MARKET COMMENTARY
The S&P 500 Index increased +6.07% in the first quarter of 2017, continuing a nearly unbroken string of quarterly gains since the beginning of 2013. The rise in equities has triggered debate about the US equity market’s current valuation. Most traditional valuation measures are above historical averages; however, these metrics are below historical averages after adjusting for the low interest rate environment. Our general view is that the broad market, as defined by the S&P 500, is fully valued. Often overlooked, however, is that some market segments contain bargains while others are richly valued. Finding such opportunities has become more difficult in recent years but we continue to observe a large valuation discrepancy between cyclical market segments and those viewed as bond surrogates. Today’s popular stocks are those that have relatively stable earnings and high dividend payouts, like REITs, consumer staples, and regulated utilities. While the underlying businesses are stable, these are mature, slow-growing market segments, and paying 20-25x earnings is a risky proposition in our view. Investing in passive ETFs that track common equity indices is the other preferred strategy of the day, pouring still more investor capital into overvalued stocks and exacerbating the situation. Meanwhile, some market segments that have been shunned trade for half the valuation levels of the more favored areas of the market, and in select circumstances, even trade at a discount to the replacement cost of the business.
As an example, we own several banks and insurers that trade at discounts to tangible book value; it would cost more to replicate the asset base than to simply buy the company. These businesses continue to have a stigma from the financial crisis, which is in part why current valuations remain attractive, in our opinion. The fact remains, however, that these companies provide essential services to the economy (low obsolescence risk) and have capital ratios/liquidity metrics at the highest levels since the 1930s. Regulatory uncertainty always represents a risk, but this also acts as a barrier to entry as leading franchises are difficult and costly to displace—an often overlooked benefit. We believe Technology is another sector that offers attractive valuation opportunities for the risks at hand. We own a mix of attractively-valued software, hardware, and equipment companies with businesses that we view as more predictable than most technology companies. These businesses have relatively sticky customers, strong balance sheets, and are prudent capital stewards.
Because we have identified attractive pockets of opportunity within a fully valued market, the portfolio trades at a large discount to the market. The portfolio trades at 1.5x book value and 9.7x normal earnings compared to 2.0x and 14.7x, respectively, for the Russell 1000 Value. Compared to the S&P 500, the portfolio’s valuation discount is even more pronounced, as the broad index trades 3.0x book value and 17.3x normal earnings.
ATTRIBUTION: 1Q 2017
The Hotchkis & Wiley Diversified Value Fund (Class I) outperformed the Russell 1000 Value Index in the first quarter of 2017. Each sector in the portfolio increased in the quarter, with the lone exception of Energy due to the decline in oil prices. Relative to the benchmark, the portfolio benefitted from strong stock selection in Industrials, Telecom and Healthcare. This was partly offset by stock selection in Energy, Consumer Staples and Financials. The largest individual contributors to relative performance were NRG, Ericsson, Oracle, Anthem, and Corning; the largest detractors were Hess, Marathon, AIG, Calpine, and Cobalt.
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. Portfolio managers’ opinions and data included in this commentary are as of 3/31/17 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. 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. Attribution is an analysis of the portfolio's return relative to a selected benchmark, is calculated using daily holding information and does not reflect the payment of transaction costs, fees and expenses of the Fund.
