MARKET COMMENTARY
The S&P 500 Index returned +1.35% during the first quarter of 2016, though it was anything but a steady trajectory. On February 11th, the S&P 500 Index was down by more than 10% for the year before recovering over the quarter’s final seven weeks. This date also represented a turning point in the value/growth cycle. From the beginning of the year through February 11th, S&P 500 Index stocks with the lowest price-to-book (P/B) ratios (lowest quintile) underperformed the index -16.1% vs. -10.3%. From February 11th through the end of the quarter, however, this lowest valued quintile outperformed the index +16.2% vs. +13.0%. While it is too early to proclaim a new value cycle is upon us, it is noteworthy that such cycles have lasted between 5 and 8 years historically once they have taken hold—this would be a welcomed tailwind for our approach.
In most market environments, some sectors/industries are coveted while others are shunned depending on the market’s disposition at the time. This behavior often results in a market that exhibits a bifurcation in stock valuations. Currently, this dichotomy is quite pronounced. Investors are fearful that the economic woes in China and other emerging economies will spill over into the US and other developed markets. This fear has caused investors to pay 20x earnings or more for the perceived safety of non-cyclicals like consumer staples or real estate and sell cyclicals like energy or industrials at a fraction of the valuation. We believe when “safe” stocks trade at excessive valuations they become risky, not safe, which is the market’s current paradox. Taking the long-term view, we see compelling risk-adjusted valuation opportunities in select market segments that have been shunned. Our bottom-up search for value in today’s market yields a portfolio that trades for 8.4x normal earnings and 1.1x book value, which represents a considerable discount to the Russell 1000 Value Index (13.2x and 1.7x, respectively) and an even larger discount to the S&P 500 Index (15.9x and 2.6x, respectively).
Performance deviations by sector were large during the quarter as non-cyclical sectors telecommunications and utilities both returned more than +15% while healthcare and financials both declined by more than -5%. The financial sector remains the portfolio’s largest weight, although we are slightly underweight relative to the Russell 1000 Value Index. We are overweight banks, which trade for less than book value and a low multiple of normal earnings. Despite the low interest rate environment, the banks we own also trade at low multiples of current earnings, which should increase handsomely if interest rates rise. We are also underweight energy but have found select opportunities that trade at a discount to book value and low multiples of normal earnings. We anticipate a recovery in crude oil prices, which is needed to spur the production needed to replace naturally depleting oil supplies. We are also finding attractive risk/return opportunities in autos/trucking, software, and insurance.
ATTRIBUTION: 1Q 2016
The Hotchkis & Wiley Large Cap Value Fund underperformed the Russell 1000 Value Index in the first quarter of 2016. Stocks within the Russell 1000 Value Index that trade at a discount to book value (i.e. P/B 1.0x) generated positive returns. This hurt relative performance as about 1/3 of the portfolio is invested in stocks with a price-to-book ratio of less than 1.0x compared to about 10% for the Russell 1000 Value Index. The portfolio’s exposure to financials (many of which trade below book value) detracted from relative performance as the overweight and stock selection in banks weighed on results. The largest individual detractors to relative performance were Citigroup (C, Financial) (4.1%)*, American International Group (AIG, Financial) (5.0%)*, and Bank of America (BAC, Financial) (4.4%)*. Positive stock selection in technology, industrials, and energy contributed to relative performance; the largest individual contributors to relative performance were Cummins (CMI, Financial) (3.6%)*, Corning (GLW, Financial) (4.5%)*, and Hewlett Packard Enterprise (HPE, Financial) (2.0%)*.
PORTFOLIO ACTIVITY: 1Q 2016
We began the quarter with 53 holdings and ended the quarter with 52; we exited two positions that began to approach our valuation targets and took a new position in an attractively valued retailer with an improving business mix that returns a lot of cash to shareholders. While the portfolio’s weight in financials was flat over the quarter, we added to several existing positions that underperformed. We reduced the weight in healthcare and staples as these sectors outperformed and the valuations became less compelling.
*% of total portfolio as of March 31, 2016
Mutual fund investing involves risk. Principal loss is possible. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. The Fund may invest in American Depository Receipts (“ADRs”) and Global Depository Receipts (“GDRs”) which may be subject to some of the same risks as direct investment in foreign companies.
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 3/31/16 and may not be accurate reflections of their opinions after that date. There is no guarantee that any forecasts made will come to pass. 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. 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.
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