“If everyone is thinking alike, then somebody isn’t thinking.”
― George S. Patton Jr, U.S. General
It’s been a battle for value investors the past several years. Easy Fed policy and macro views have trumped valuations, causing many to hunker down in pricey, low-growth areas. The chase for yield-at-any-cost has tested contrarians like us, and as index funds flows show, many have decided it is easier to go with the masses and give up prospects for outperformance than think for themselves.
However, the challenges have made successes more sweet and each a cause to celebrate. The two-year anniversary of our Mid Cap Value Fund (HRMDX) is an example of a win that deserves notice. We launched the Fund in October 2014* with a straightforward mandate—focus on medium-sized companies and manage it using the same time-tested 10 Principles™ that have defined Heartland since its founding.
We think the results speak for themselves. On a one-year basis, the Fund’s investor class ranks in the 10th percentile by Morningstar out of 466 Mid Cap Value Funds as of 8/31/2016. It has beaten its Russell MidCap® Value Index and continued to perform solidly heading into its second anniversary. The quick start is noteworthy given the Index is loaded with expensive names that have benefited from depressed interest rates. The ability for the Portfolio Management team to produce strong results while staying true to their value roots is impressive!
The success of the Mid Cap Fund is one of several signs that valuations, free cash flow, and quality management may be gaining traction. Performance for the majority of our strategies has rebounded and attractively valued companies in the broader market are beating their growth counterparts. Market breadth is also improving and suggests investors are more willing to take on risk if it is priced right.
Not Everyone Will Win
As fundamentals play a bigger role, passive investors may be in for a rough ride. At 19.4x earnings and 3.3x book value, the S&P 500 seems pricey compared to its historical average. Adding to the nose-bleed valuations is the fact that earnings for the group, as shown, continue to shrink.
S&P 500 Earnings per Share
Source: Bloomberg L.P. and Standard & Poor’s, 12/31/2012 to 9/30/2016
Chart measures the weighted trailing earnings of index constituents.
Past performance does not guarantee future results.
With declining earnings and rich valuations, we believe investors will cast a wider net in search of opportunities and begin to seek the types of overlooked names we have long been attracted to.
This dynamic could spell trouble for index investors left holding a bag of pricey names with weak earnings. Active managers should fare better by focusing on businesses with growing revenue that are trading at significant discounts to intrinsic value.
Although we are optimistic about the road ahead, the transition to a world where valuations matter won’t be completed overnight. Investors remain guarded as they survey the landscape. Here are just a few concerns they see:
Slow gross domestic product (GDP) growth
Inflation simmering below the surface
Rising employment costs
Global and political uncertainty
We share many of the same concerns, yet are encouraged by the number of compelling opportunities out there. Leveraging our thoughtful approach, our bottom-up analysis has helped us unearth niche companies that have unique product offerings or idiosyncratic drivers that should help them thrive regardless of the strength of the broader global economy. We believe this approach syncs well with Patton’s warning about the perils of letting others do the thinking.
We thank you for your continued trust and confidence.