MARKET COMMENTARY
The Russell Developed Index had a flat -0.04% return during the first quarter of 2016, though it was anything but a flat trajectory. On February 11th, the index was down by more than 11% 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, Russell Developed Index stocks with the lowest price-to-book ratios (lowest quintile) underperformed the index -20.5% vs. -11.7%. From February 11th through the end of the quarter, however, this lowest valued quintile outperformed the index +16.5% vs. +13.2%. 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 global 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 7.2x normal earnings and 0.9x book value, which represents a considerable discount to the Russell Developed Index (14.5x and 2.0x, respectively).
Performance deviations by sector were large during the quarter as non-cyclical sectors utilities and telecom both returned more than +5% while healthcare and financials both declined by more than -5%. The financial sector remains the portfolio’s largest weight as we are overweight banks, which trade for less than book value and a low multiple of normal earnings. Despite the low interest rate environment globally, the banks we own also trade at low multiples of current earnings, which should increase handsomely if interest rates rise. We are slightly overweight energy and 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, insurance, and cyclical industrials. The dollar weakened versus the Euro and the Yen but strengthened versus the Pound.
ATTRIBUTION: 1Q 2016
The Hotchkis & Wiley Global Value Fund (Class I) outperformed the Russell Developed Index in the first quarter of 2016. Positive stock selection in consumer staples, technology, and industrials drove the outperformance in the quarter. The largest individual contributors to relative performance were WorleyParsons (WOR, Financial) (2.4%)*, Cummins (CMI, Financial) (3.3%)*, and Office Depot (ODP, Financial) (2.6%)*. Global stocks with a price-to-book ratio of less than 1.0x declined -7% during the quarter while the rest of the market rose. The portfolio’s average weight to stocks trading at a discount to book value was 38% compared to 10% for the index. This was a considerable performance drag during the quarter but not enough to overcome the positive security selection. The largest individual detractors to relative performance during the quarter were Bank of America (BAC, Financial) (3.4%)*, Ophir Energy (OPHR, Financial) (2.0%)*, and Citigroup (C, Financial) (3.0%)*. Currency exposures detracted from relative performance because the portfolio is overweight the Pound, which weakened vs. the Dollar and underweight the Yen, which strengthened versus the Dollar.
PORTFOLIO ACTIVITY: 1Q 2016
We began and ended the quarter with 59 holdings as we added four new positions exited four existing positions in lieu of better risk-adjusted return opportunities. While the portfolio’s weight in financials was reasonably flat over the quarter, we added to several existing positions that underperformed. We also added two new financial positions. We reduced the weight in industrials, healthcare, and technology.
*% 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. These risks are greater for emerging markets. 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 Developed 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.
