The S&P 500 Index returned a modest +0.3% during the second quarter of 2015 and is now up +1.2% since the beginning of the year. Growth and value performed similarly during the quarter but value stocks have lagged considerably over the past 12 months. Typically, such environments present a headwind for our value-focused strategy but we have managed to navigate the past twelve months satisfactorily considering the circumstances. Naturally, however, we would welcome a value tailwind which our experience has taught us should inevitably emerge in due course.
The economic perils in Greece have reemerged as an important concern that is giving investors pause. The good news is that Greece is small, representing about 2% of the total economic output of all countries that use the euro as their currency. The primary risk for equity investors is that a Greek exit from the Eurozone sets a new precedent, and investors may ponder the possibility that a larger European economy (e.g. Italy, Spain) may share a similar fate if/when stressed, which could trigger economic turmoil throughout the region. Thus far, the market appears to perceive the Greece situation as largely quarantined—government bond spreads for other European periphery countries have remained relatively tight versus the German Bund. Nonetheless, we are monitoring the situation closely and have evaluated in detail each of our positions’ exposure to changes in the value of the dollar; we remain confident that we are not bearing unnecessary risk.
Strengthened corporate balance sheets, robust earnings growth, and an improved economic backdrop have supported the strong rise in US stock prices in recent years. In our view, the broad equity market’s valuation appears about average—neither exceptionally attractive nor dramatically overextended. Fortunately, we have been able to identify select pockets of attractive valuation opportunities. We have identified a disproportionate number of such opportunities in financials, which remain out-of-favor despite representing the most de-risked segment of the market. Select insurers and money center banks, for example, trade near or even below book value despite undergoing unprecedented efforts to improve their capital positions. These are businesses that provide essential services to the marketplace and would be next to impossible to replicate organically. The prospects for increased ROE and earnings growth have improved, and the companies are either returning considerable capital to shareholders or have plans to do so in the near term. The prospect of paying less than book value for a company possessing such qualities represents an uncommon and compelling valuation opportunity.
While we have identified select opportunities, the breadth of attractive risk-adjusted valuation opportunities is not what it was five years ago. Our experience has taught us that a keen focus on risk controls in such environments is especially critical. We gravitate to companies with sustainable cash flows, strong balance sheets, prudent capital allocation, and appropriate valuation support. The portfolio’s risk/return profile is attractive in the current environment and trades at a considerable discount to the market. The portfolio trades at 10.6x our normal earnings estimate versus 13.8x for the Russell 1000 Value Index and 16.3x for the S&P 500 Index. It also trades at 1.4x book value compared to 1.8x and 2.7x for the Russell 1000 Value Index and the S&P 500 Index, respectively.
ATTRIBUTION: 2Q 2015
The Hotchkis & Wiley Large Cap Diversified Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the second quarter of 2015. The largest contributor to relative performance, by far, was positive stock selection in the financial sector. The portfolio’s banks and insurers both outperformed. REITs returned -10.5% in the quarter, which also helped relative performance as we have viewed the industry as one of the more overvalued segments of the market—the portfolio has zero REIT exposure. Stock selection in telecom and consumer discretionary also helped performance. The largest individual contributors were AIG (AIG, Financial), Vodafone (VOD, Financial), and Time Warner Cable (TWC, Financial). On the negative side, stock selection in technology, utilities, and consumer staples detracted from relative performance. The largest individual detractors were Calpine (CPN, Financial), Corning (GLW, Financial), and Ericsson.
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 June 30, 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.
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