Old-school value investing demands both cheapness and a margin of safety against financial distress. But the hundreds of value funds on the market today have largely suffered in the past decade. Growth stocks have outperformed since the financial crisis, but that’s not the only factor that has held back value funds: Most own hundreds of stocks that either aren’t so cheap or are cheap for good reason.
David Green goes beyond the traditional metrics. “Just looking at a screen gives you only a snapshot that won’t tell you what a company will do in the future,” says the manager of Hotchkis & Wiley Value Opportunities fund (HWAAX). “It won’t tell you what a company’s competitive position is, or if it has some hidden liability. So, each company’s earnings profile is determined by our research team.”
The extra work has paid off. Since Value Opportunities’ inception in December 2002, the fund has dusted its benchmark, the Russell 3000 Value Index (.RUA), with a 12% annualized return to the index’s 9%.
Green’s portfolio is so distinct that it is hard to categorize. It’s the firm’s most flexible, able to invest in stocks of any size, bonds of any credit quality, preferred stock, and even merger arbitrage. Yet it is also concentrated, typically owning 40 to 75 securities.
The fund has already had a home in a few Morningstar categories, including mid value and large value. Last year, Morningstar moved Value Opportunities to an allocation category for funds that can own fixed income and other assets, but have at least 85% in stocks—and it’s outpacing competitors there, too. The fund’s 16% 10-year annualized return beats 98% of peers in Morningstar’s Allocation 85%+ Equity category.
But Green’s focus on value has been consistent; it’s all he has done since graduating from the University of California, Berkeley with an economics degree in 1990. He joined Hotchkis in 1997.
Although Green runs the fund’s day-to-day operations, he has help from his co-manager and firm CEO George Davis and Hotchkis’ experienced analytical team. The firm has 22 investment professionals, and is primarily owned by its employees. The firm is split into six different sector teams; each team peer-reviews each analyst’s ideas before Green includes them in the fund.
“We go where the opportunities are at any given time,” says Green. At the height of the 2008-09 crisis, for instance, Green was investing in merger-arbitrage deals because the big investment banks that normally support such deals were crashing, so arbitrage spreads increased significantly. Today, he has nothing in merger arbitrage.
By contrast, the fund throughout its entire 17-year history hadn’t owned General Electric (GE)—until the fourth quarter of 2018. “Last year, General Electric came under tremendous selling pressure, and now it’s our largest equity position,” Green says. He was willing to take such a risk because Hotchkis’ sector teams analyzed GE’s diverse subsidiaries separately—industrial, financial, energy, and health care.
By breaking GE into its constituent parts, Green realized that the credit risk to the company’s balance sheet wasn’t as great as most investors perceived during its selloff. The appearance of excessive debt was because of its financial-services subsidiary GE Capital, which Green concluded was only somewhat overleveraged, and GE “could easily get that debt down with asset sales.” Indeed, this February, Danaher (DHR) agreed to purchase GE’s biopharma division for $21.4 billion. “That alone gets GE’s balance sheet to a reasonable level,” Green says.
A company has to meet five criteria: The first three are cheapness, financial strength, and long-term business visibility. “So, if we turned off our Bloomberg terminals and came back five years from now, we’d have a pretty good idea of where that business would be,” Green says. That means avoiding companies in harder-to-predict sectors like biotech. The company should also have a history of smart capital-allocation decisions—paying dividends, for instance, instead of making overpriced acquisitions. The last requirement is promising adequate returns for liquidity risks. If a small stock is illiquid, Green requires higher expected returns to include it.
Green’s strategy often involves looking across a company’s capital structure to find the most attractive balance of risk and reward. In some cases, the risk to a company’s stock is too great, but its bonds remain attractive. Bonds make up 6.5% of the fund. “When we buy debt, ideally we’re looking for equity-like returns,” Green says. “Usually that happens if there’s some kind of distress around certain bonds.”
A recent example is J.C. Penney (JCP) bonds. The troubled retailer’s stock is down 60% in the past year. But the 2023-maturity bonds Green purchased at a deep discount to their par value are secured by the company’s real estate—more than 280 stores and distribution centers. “If things don’t work out with J.C. Penney, we own an asset that we think is worth in excess of what we’re paying for the bonds,” he says.
Of course, distressed bonds are riskier than ordinary ones, and investors should think of this fund as a pure equity one, despite its Morningstar category. In fact, the fund’s standard deviation—a volatility measure—has been 18.9% over the past 15 years, versus Vanguard Total Stock Market Index’s (VTSMX) 14.1%.
Though the fund’s portfolio is eclectic, it has 27% in financial services—familiar turf for value managers—including warty holdings such as scandal-plagued bank Wells Fargo (WFC), insurance comeback American International Group (AIG), and Goldman Sachs Group (GS). The Russell 3000 Value Index has a 22% financial weighting.
“Any time you have a relatively concentrated portfolio, you should expect volatility,” he says. “But the goal here is to identify businesses that are creating a lot of value over long periods of time.”
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