MARKET COMMENTARY
The S&P 500 Index returned +13.7% in 2014, its sixth consecutive positive year—the longest such streak since the mid to late 1990s. Unlike the extended bull market of the 1990s, which was driven by irrational growth expectations and swelling price-to-earnings multiples, the stock market’s rise over the past six years has been powered by broad corporate earnings growth. Moreover, household debt has been reduced by about 25% and corporate debt has been more than halved—an unprecedented deleveraging cycle that has de-risked the market considerably. Stock prices are up, earnings are higher, balance sheets are stronger, interest rates are lower, and inflation remains subdued. The U.S. economy has demonstrated clear progress though growth in Europe, Asia, and emerging markets has somewhat disappointed. Taking into account the confluence of these factors, we find the broad equity market reasonably valued for the risks at hand; it is neither especially compelling nor overextended. We have identified valuation opportunities selectively, as demonstrated by the portfolio’s discount to the market, but we remain highly reluctant to assume undue risk. The portfolio trades at 9.6x our estimate of normal/sustainable earnings compared to the S&P 500 Index trading at 16.6x normal earnings and 17.2x next year’s consensus earnings. We remain keenly focused not only on valuation support as a primary risk control, but also on strong balance sheets, sustainable cash flows, and prudent use of capital.
Crude oil prices tumbled 46% during 2014, precipitated by concerns about economic growth in developing economies (i.e. shrinking demand) without a corresponding slowdown in production from the world’s major oil producers (i.e. excess supply). Commodity price changes should not affect total economic growth globally, but net importers benefit at the expense of net exporters when crude oil prices plummet. Accordingly, equities in the U.S., Western Europe, and developed Asia performed significantly better than equities in oil producing countries such as Russia and Brazil. Also, performance disparity was significant between sectors because the energy sector lagged by a sizable margin. During the year, S&P 500 Index energy stocks returned -8% as a group, making it the only sector with a negative return.
In December, the Bureau of Economic Analysis revised real U.S. gross domestic product growth to a +5.0% annual rate for the quarter ended 9/30/14. This was on the heels of a +4.6% real growth rate in the previous quarter and marked the fastest pace in more than a decade. The primary driver was increased consumer spending, but business investment, exports, and government spending also increased. Also in 2014, the unemployment rate dipped below 6% for the first time in six years and consumer confidence hit a seven-year high.
Against this backdrop, the U.S. Dollar appreciated relative to other major global currencies. The Dollar was up 12% versus the Euro, 6% versus the Pound, and 14% versus the Yen. An improved economy, robust corporate earnings, and lower financial leverage provide a solid foundation for the equity market though stock prices have increased commensurately. Amenable conditions can persist for long periods, though we remain somewhat guarded. In the current environment, we have identified attractive valuation opportunities selectively while emphasizing appropriate risk controls, and are optimistic regarding the portfolio’s resulting risk/return profile.
ATTRIBUTION: 2014
The Hotchkis & Wiley Value Opportunities Fund (Class I) underperformed the S&P 500 in 2014. In broad terms, the underperformance can be attributed to two factors: 1) foreign currency exposure; and 2) small cap exposure. The Pound, Euro, and Yen each declined relative to the U.S. Dollar over the year. The portfolio’s gross exposure averaged a little more than 20% during the year. Between 35% and 40% of the currency exposure was hedged, which helped, but the net exposure outside the U.S. was a detractor. Also, the portfolio’s average small cap exposure was about 18% throughout the year. This detracted from performance considerably as small caps underperformed large caps, measured by the Russell 2000 and S&P 500 Indexes, by 9%--the largest margin since 1998.
PORTFOLIO ACTIVITY: 2014
The portfolio’s exposure to high yield bonds increased over the year as we identified several high yielding credits with what we believe were attractive risk/return profiles; the allocation increased from about 2% to nearly 8%. Energy or energy related bonds comprise a large portion of the increased high yield exposure. We also added several risk arbitrage equity positions, which account for nearly 7% of the portfolio as of year-end (we had none at the beginning of the year). Our largest sector increase in the general stock portfolio was in healthcare, as we added new positions in pharmaceuticals, medical devices, and pharmacy benefit management. We decreased the weight in financials, primarily by exiting/trimming the positions in Direct Line Insurance (LSE:DLG, Financial) (0.1%)*, Wells Fargo (WFC, Financial) (0.0%)* , and Capital One Financial (COF, Financial) (0.0%)*.
*% of total portfolio as of December 31, 2014
Mutual fund investing involves risk. Principal loss is possible. Investing in non-diversified funds and/or smaller and/or medium-sized companies involves greater risks than those associated with investing in diversified funds and/or large company stocks, such as business risk, significant stock price fluctuations, sector concentration and illiquidity. The Fund is non-diversified, meaning it may concentrate its assets in fewer individual holdings than a diversified fund. The Fund may invest in ETFs, which are subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of an ETF’s shares may trade at a discount to its net asset value ("NAV"), an active secondary trading market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact a Fund’s ability to sell its shares. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. Investment by the Fund in lower-rated and non-rated securities presents a greater risk of loss to principal and interest than higher-rated securities. The Fund may invest in derivative securities, which derive their performance from the performance of an underlying asset, index, interest rate or currency exchange rate. Derivatives can be volatile and involve various types and degrees of risks. Depending on the characteristics of the particular derivative, it could become illiquid.
Fund holdings and/or sector allocations are subject to change and are not buy/sell recommendations. Current and future portfolio holdings are subject to risk. Certain information presented based on proprietary or third-party estimates are subject to change and cannot be guaranteed. The opinions expressed are those of the portfolio managers as of 12/31/14 and may not be accurate reflections of their opinions after that date. There is no guarantee that any forecasts made will come to pass. The Fund may not continue to hold the securities mentioned and the Advisor has no obligation to disclose purchases or sales of these securities. Past performance is no guarantee of future results. Diversification does not assure a profit nor protect against loss in a declining market.
Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform other asset types during a given periods. Equities, bonds, and other asset classes have different risk profiles, which should be considered when investing. All investments contain risk and may lose value.
