The S&P 500 Index returned +3.1% in the second quarter. Growth stocks outperformed value stocks in the quarter, with the Russell 1000 Growth Index returning +4.7% compared to the Russell 1000 Value Index’s return of +1.3%. Year-to-date, the growth index has outperformed the value index by more than 9 percentage points, a reversal of value’s 10 percentage point advantage in 2016. In the last few years, investors flocked to companies with high dividend payouts (i.e. bond surrogates) because interest rates have been persistently low. In 2017, with GDP advancing at a positive but lackluster pace, investors have flocked to stocks that have exhibited above average growth. This has not only led to growth’s outperformance but also produced a market with narrow leadership. More than one-third of growth’s outperformance has come from just five mega cap stocks—Apple, Amazon, Facebook, Google, and Microsoft.
Financials have represented the portfolio’s largest sector since the end of the financial crisis, and banks have comprised a meaningful portion of that exposure. In late June, the Federal Reserve Board completed its Comprehensive Capital Analysis and Review (“CCAR”) and did not object to the capital plans of the 34 participating companies1. In its press release, the Fed noted that the common equity capital ratio of the 34 banks “has more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 percent in the first quarter of 2017”. Of the 34 banks, 26 are public US companies. These 26 banks were approved for returning 100% of earnings to shareholders on average, which equates to 7.5% of their equity value; i.e. a 7.5% payout yield—a handful have a payout yield of more than 10%. We view this as a compelling dynamic for companies that have not had better balance sheets in our lifetime.
Equity valuation multiples leave us somewhat guarded. Valuations are above average, though a healthy corporate environment, an accommodating Federal Reserve, and a resilient consumer provide support. Potential policy changes remain a looming uncertainty across equity markets. In addition to the mega cap growth stocks previously mentioned, investors have favored sectors with stable earnings and high dividend payouts, bidding them up to levels we view as excessive; we are underweight consumer staples, healthcare, REITs, and utilities. We are overweight technology, industrials, and financials, which exhibit compelling valuations for the risks at hand. The portfolio trades at a considerable discount to the market, largely due to this valuation dichotomy. The portfolio trades at 9.8x normal earnings compared to 14.9x and 17.3x for the Russell 1000 Value and S&P 500 Indices, respectively. The portfolio trades at 1.5x book value compared to 2.0x and 3.0x for the two indices, respectively.
ATTRIBUTION: 2Q 2017
The Hotchkis & Wiley Large Cap Diversified Value portfolio (gross and net of management fees) outperformed the Russell 1000 Value Index in the second quarter. Positive stock selection drove the outperformance in the quarter. Stock selection was positive or neutral in 7 of the 11 GICS sectors. Stock picking in utilities, telecommunications, and industrials were the most notable positive contributors. The largest individual contributors to relative performance were Calpine, Citigroup, Koninklijke Philips, Oracle, and CNH Industrial; the largest detractors were Marathon Oil, Hewlett Packard Enterprise, Discovery Communications, Bed Bath & Beyond, and Murphy Oil.
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1While the Fed did not object to its plan, Capital One is required to address weaknesses in its capital planning process and resubmit its plan.
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, 2017 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.
