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“It requires strength of character in order to think and to act in opposite fashion from the crowd and also patience to wait for opportunities that may be spaced years apart.”
-Benjamin Graham
At year end, based on a historic valuation gap, we professed our enthusiasm for small stocks versus their mega-cap brethren. Mr. Market proved us wrong, with the S&P 500 (SP500, SPX) up 10.6% in the first quarter, compared with the Russell 2000® Value Index, which was up only 2.9%. In the long run, we’re confident a portfolio selected on the merits of low price to earnings and low debt with strong revenue growth prospects makes sense.
Our confidence is couched in classic Ben Graham value investing principles.*
The Value Fund is priced at 12X estimated profits for an 8% earnings yield (calculated by inverting the P/E ratio). According to Graham, to account for equity risk, earnings yields should exceed payouts available in the bond market. Also in our view, the Fund’s P/E is attractive to the S&P 500’s 22X multiple.
Yet investors often overlook opportunities in undervalued parts of the market because they get caught up in popular names that grab the headlines. Thus, Ben believed it takes strength of character and patience to wait for openings that others don’t see.
What might be the catalyst that will shift the spotlight to the value present among small caps?
Small stocks took a disproportionate hit when interest rates began to rise two years ago on the belief that emerging companies rely more on bank financing than blue chips. By that token, they should be early beneficiaries once the Federal Reserve begins to loosen monetary policy, which is expected to start later this year.
These businesses – and the executives who run them – are also out to prove their worth. In the face of low investor interest, we are witnessing a growing number of firms stepping up on attractive valuations by instituting share buybacks. At the same time, insiders at these companies are increasingly buying their own shares.
This part of the market also enjoys another advantage: If investors are concerned about the possibility of a recession lurking around the corner, many small businesses have already experienced a de facto downturn. Their equity prices, on a relative basis compared with S&P 600 companies, are at their lowest levels since 2000, which, by the way, proved to be a great time to be buying small caps (see chart below).
| Source: FactSet Research Systems Inc., monthly data from 12/31/1999 to 3/31/2024. This chart represents the S&P 600 next twelve months relative price to earnings ratio. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results. |
Attribution Analysis & Portfolio Activity
For the quarter, the Heartland Value Fund returned 6.7%, outperforming the 2.9% gains for the Russell 2000® Value Index. Almost all of that was attributable to stock selection, which was particularly strong in the Financial, Industrials, and Consumer Discretionary sectors. Over the past year, the Fund also outperformed, up 21.7% versus 18.8% for the benchmark, again driven primarily by stock selection.
After the market’s recent run-up, the opportunity set doesn’t appear as attractive as it was last Fall, even within the small value universe. There are fewer compelling buys, and we remain focused on a balanced approach driven by a risk-reward mindset.
We continue to focus on taking what the market gives us while waiting for fat pitches to come our way. This quarter, for instance, we started a new position in Chart Industries, Inc. (GTLS). We’ve been monitoring the stock for years and finally saw the buying opportunity we’ve been waiting for. As the leading producer of equipment for the shipment of liquefied natural gas (‘LNG’), Chart Industries sold off sharply on the Biden Administration’s decree to pause new export permits.
We view the pause as a short-term political action in anticipation of the coming election. In any case, GTLS has robust backlogs for the next several years. And if the U.S. truly slows, Chart, an international provider, should benefit as the rest of the world accelerates LNG development.
With an improved outlook due to the growth of a 2023 acquisition and its integration, Chart provides a broad product line across vast global end markets. This includes leadership in heat transfer systems and gaseous equipment used as alternatives to traditional fuels in hydrogen, carbon capture, and water treatment.
Chart’s Q4 was better than expected with record orders and increased sales, gross profit margin, operating income, and free cash flow. Due to above-plan integration synergies, GTLS built cash, paid down debt, and earned a recent upgrade in its bond rating. Now that one third of its revenues are coming from short-cycle maintenance and service, added benefits include higher margins and increased sustainability.
The company guided to another record year. We estimate sales of $4.8 billion, up from $3.7 billion in ’23. Adjusted earnings per share are estimated at $12, versus $6.09 a year ago. Priced at 8.3X estimated EBITDA, a substantial discount to peers, we view Chart Industries as an attractive value.
We believe Chart represents a better opportunity in the Industrials sector than BWX Technologies (BWXT), the nuclear components manufacturer we sold in the first quarter.
BWX was a profitable investment, but two catalysts drove valuations to a level we deemed fully priced. For starters, BWX’s development of small nuclear reactors gained steam, with appeal to Energy sector customers. So, too, did the company’s work on medical nuclear isotopes, critical to healthcare supply and security issues.
We sold the stock, which jumped 33.7% in the quarter, after hitting our price target. At 30X earnings, BWX’s risk-reward proposition disintegrated.
Elsewhere in our portfolio, we added to our position in the consumer health goods company Perrigo (PRGO) in the fourth quarter after its sell off, which was largely driven by troubles in the company’s infant nutrition business.
Last September, the Food and Drug Administration updated guidelines for the agency’s approach to inspections and compliance for infant formula production. This included more frequent cleaning of its facilities, which resulted in slowing output. We see the manufacturing headwind in this space as a temporary challenge. Perrigo, in fact, recently provided an encouraging update on its remediation efforts.
Ongoing progress on the issue should help refocus investors on the positive developments underway. This includes making its U.S. business, which is largely focused on lower-cost and lower-margin private label brands for retailers like Walmart (WMT) and (CVS), more like its European business, which focuses on higher-margin national brands. The good news: It can make this transition while utilizing its existing distribution and manufacturing footprint. Perrigo is also in the process of eliminating unproductive product lines, as more than 1,500 items drive just 1% of operating profit.
Meanwhile, the stock is enjoying considerable insider buying, and we believe it is attractively priced at just 12.2 times earnings.
Outlook
The first quarter demonstrated that investors aren’t quite ready to give up the mega-cap growth ghost. Yet, in our opinion, this does not detract from the historic appeal of small value. The part of the market we have devoted more than 40 years researching has only sold at such steep discounts relative to large caps three other times. The market may not be paying attention now, but we are convinced it eventually will. As value investors, it’s our job to remain disciplined and focused on the fundamentals until that happens. We will continue to use our 10 Principles of Value Investing™ to guide us, helping us find opportunities with low prices relative to earnings and cash flow to create a margin of safety.
Fundamentally and patiently yours,
The Heartland Investment Team
* If you’d like to learn more about the principles of value investing and want a free copy of Ben Graham’s The Intelligent Investor, we would be happy to send you one, until supplies last. Please contact us at 414-977-8746.
Fund Returns (3/31/2024)
| Since Inception (%) | 20-Year (%) | 15-Year (%) | 10-Year (%) | 5-Year (%) | 3-Year (%) | 1-Year (%) | YTD* (%) | QTD* (%) | |
|---|---|---|---|---|---|---|---|---|---|
| Value
Investor Class |
11.21 | 6.44 | 11.57 | 5.89 | 10.00 | 6.74 | 21.66 | 6.71 | 6.71 |
| Value
Institutional Class |
11.29 | 6.58 | 11.75 | 6.05 | 10.15 | 6.88 | 21.86 | 6.78 | 6.78 |
| Russell 2000® Value | 10.52 | 7.47 | 12.10 | 6.87 | 8.17 | 2.22 | 18.75 | 2.90 | 2.90 |
|
*Not annualized Source: FactSet Research Systems Inc., Russell®, and Heartland Advisors, Inc. The inception date for the Value Fund is 12/28/1984 for the investor class and 5/1/2008 for the institutional class. |
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©2024 Heartland Advisors In the prospectus dated 5/1/2023, the Gross Fund Operating Expenses for the investor and institutional classes of the Value Fund are 1.09% and 0.98%, respectively. Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance for institutional class shares prior to their initial offering is based on the performance of investor class shares. The investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than the original cost. All returns reflect reinvested dividends and capital gains distributions, but do not reflect the deduction of taxes that an investor would pay on distributions or redemptions. Subject to certain exceptions, shares of a Fund redeemed or exchanged within 10 days of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual’s return. To obtain performance through the most recent month end, call 800-432-7856 or visit Value Investing Manager Value Mutual Funds | Heartland Advisors. An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the Funds’ prospectus. To obtain a prospectus, please call 800-432-7856 or visit Value Investing Manager Value Mutual Funds | Heartland Advisors. Please read the prospectus carefully before investing. As of 3/31/2024, Chart Industries, Inc. (GTLS) and Perrigo Co. PLC (PRGO) represented 2.00% and 2.39% of the Value Fund’s net assets, respectively. BWX Technologies, Inc. (BWXT) is unowned by Heartland Funds, Inc. Statements regarding securities are not recommendations to buy or sell. Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk. The Value Fund primarily invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies. Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market. The Value Fund seeks long-term capital appreciation through investing in small companies. The above individuals are registered representatives of ALPS Distributors, Inc. The Heartland Funds are distributed by ALPS Distributors, Inc. The statements and opinions expressed in this article are those of the presenter(s). Any discussion of investments and investment strategies represents the presenters’ views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change. There is no guarantee that a particular investment strategy will be successful. Sector and Industry classifications are sourced from GICS®.The Global Industry Classification Standard (GICS®) is the exclusive intellectual property of MSCI Inc. (MSCI) and S&P Global Market Intelligence (“S&P”). Neither MSCI, S&P, their affiliates, nor any of their third party providers (“GICS Parties”) makes any representations or warranties, express or implied, with respect to GICS or the results to be obtained by the use thereof, and expressly disclaim all warranties, including warranties of accuracy, completeness, merchantability and fitness for a particular purpose. The GICS Parties shall not have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of such damages. Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®. Because of ongoing market volatility, performance may be subject to substantial short-term changes. Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time. There is no assurance that dividend-paying stocks will mitigate volatility. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indices. Russell® is a trademark of the Frank Russell Investment Group. Data sourced from FactSet: Copyright 2024 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved. Heartland’s investing glossary provides definitions for several terms used on this page. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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