarter of 2015. Positive stock selection in healthcare was the large contributor to outperformance as the portfolio’s managed care holdings performed well. An overweight position in consumer discretionary and positive stock selection in utilities also helped relative performance. The largest individual contributors were Anthem, GlaxoSmithKline, and Humana. Stock selection in financials and an overweight position in technology detracted from performance in the quarter. The largest individual detractors were Royal Dutch Shell, Hewlett-Packard, and Bank of America.
Composite performance for the strategy is located on the Performance tab. Portfolio attribution is based on a representative Large Cap Diversified Value portfolio. Certain client portfolio(s) may or may not hold the securities discussed due to the account’s guideline restrictions, cash flow, tax and other relevant considerations. Equity performance attribution is an analysis of the portfolio's return relative to a selected benchmark, is calculated using daily holding information and does not reflect management fees and other transaction costs and expenses. 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. Specific securities identified are the largest contributors (or detractors) on a relative basis to the Russell 1000 Value Index. Securities’ absolute performance may reflect different results. Securities identified do not represent all of the securities purchased, sold, or recommended for advisory clients, and are not indicative of current or future holdings or trading activity. H&W has no obligation to disclose purchases or sales of these securities. No assurance is made that any securities identified, or all investment decisions by H&W were, or will be profitable. Quarterly characteristics and portfolio holdings are available on theCharacteristics and Literature tabs (subject to the firm’s portfolio holdings disclosure policy).
The commentary is for information purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Portfolio managers’ opinions and data included in this commentary are as of March 31, 2015 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. Certain information presented is based on proprietary or third-party estimates, which are subject to change and cannot be guaranteed. 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. Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods. All investments contain risk and may lose value.
Past performance is no guarantee of future results.
