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Holly LaFon
Holly LaFon
Articles (8092) 

NWQ's Large Cap Value 3rd Quarter Commentary

Review of holdings and market

November 28, 2017 | About:

U.S. equities reached new record highs once again during the third quarter despite geopolitical tensions with North Korea and significant economic losses caused by hurricanes Harvey and Irma that briefly weighed on the market. Stocks advanced as economic fundamentals continue to modestly improve, coupled with the second quarter earnings season which marked the second straight quarter of double digit earnings growth for the S&P 500, aided by a weaker U.S. dollar. The Organization for Economic Cooperation and Development (OECD) also reported during the period that the world’s 45 major economies grew in sync for the first time since the global financial crisis in 2007. The Russell 1000 Value Index gained 3% for the quarter, bringing its return for the year-to-date period to 8%. Energy and materials were the top performing sectors as the price of oil rose, and the prices of copper, aluminum, and other industrial metals reached multi-year highs driven by expectations that resurgent global growth will stoke demand for raw materials. Consumer staples stock declined modestly while grocers fell more significantly as changing consumer preference towards private label brands and a shift in the retail landscape has raised concerns about company margins, accentuated by Amazon’s purchase of Whole Foods in August. The consumer discretionary sector also lagged, pulled down by the soft outlook for retail as well as advertising and media companies, and in many cases, fear of where will Amazon go next. From a style perspective, growth outperformed value across all capitalization ranges during the quarter, although value meaningfully beat growth in September as prospects for higher interest rates and tax reform resurfaced. Small cap stocks outperformed large caps, as measured by the Russell indices, as the same two factors (higher interest rates and tax reform) drove recent momentum and performance for small cap stocks. Small caps have appreciated to record levels on speculation that President Trump’s plans to roll back regulations, taxes, and pump money into infrastructure projects will benefit smaller, more domestically focused firms.

The Fed kept the door open for a December interest rate hike at its September meeting, and said it would begin to slowly shrink the central bank’s $4.5 trillion bond portfolio starting in October, which may help lead to higher interest rates. Fed chair Janet Yellen spoke recently indicating the potential to raise rates in the nearer term to get ahead of any oncoming inflation. Banks stocks rallied on the news, helping to lift the KBW Bank Index to a gain of nearly 4% for the quarter. Property casualty and reinsurance stocks broadly underperformed, however, driven by concerns over losses caused by the hurricanes and flooding that devastated parts of Texas, Louisiana, Florida, and the Caribbean in September in addition to a major earthquake in Mexico City.

The U.S. Dollar Index (DXY) was down nearly 3% in the third quarter, and has declined 10% since its peak at the beginning of this year. The U.S. dollar has depreciated against a range of global currencies since surging to a 15-year high after the U.S. election. The weaker dollar has been benefiting multi-nationals and U.S. exporters. Morgan Stanley estimates that profits for companies in the S&P 500 increase 1% for every 2% decline in the dollar.

Overseas, most European stock indices appreciated as economic growth in the 19-nation Eurozone continued to strengthen, outpacing the U.S. in both the first and second quarters of this year. Growth has broadened beyond the traditional powerhouses such as Germany and the Netherland as the aftereffects of the financial crisis have finally begun to fade and spending patterns have accelerated for both consumers and businesses. Economic confidence in the Eurozone reached its highest level in more than 10 years during the third quarter, and unemployment has fallen to an eight year low, underpinning expectations that the Eurozone will remain on its solid growth path despite the stronger euro. The potential for structural reforms is allowing greater productivity gains and more flexible union work rules are gaining traction. Japanese stocks also posted gains despite concerns about a weaker dollar and military tensions with North Korea that had weighed on the market. Exports are a major part of the Japanese economy. In Latin America, Brazil’s Bovespa Index closed near an all-time high as investors believe that the worst days of that country's economic slide may be over. Brazil’s Congress has approved a loosening of work rules, and for the time being President Michel Temer has survived a corruption allegation charge that could have removed him from office. Overall, the MSCI Emerging Market Index gained 7% for the quarter, driven by exports and a rally in global technology stocks such as Alibaba, Samsung, and Taiwan Semiconductor. The technology sector comprises roughly 27% of the emerging market index, and appreciated 4% during the period.

PORTFOLIO REVIEW

NWQ Large Cap Value portfolios posted positive returns (gross of fees) for the third quarter that exceeded the Russell 1000 Value Index even after an extremely tough August. Results for the year-to-date period also continue to exceed the benchmark. Financial services was the largest contributor to performance given both our higher weighting relative to the benchmark and superior stock selection, highlighted by our investment in Citigroup (NYSE:C). The stock has continued its strong performance driven by an attractive valuation and improving fundamentals, including increased capital return to shareholders. Energy also contributed to performance, led by EQT Corp (NYSE:EQT), which appreciated on reports that management, pressured by activist investors, is looking to and/or will be forced to accelerate plans to unlock value, potentially by separating its upstream and midstream businesses. Cheniere Energy (NYSE:CHK) did detract from performance, however, as several international LNG contract negotiations spurred investor concerns that Cheniere’s counterparties could also seek to lower fixed fee contracts. We see this as unlikely. Negative stock selection in the materials and consumer discretionary sectors also detracted from performance, particularly our investment in Viacom, which declined due to lower than expected earnings and guidance on softer advertising and affiliate growth expectations.

Financials, particularly banks, outperformed during the quarter, driven by positive developments including deregulation and further confidence around improved capital return. Additionally, guidance from the Fed to reduce its balance sheet starting in October, and for further rate hikes starting in December, have also been beneficial. More recently, the prospect of tax reform has helped, especially as the group is one of the higher tax payers.

Energy has been a challenging sector this year, declining by 7% in the Russell 1000 Value Index while all other sectors have posted gains. The third quarter saw energy post its first positive quarter this year, up 6.8%. Our energy holdings have outperformed sector returns for the quarter and year-to- date periods, although our overweight position has hurt our results. We believe the market is beginning to acknowledge the supportive fundamentals for crude oil as demand has been strong, supply growth continues to lag Wall Street’s predictions, and inventories have been consistently declining. Looking forward, the market has the potential to tighten as shale production is showing signs of declining efficiencies and the U.S. rig count has leveled off. We doubt that the current oil price is sufficient to justify the investment needed to meet strong global demand. We continue to see compelling value in our energy holdings, many of which are still trading at valuations when the price of crude oil was substantially lower.

TRADING ACTIVITY

New investments during the quarter included Chevron, First Horizon National, FirstEnergy, Gilead Sciences, and Trinity Industries. We believe Chevron has a compelling capital return story versus its integrated oil peers, and the company’s goal to double its return on invested capital (ROIC) at current oil prices is both powerful and differentiated. Chevron’s Permian position is the best in the sector and provides growth potential with flexible capital expenditure. We also initiated a position in First Horizon National Corporation following weakness in its share price. The company offers a variety of commercial banking services and conducts mortgage banking, capital markets, and transaction processing. We believe the stock has been overly punished by the company’s proposed acquisition of Capital Bank as book value growth should resume quickly as the company should be able to cut costs deeper than guided. FirstEnergy Corp. is an integrated utility (part regulated/part unregulated) that is in the process of disposing of its unregulated generation business, most likely through a value creating bankruptcy restructuring. Gilead Sciences is a research-based biopharmaceutical company dominant in two solid therapeutic categories

THIRD QUARTER 2017

(Hepatitis C and HIV). It trades at an attractive multiple of 8x earnings with a double digit free-cash-flow yield, has a clean balance sheet, and a well-respected management team. We find Gilead’s valuation attractive as we are optimistic on the longer sustainability of the company’s HPC and HIV franchises, and its undervalued pipeline. Trinity Industries is a diversified industrial company with market-leading businesses that provide products and services to the energy, chemical, agriculture, transportation, and construction sectors. After peaking in 2015, railcar industry dynamics and earnings for Trinity are bottoming, and we believe the downside appears limited at this point. Railcar manufacturing and leasing make up approximately 70% of Trinity’s value. We believed there was a substantial possibility that a $600+ million legal judgement levied against the company might be overturned, which in fact occurred after the close of September 29th.

Conversely, Calpine, Microsoft, Phillips 66, and PNC Financial Services Group were eliminated from the portfolio as the stocks approached our price target and we believed the risk reward was no longer compelling. Our position in Bank of Ireland was eliminated as its unsponsored ADR program was terminated due to a technical requirement after a reverse stock split. We are extremely optimistic on their prospects, and will consider re-establishing a position when an ADR investment becomes possible. Finally Brighthouse Financial, a small spin-off from our position in MetLife was eliminated as we did not find the risk reward compelling. ■

This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors.

The statements contained herein reflect opinions of NWQ Investment Management Company, LLC (“NWQ”) as of the date written. Certain statements are forward looking or based on current expectations, projections and information currently available to NWQ and are subject to change without notice. There is no assurance that any predicted results will actually occur. The securities identified herein are based on the institutional representative account, which may vary from securities held in other client accounts. These securities represent relevant contributors or detractors from performance over the period described and include all of the new and eliminated positions purchased or sold in the representative account during the period. Such securities do not represent all of the securities purchased, sold or recommended over the past year and the reader should not assume that the securities identified necessarily were or will be profitable. All investments carry a certain degree of risk of loss and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. There may be specific risks associated with small- and midsize company investing, including potentially increased volatility with smaller companies. Value style investing presents the risk that the holdings or securities may never reach their full market value because the market fails to recognize what the portfolio management team considers the true business value or because the portfolio management team has misjudged those values. In addition, value style investing may fall out of favor and underperform growth or other style investing during given periods. This report contains no recommendation to buy or sell any specific

THIRD QUARTER 2017

security and should not be considered investment advice of any kind. Individual portfolio returns and holdings will differbased on client restrictions, date of account inception, substitutions, cash flows and other factors that are specific to individual accounts (e.g., tax loss sale requests). Accordingly, not all client portfolios will achieve the same results. Holdings are subject to change without notice. Index returns are provided to represent the investment environment during the time periods shown. Index returns do not reflect taxes, transaction costs, investment management fees or other fees and expenses that would reduce performance in an actual account. It is not possible to invest in an index. Statistical data was taken from sources which we deem to be reliable, but are not guaranteed. NWQ’s Form ADV Part 2A is available on the SEC’s website at www.adviserinfo.sec.gov or upon request via email at [email protected]


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