MASTERCLASS: Small-Cap Investing

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Courtney: Gentlemen, today we're talking about investing in small caps. The Russell 2000 has outperformed the broader index here to date, is it your sense, Craig, that small caps are the beneficiary of this boost in risk assets?

Craig Hodges: I think that's pretty obvious that that's the case. The interesting thing about the Russell, to me is that a lot of the outperformance of the Russell or the performance of the Russell has come out of the utility sector, the Telco sector, consumer staples, really the kind of flight to safety parts of the small cap which typically is not known for, you know, small caps aren't known for flying to safety. But that's what's actually kind of buoyed the index in our eyes. So I don't think that part of it's permanent, I think as people become more ... less risk averse that other segments of the market will outperform.

Courtney: Alright, so when things go risk off. Andrew, what's your sense of the opportunity set in small caps right now?

Andrew J. Fleming: Well, in the first quarter it was really a risk off, this abated a bit in the second quarter. And the third quarter it's been much of a tailwind. This is a positive and it's great to see. But at Heartland it's not something that we're going to be reliant upon. At Heartland you won't find a portfolio comprised of companies that are reliant upon cyclical growth. Are really comprised of companies that are reliant upon company specific catalysts, so while risk on is great to see, it's not something we're really relying upon.

Courtney: Alright, so company specific catalysts is where you're looking. What about you, Chip?

Chip Rewey: Well, it's been quite a year. And then we came into the year expecting 2%+ GDP growth and a bunch of interest rate increases out of The Fed, only to all have all that shattered and a pretty strong selloff in the Russell to begin the year. And then with the Brexit which caught everybody by surprise and the promise of more QE by just about every central bank around the world. We've seen interest rates fall and we've seen REITs and utilities really accelerate. And I think that demonstrates that we wouldn't have gotten that forecast right if we tried. At Third Avenue we don't start with the macro, we start with the balance sheet of companies and the ability to outperform and have durability across the cycle. So despite tremendous underweight to REITs and utilities, we've outperformed this year and we've been able to buy down and sell high, so we've taken advantage of some of the volatility.

Courtney: Bill, what do you think?

Bill Hench: I think you were set up this year for a very good performance year for small cap especially on the value side. We trailed miserably for about a year and a half/two years growth hadn't had such a performance edge versus value since 99/2000. So you had a lot of cheap stocks and you had on paper what was, you know, a pretty nice scenario. You had low interest rates, you had very, very low commodity prices, you had employment improving, a strong auto market and a strong housing market. If you just knew those things intuitively you would think that small caps which predominantly have all the revenues and earnings in the US would do well. And I think we're seeing that now.

Courtney: So it sounds like interest rates, you know, one way or the other are a big topic for small caps, is that fair, Craig?

Craig Hodges: Not to us, it's something that we don't even really think about. We're very bottoms up focused. We're looking for companies that are having extraordinary growth in industries that have very high barriers of entry. And you know I don't think that a move in interest rates one way or the other isn't necessarily going to make or break the investments that we're making. So, you know, we focus just on companies and just let the things we can't control, just let those happen.

Courtney: Alright.

Bill Hench: You know, the myth that small caps can't do well if rates are rising, you know, just seems to be repeated every time there's a hint of a change in rates. And while a lot of our companies do survive well, bank debt, most of the companies that I talk to anyway, and maybe my colleagues will back this up hopefully. You know, most companies will trade off paying more for money if it means they're going to do more business, right. You should be making a bigger spread on your margin versus what you're paying to borrow money. So I agree with Craig. I don't really spend too much time worrying about where rates are when you have companies performing as they should be.

Chip Rewey: And I think it's the ... it's how we have taken advantage of the rate cycle; again I don't think it's predictable. I don't think that's any part of our philosophy, at least to start and trying to predict rates. And I say economists have one yearly forecasts and 51 weekly revisions. So I don't think you can plan your portfolio for rates anyway. But you know, I think rates have driven up the REITs and driven up utilities. And we've been selling REITs into this rally. And now we own zero utilities. And we've been redeploying in the new sectors that are unloved as a result, taking advantage of that volatility as we look forward for the next 3 or 5 years. So without trying to predict the macro I think you have to think about what's going on in the market and how you're managing your portfolio, both on the investing and the harvesting side.

Courtney: So still being aware of what's going on with the macro, but it's really a bottoms up process. And tell me a little bit more, Andrew, about, you know, why in this market, why small caps?

Andrew J. Fleming: Well, right now you're seeing a very volatile market. And in volatile markets we think you want to be nimble. And small caps generally speaking are more nimble than large caps. An example of this would be an ingredient company in our portfolio, it's employing a strategy that we call self help, what that means is they're aggressively taking costs out, cutting costs, firing unprofitable customers, and raising prices where able. A larger cap company couldn't do this as fast as the company that I'm talking about can. And that's the advantage of small caps right now, being nimble.

Courtney: And you mentioned volatility, Chip, what's your sense of how volatility plays into investing in small caps?

Chip Rewey: So I think the first thing you have to think about is starting with a strong balance sheet, which we do. And I think that's a big differentiation of our strategy at Third Avenue is starting at the balance sheet, looking at low leverage and looking at a strong asset base that you can earn off of, can really compound that growth for the next 3 to 5 years. And so you start with defense. And so when volatility shows up and there's fear in the market and things sell off, you're a happy buyer, you're a enthusiastic buyer of things down. And so that's how we manage volatility and we manage risk. Conversely, when volatility gets to be risk on in a period like we are now we have a solid estimate of what a fair value of our companies are. And we have a disciplined portfolio management process, well, we'll harvest and we'll sell the things that are overvalued and redeploy. It sounds simple, but that volatility exists and we tailor our process to take advantage of it.

Craig Hodges: I think one reason why small caps is, the large caps have basically what their form of investing for the last 5 to 10 years is stock buybacks. They've been doing very little investing in plant and equipment and future, you know, earnings possibilities. So we're in a low growth environment. And they're going to grow extremely slow. So how do they get growth if they haven't been investing? They're going to need to acquire growth companies. And that's, I think that's one reason why small caps are attractive is because you're going to need to see large companies finding growth. And I think they'll do that in small caps, plus the fact, when you're investing in small caps, you're going to get a lot less currency risk, you know, there's a lot of those kind of things, it's upset people in the market, you know. And there's a lot less European exposure, you know, we've seen, you know, with stuff with China and all the Brexit stuff, that can really hurt stocks, well that's minimized in small cap investing.

Courtney: Because most of them are just US centric?

Craig Hodges: Yeah, yeah, most of them.

Bill Hench: I mean, we've had ... I run a very, very diverse portfolio. So we have over 200 names and we've already had 13 companies taken over this year. And it is, as you said, about getting growth, and it's also the fact that they're cheap. And they're cheap because they were not part of a momentum cycle, which was even more pronounced, I think, than growth last year. And as such you have these, you know, terrific assets out there that you could get for a bargain. And obviously if someone's giving me 20 or 30% more than the stock was trading for yesterday, they're not being nice, they know it's worth 40 or 50% more. So if the valuations are there you're going to have a lot of M&A.

Courtney: So we are seeing a lot of M&A, more so than last year?

Bill Hench: I think dollar wise it's probably down. But last year it was skewed toward bigger deals, bigger companies buying bigger companies and a tremendous amount of private equity to private equity transactions.
Craig Hodges: I think it's a pin up situation as well like we have mentioned. There hasn't been a lot of investing by the big companies. And so at some point if they want to keep their jobs they're going to need to grow, and where do you find growth? It's with the smaller companies.

Courtney: So less stock buybacks will probably be...

Craig Hodges: Probably less stock buybacks on the large end, but probably more acquisitions as we go forward.

Andrew Fleming: Yeah. You're not going to really try to take a private equity approach to the public market. So we're very cognizant of all the deals that are going off. And we mark those down as a gauge of what intrinsic value is, using the EBITDA multiples of takeouts. So it's a very important part of our process, we're not relying upon that when we're making an investment, but it's a very good gauge of what intrinsic value is.

Chip Rewey: And we'll look at the potential for being taken over a small cap company. Again, that's something small caps have that are probably more unique than large caps, you get these 20/30/40% takeover premiums. And you typically see a few every year, even in our portfolio, which is 55 to 60 names, relatively concentrated. We've already had two this year. But we look at the asset value, again going back to the balance sheet and what's it worth. And we factor that in to our downside protection, this franchise is valuable, doesn't matter where the market is marking it today, it's what it's worth. And so that's obviously conviction back to volatility to buy down if the market doesn't want to own it today, this week, this quarter, we can buy it down knowing that the market will cycle back around to strong assets and a strong outlook.

Courtney: Are there any other opportunities that volatility is creating in this space?

Chip Rewey: Well, we've, as I said taken advantage of trimming even more of our REIT exposure, into strength, I think cap rates are very, very low and these companies are fairly rich, if you looked at them. Clearly we're not deploying new capital there. And coincidently we have picked up three names in the consumer sector over the last quarter, over the second quarter. And I think that's a result of where markets were fickle and where markets were moving away and where we saw the opportunity. Now, one was a restaurant, one was a home builder and one was an apparel manufacture, they have nothing to do with each other, but they all had net cash or less than one turn of EBITDA. So we did see the opportunity to look forward a few years and redeploy some capital there.
Courtney: Is your sense Craig, that small caps are range bound at this point? And if so, what opportunity might that create?

Craig Hodges: I don't believe they are, you know the unique thing about small caps, it's the most inefficient and the most volatile. And at Hodges Capital, what we try to do is just try to be opportunistic, for example, just to give you an example, you may have seen in the news, where these private prisons have come under some government, maybe getting out of that. We followed those stocks for 25 years. We knew exactly what percent was that part of the government that they were talking about. They cut those things in half on Thursday, we made a lot of buys on Thursdays and Fridays, and we've already gotten a really nice bounce. So you use the volatility, you use the lack and depth of markets for our good and, you know, that's what kind of we're assigned to do. It's hard to say the market's cheap; it's hard to say it's expensive, but be opportunistic, and that's kind of what our focus is.

Courtney: And you mentioned inefficiency, how do you use that when you're selecting stocks?

Craig Hodges: It's part of the business and, you know, when market making became a non-profitable venture for a lot of firms, and they took away that incentive, markets became very thin, and that's when you saw, you know, like a lot of the retail or a lot of the wirehouses get out of the selling of REITs or just small cap just because it was no longer profitable. That created tremendous opportunities for us, 03 was a tremendous year for small caps for that very reason. And it remains today; we have about 15 small cap firms that give us research. We've had four of those go away this quarter, when they just got out of the business, it's not profitable. So there's less and less people doing what we are doing and that excites me from an opportunistic point of view.

Courtney: Interesting, so the diminishment of sale side research is actually an additive for you?

Craig Hodges: We look at it that way.

Courtney: Interesting.

Bill Hench: Right, what you'll find is most of us probably do a lot of our own work. And it's now becoming an ever bigger portion probably. But you could also add the fact that so much of the money in our cap range has become passive. And it's very easy for people to position themselves, if they call it that, day in and day out. And you're getting a lot of opportunities, and you could call it volatility. But in point of fact you could wake up one day and all of a sudden the healthcare stocks could be for sale, whether good news, or bad news, or no news at all. And if you happen to be in the market for that, and you're buying it, you're getting a discount, you know, you're getting the opportunity to buy it at a better price. And conversely, if everybody wants to buy healthcare and you're selling it. So it's another entrant, it's another little change to our market. In 08 and 09 I think we had a fair amount of hedge fund activity, where you saw a lot of players in that area from the hedge funds, they've left us. Now we have the ETFs, and I'm sure 4 or 5 years from now, if we're all sitting around here there'll be another part of the market that we didn't think about, that's crept in and given us an opportunity.

Chip Rewey: Yeah, that's why small caps are exciting; it's this factor of more money going passive, so less active research. And in small cap there's always an aura of neglect, companies are so small nobody really knows what they do, don't recognize the name, they're not household names. And so that causes undervaluation in and of itself. So you match those two and you can really do some original active research, know your companies deeply, start with the balance sheet, really know what the assets are and what they can earn over an extended period of time and differentiate. And so when you do have runs, you can pull a little off, and when you do see opportunities and things sell off, you can deploy capital there. Be a patient buyer and it's a fun space to be in. And I think the more money going passive actually sets up active better to outperform, so we can't be a little bit more ... we can't be more [inaudible].

Craig Hodges: I don't agree with that. And in fact we have a whitepaper out there, it says thank God for ETFs and it's ... I don't know about you guys. But that's the question I get the most, is why shouldn't everyone just index? And because historically, you know, and we're talking about the last 6 months or 2 years or whatever, it's worked. Well, that pendulum swings both ways. And the fact that you're seeing less and less bottoms up stock picking excites me tremendously. I know that that's where the opportunities will be, because if you have totally correlated investing and you have good stocks or good companies and bad companies, they should not be correlated, there's a lot of mispriced stocks out there.

Andrew J. Fleming: And I agree with what Craig was saying about the sell side firms going away, it really makes an already somewhat inefficient market more inefficient, so that just presents more opportunities for us.

Courtney: So you love inefficiency ... inefficiency is what you can capitalize on.

Andrew J. Fleming: Exactly.

Courtney: And is your sense that this market in particular, aside from the, you know, the secular trend of the emergence of ETFs, is this market more right for active management just for fundamental reasons, you know, the whole trend of the rise of passive investing?

Chip Rewey: Well, I think ... I'm not sure people have really thought through what the benchmarks are and what passive means. Because it doesn't cut your risk of underperforming, it cuts your risk of underperforming versus a benchmark which was not created by any sort of investment committee. And I don't know who would really want to be allocating a lot of capital into REITs and into utilities here, given evaluations and where they are. So again, being active and being our focus, we're focused on absolute returns and outperforming for our clients. And so the benchmark is what it is, and we're aware of it. But there's a lot of things in the benchmark that don't make any sense. They'll talk about industrial stocks, but we'll break that down in our portfolio and think, well that doesn't really mean anything. What's more meaningful is if I have an aircraft engine supplier, a hotel company and a car rental company, and a restaurant. I have big travel exposure in my portfolio, how do I manage that? How do I mitigate it? And how do I structure my portfolio to survive volatile periods with that exposure? And so when you think of industrials or consumer or even financials if it's a hotel REIT, that's not going to tell you about risk and how your portfolio is set up. So that's why active is exciting, you know what you own, you know how they correlate. And rushing to these ETFs and being a closet indexer, only protects you from underperforming your benchmark, not underperforming and clearly it doesn't help you outperform in an absolute sense.

Courtney: And active management just goes to the point that, you know, a lot of people are trying to avoid closet indexers at this point like you said.

Chip Rewey: Absolutely.

Courtney: Bill, is it your sense that small caps are going to outperform the rest of the year and next?

Bill Hench: I think it's easy to create a scenario where you could continue to see strength in small caps, and outperform this year and into next year. Precisely because of what we've all been talking about, right. You've got a friendly interest rate environment, even if there are a couple of increases going forward, you've got great commodity prices, despite complaining, employment gets better, housing is good, autos are good. And most importantly, if you've been buying these things over the last year and a half you've gotten some great prices, right. So the performance you're going to get today and next month and into next year isn't necessarily about what you're doing today or tomorrow, but rather what you did last year. So if you're able to accumulate these things at good prices you should be in a position to, I think, outperform if you throw in a little bit of, maybe a better than expected surprise from overseas, it could be even better. Don't forget you're [inaudible] against if you, you know, everybody likes to say big cap, small cap. Most of the big cap stocks that I look at are rich and a lot of them are rich because of interest rates. A lot of companies that are growing 5-10%, where the buyback is accounting for half of that, you know, trading in the 20s and even 30 multiples. So to come down in our world where you see much, much lower PEs, it doesn't mean they're going to get a par with them, you can easily, I think, project some pretty good performance going forward.

Courtney: Bill, we actually have a chart that will show. So this is the Russell 2000 and you can see the index price PE versus just the price in the white. And this is from 2011 until today.

Bill Hench: Okay. So depending on where you go in the Russell, the PEs are going to tell you a different story. So I can sit over here and tell you whatever you want to hear. I could tell you that last year things were good for the Russell because the Index did well. But when you looked at what happened you saw biotechs or REITs and maybe utilities. That was the whole thing. So what do you want me to tell you about the PEs from last year? What do you want me to tell you about the PEs for this year? I could show you the semiconductors and the semiconductor capital equipment names that are trading at 10 and 11 multiples and say they're really, really cheap. So to pull out a chart, I can make it say what ever you want, I think personally, and what our work tells us is that as always there are places we don't want to go because they're a little expensive. But if you look at things like industrial America and you say what are the PEs? Well, maybe they look expensive. They do, but that's only if you think that energy's going to get cut in half again or if you think that the dollar's going to go up another 25%. So a picture like that can tell you whatever you want, personally we think that PEs are pretty reasonable for the names that we like to traffic in.

Andrew J Fleming: Yeah, I think an interesting point here is a lot of investors are looking for the same things right now, they're looking for low beta, they're looking for low volatility, they're looking for momentum and high yield. So, that's caused some really crowded trades in areas of the market that my colleagues alluded to earlier, REITs, utilities, staples. So those are areas of the market that have very frothy multiples right now, and we think right for a correction, interest rates could be that catalyst to cause a correction. But even without, you know, rates rising, the risk reward's simply not there in some of these more defensive parts of the market because of the reason we just talked about.

Courtney: So the defensive part of the market looks a little bit richly valued, but even widening the aperture in general, the large caps look more richly valued than small caps, is that fair?

Craig Hodges: I guess, I think it's fair, you know, we see it a little differently. You know, one thing that no one really talks about is we've actually seen about 9 years of market coming out of US stocks, meanwhile the market has gone up in the face of that. I mean this is one of the most underinvested stock markets I've ever seen, but yet it continues to. So the pendulum will swing back the other way. My assumption is, is that when rates start going up and you've had, you know, trillions of dollars come out of stocks into bonds and bond funds that that's going to be very ugly at some point. And where does that money go? It has to go back into US dividend paying large cap stocks, that's … but we don't do that, that's not our core competency. That's where most likely you'll see multiple expansion for probably a 5 year period of money going the other way, that will create opportunities in small cap, without question.

Courtney: Especially with interest rates so low, people are looking for yield.

Chip Rewey: I think you use a nice term, widening the aperture. And I think that you widen the aperture and you're patient. And I can remember really selling a lot of my tech stocks in 1999 because they were dramatically overvalued. And it was a tough year in 2000 and in 2001 you were a hero. I sold lot of my banks in 2005 and 2006, and you didn't really get that payoff until 2007 to 2009. So you have to have conviction. You have to have a long term timeframe. And you have to widen the aperture. And so although our benchmark is the Russell 2000 Value, about 45% of our stocks and dollars that we own are not in there. And so we're starting with a playing field of somewhere around 4,000 stocks, and trying to select 55 to 65, so when we talk about the market and the chart, it's a little less relevant because that market and that chart is not a good substitute for what our portfolio is. We're concentrated, we have high conviction, we'll buy our names down and we think they have a great asset base to grow off for 2-3 years. So really just approaching it differently, I can't predict the macro, never gotten it right, never going to try, so you know, just focus on fundamentals.

Courtney: Andrew, what's the relationship between dividends and capital allocation?

Andrew J. Fleming: Well, we think dividends are a very important component of capital allocation. And the reason that we like dividend payers is it really served as a governor on capital allocation, and we believe it forces capital allocation discipline. [Inaudible] they have to cover that dividend first; they're going to be more prudent when allocating the remaining capital. As a result we think they're more likely to invest in the highest return investments when they have to cover that dividend.

Courtney: So you're looking at companies that really hold that dividend sacrosanct?

Andrew J. Fleming: Correct.

Courtney: Let's turn to the approach, Bill, what's your approach to small cap investing?

Bill Hench: Sure. Well, we start out with the premise that if you're going to traffic in these things, you need to get paid for it, because they're riskier by nature, there's a liquidity risk, there's financing risk, and most importantly there's management risk. And most of our companies have wonderful management teams and we love all our companies, and they do a great job. But they're thinner, they don't have a backup. If we lose a CFO, a Head of Research, a Head of Sales, it can set them back a little bit. So you want to get paid for that risk. So what we try to do is get very, very, very low prices. I like to buy our assets as cheaply as we can. It takes us a long time for these things to get to valuations that we think are fair. So we're really buying turnarounds. We're buying asset plays and buying companies that came public at a nice lofty evaluation that had pulled back and still are growing, but maybe in the short term are having some problems. So we like to buy things that are very, very cheap. And we tend to hold onto them for a long time as they fix themselves. Because what we found over a really, really long period of time is that if you could buy these things when they're either not doing well, not generating a lot of cash and sell them as they start to generate significant cash, you tend to get a lot of the stock's performance.

Courtney: So what time period when you mention that?

Chip Rewey: Similar, and I think I have mentioned our philosophy. We start with the balance sheet and really focus on credit worthiness, making sure we're not in a situation that's too levered, because you do have the bumps that they'll reference. And you do have the bumps of the market, so you have to make sure you're not going to be a forced seller of assets or be forced to come to the debt or equity markets, and that can really destroy value. So you have to start with a strong balance sheet and then you move to the assets. And you have a strong asset pace that can grow. And I think it's funny that a lot of value investors kind of fall into the value versus growth. I want to own companies that grow. I don't think value and growth are antonyms. I think they are complementary and any great value investor talks about compounding over time. So we look for companies that can compound and grow. Then the key is that discount, you need 30% plus over a 3 year 3-5 year period is what we look at. Again, we'll hold them longer. We like to hold them longer. But we will sell and we'll at least trim in the strength into our fair value.

Courtney: That's really interesting that you don't see growth in value as antonyms. Andrew, what about the balance sheet, what role, we've heard about that a lot about from Chip, what role do you think it plays in fundamental research?

Andrew J. Fleming: Right. It's vitally important, similar to Chip; we take balance sheet analysis very seriously. And what we're doing when we're looking at balance sheets, we're really trying to think like credit analysts. So we're focused on leverage ratios, interest coverage ratios. And more big picture, when we're thinking about a company we're really putting its risks into two buckets. We're really thinking about operational risk and financial risk. And through our credit analysis we're really trying to remove financial risk from the equation. That's evidenced in the leverage ratio of our portfolios, for example, our portfolios, you know, approximately 75% lower than that of its benchmark right now.

Courtney: Wow! What kind of leverage ratios are you looking at?

Andrew J. Fleming: We're looking at net debt to EBITDA.

Courtney: Let's talk about portfolio construction too, that's another big part of it. And what's your sense? I know you're pretty concentrated, Chip, about 55 names.

Chip Rewey: 55 to 65 names, a little closer to 60 today. And again I think it's looking at those, what I would call correlations within the portfolio, when you think of how to manage your portfolio, you have to understand your risk. And the benchmark, albeit a financial, it is a REIT, the same thing as an insurance company, but they're financial. So you can't really look at the benchmark headers and say, "Oh my gosh, that's my risk." You have to think about how you're deploying capital and how they correlate to one another. And especially I think you have to be disciplined on position size, not only on harvesting but buying. When you get the chance and you have a well funded company with a good growth outlook and you have the discount, you have to have the courage and the conviction to buy 2/3% in a small cap portfolio, and that's how we can get concentrated. And that's how we can get the outsized returns over time.

Courtney: That's very good, that absolute return. Where are you seeing growth and value opportunities, Craig?

Craig Hodges: You know, we start with kind of the industry. We love industries that have high barriers to entry; every big mistake I've ever made in this business is getting into overly competitive hard areas. And so we love the ones that are hard to get into. And we're similar; we've more of a concentrated portfolio. We have anywhere from as many as 90, right now we're probably in the mid 60s. But we do something that's a little different; I think when the market advances and does well we tend to spread out, our names go more and then when the markets are tough we tend to go more convicted into our most convicted names, if you will. But right now the opportunities I see, the greatest opportunities I see are, you know, everyone knows what energy has done, it's basically cut in half in the last couple of years. And it's created a lot of opportunities in energy stocks. But even more so, companies that aren't in the energy business that are related to the energy business like a United Reynolds which sells equipment or leases equipment, or like a [inaudible] Inns which has 25% of their hotels in Texas, it's gone from 25 to 10, or a ClubCorp, same situation, 25 to 10 on their exposure to oil areas and stuff. You know a lot of cement names in that part of the country have really come down and created opportunities. So that scenario, you don't have to have oil go back to 70 or 80 to make money, if oil just stays here they'll do fine. And so that's the part of the market where I think we see the most opportunity right now.

Courtney: That's interesting. And what were the high barrier to entry markets that you were referring to?

Craig Hodges: Yeah, you know, things like cement, it's virtually impossible to create a cement company, steel is the same way, corrugated paper, it's very difficult to get in that business, even the airline business which used to be not high barrier entry now has kind of been right size. You'd have to have the fuel efficient planes in order to compete. And so we love those industries where they're hard to get into and the existing participants in this next demand cycle will do extremely well compared to the last one. So those are the opportunities we see.

Courtney: And, Andrew, what are your views on energy?

Andrew J. Fleming: We're generally constructive on energy. We're not trying to make a call on energy or where oil is going to be at the end of this year. But the self in this space has presented a lot of opportunities. But when we're looking at these names we're very laser focused on balance sheets. So we're looking at companies that'll be able to survive in downtimes and hopefully thrive in good times. But having a nice balance sheet and being a cheap stock isn't enough, there has to be some sort of value proposition there as well. An example, a couple of names in our portfolio, the pressure pumping services space, this is a space that's been really neglected over the last few years, really starved for capital. The couple of companies that we own have maintained very strong balance sheets and have actually been reinvesting kind of cyclically in their fleets during this time. So as they stand today, this space has been starved for capital, capacity has come down by, you know, approximately 50%. So they stand to potentially gain market share and actually raise prices as demand picks up.

Courtney: Interesting. Focus on the balance sheet there. Bill, what sectors do you like right now?

Bill Hench: Oh! We have had our most success with non-residential construction. And I think there's probably still more room there as no matter who wins the election is going to have a little work to do to get the country back in shape. We're also involved in residential construction; we've started to buy some energy as well. And we tend to go name, by name, by name. So a lot of what we've been doing lately are buying companies that have come public in the last three years, that are selling below the price, their IPO [inaudible]. They tend to be extremely well funded having just come public with lots of cash. But perhaps they reported a number that were slightly disappointing; the buyers of those companies tend to have their disciplines too. And when that happens they tend to all run at the same time and are sort of left in a nowhere no man's land. So we've been taking a lot of advantage of that. But ours is an approach which is name, by name, by name, our sector bets just come out of the fact that a lot of companies in the same sector tend to get the same attributes.

Courtney: So it's a byproduct, would you say the same, Chip?

Chip Rewey: Exactly. I think when you do have so much money being run passive, you do get that, oh my gosh, let's sell consumer and let's buy REITs. And so even a lot of consumer names might not relate to each other, so we were able to buy a restaurant, we were able to buy an apparel manufacturer. We're also able to significantly increase our position at Home Builder, WCI Communities, 100% in Florida. We Are buying it at 80% at tangible book, it still trades under a tangible book, but not Miami, their second home, inactive adult move up, cash buyers, normally less than 40 times leverage, so you don't have financing problems. They're not in tourist areas, and this population won't be affected by a Zika scare because these are retirees by definition, they're older and they wouldn't have the worries that would be associated with that. So it's the state that people want to go to, no income taxes and the demographics in our favor is as you've seen, the statistics for this country, people are going to be retiring and they want to go where it's warm. So we think we're set up. We think it's cheap now. And we think the growth outlook looks fantastic over the next 3-5 years. And we're getting that 30, actually we think 50%+ discount here. So excited about things like that, make it a concentrated position, good downside protection, have that discount. All brought to us because somebody didn't want to be in consumer.

Courtney: Interesting. Interesting byproduct, and WCIC as you mentioned is taking advantage of a lot of secular tailwinds that you mentioned as well as they have a very robust balance sheet.

Chip Rewey: Yes.

Courtney: Andrew, should investors be looking at defensive areas right now?

Andrew J. Fleming: We think not, as I allude to earlier, the most defensive parts of the market have become very crowded right now because people are looking at those factors I alluded to earlier. People are looking for high momentum, low volatility, low beta. So for that reason, these little pockets of the market have become very inflated, [inaudible] valuation wise. So the risk rewards are not there in our opinion.

Courtney: And you mentioned a few scenarios, but any other areas where you're still finding value?

Andrew J. Fleming: Yeah. Well, we'll go to where the value is and let the company specific catalyst drive us there. But lately we've actually found some value in some kind of non-traditional value sectors, that being IT and even healthcare. Most people would say healthcare's a pretty frothy evaluation place. But I'll give you the healthcare example, and this is another self-help story where new management is coming in, really focused the company, you know, they have now core and non-core parts of their business, they're going to milk the non-core parts of the business for cash, plug it into their core business which is higher growth, higher margin. As a result of this, returns on invested capital should be up. And we think the stock has a nice runway moving forward. So again that happened to be a healthcare company, but it's really the company specific catalyst that's driving us there.

Courtney: And do you see any sector biases inherent in value investing?

Andrew J. Fleming: I think that is the perception. But at Heartland we really go to where the value is and let those company specific catalysts drive us there. Again, we're not relying upon cyclical growth. We're relying upon company specific catalysts.

Courtney: And, Craig, give us, just round out this picture for us with, you know, when you look at the broader opportunity set in sectors.

Craig Hodges: More opportunities than there is money out there. I do believe, that's the beauty of small cap investing is there's always something emerging, always something new that's out there, new emerging companies and such. And so we have seven analysts that make about 3,000 company touches a year. They do nothing but give as much information as they can, good and bad. We want to know the short story on all these names and know it from that standpoint. But once we get a feeling for good management that are doing the right things that are not playing defense, they're actually being aggressive and allocating capital in the proper way, that's when we will be comfortable with a name. And there is a lot of that out there, especially with the volatility that we see in the marketplace.

Courtney: So a huge opportunity set with a lot or runway. You mentioned secular trends, especially with WCIC and the rise of the baby boomers, Florida. What other secular trends are you seeing, particularly with regional banks?

Chip Rewey: Regional banks are in completely the opposite position than they were in 2007 and 2008. Today they have excess capital mandated by the government. The government won't let them dividend it out and won't let them buy back stock. In 2008 they were all short capital, they all had bad loans and they were mis-positioned. And in a bank, capital is everything, that capital goes away, you're finished. It's not like you have a factory that you can take down to one shift or shut for a couple of weeks, it's when it's gone it's gone. And so today you have banks that are overcapitalized, lots of cash there. There's not a lot of loan growth, they can't dividend it out. And then interest rates are extremely low. And so that excess capital is not earning a lot. And then you get the short term impact, and we talk about short termism a lot, earnings don't look so good, their ROEs don't look so good today. Well, if you normalize interest rates and you think the economy is going to grow over time and they can deploy their balance sheet, their loan growth and eventually return a lot more of their capital to shareholders, you have tremendous forward earnings power. And we have banks in our portfolio, at 1 times, 1.2 times tangible book. And in the past they have been 1.5/2 in growth periods. So if you have a horizon, 3-5 years, I don't know what the next rate hike would be, September, December 2018, it's within our horizon and we do think we have growth and we have that downside protection to wait and be patient. So we're seeing a lot of exciting things in boring little banks.

Craig Hodges: And I'll mention there too also that the Texas banks have acted like oil stocks basically. And you know, even probably your most exposed Texas bank probably has 16%. The ones we own which are like Legacy and Independent Bank, they probably have less than 5% of their loans related to the energy sector. But yet, they've been cut in half.

Chip Rewey: And one of the positions we added was Southside Bank, yeah, it's no energy exposure and was thrown out with the Texas Bank play, and we've added to Cullen/Frost and Prosperity, good healthy long term growers that were thrown out when people just wanted to short Texas banks on energy and didn't really do a lot deeper work to understand the credit quality and the underwriting standards.

Craig Hodges: I think the market was saying that this was the 80s in Texas all over again with real estate and banking and just every industry going up in flames. And you know, that is a very diverse economy now and Dallas is probably less than 5% energy. Houston's still pretty dependent on energy. But that's a big misconception and there were, you know, real opportunities in those names.

Courtney: But your sense is the credit quality there was Pristine?

Chip Rewey: Pristine is an absolute. In a bank like Southside that had Dallas and Austin, no real energy exposure at all, less than 1%. And at Cullen/Frost there was more energy but they wrote to very low loan to value ratios, very secured with higher quality companies, and that was discounted; the risk was more than discounted. And the market valuation had come off the stock when we added. And so there wasn't an insolvency issues that wasn't really even an earnings issue. But you got a chance to really buy into franchises on fear. And again this fear and neglect can create an opportunity, if you start having a good pile of assets that you're happy to buy down.

Courtney: What about, I know you like some of the retailers, Craig?

Craig Hodges: Yeah. Well, my favorite idea right now is JC Penney's and people kind of scratch their head. Isn't Amazon killing them and aren't the malls and department stores in a tailspin? And yes, but the JC Penney's thesis does not depend on them even increasing market share or they made such gigantic mistakes that just the low hanging fruit, the refinancings and the selling of their headquarters. And they'll be able to, you know earn a billion dollars EBITDA this year. And you know, that stock probably has the chance to earn $2 a share, we think, over the next couple of years, the stock at $10, I think that can be a mid $20 stock. And the new management team has like I mentioned, very low hanging fruit that they can do. They don't necessarily have to, you know have a big demand or have a bunch of people come back to their stores. It's all stuff that's pretty easy. And it's got a 28% short position, which that excites me as well. So I think people are kind of broadly shorting department stores and retail. And we'll take advantage of that because that's about as sure as a turnaround as I've ever seen. And we're on the very, very early innings of that.

Courtney: How long do you think that runway is though, with, as you mentioned, the shift away from the brick and mortar stores and millennials being less?

Craig Hodges: It's here to say, but there's still a segment of the population that needs to go to the store and try it on, that just doesn't trust you to mail it to you and then hope it works. And so and they're doing a lot of things. They're getting into some new areas like the Sephora kind of make-up parts. And they're taking part of their business and turning it into appliances. You know, we've had a lot of executives come over from Home Depot, and I've been really digging in on this name and it's one of the best turnaround situations I've come across in a long time.

Courtney: Interesting. And we've mentioned turnaround situations before as well. That seems to be a common theme within small caps.

Bill Hench: Well, if you think specifically about the environment we've been in with low growth, how do you take that dollar of revenue that you have and get an acceptable margin on it. And that's why you see all the new management teams, you see all the restructurings. And that's where most of our performance has come from this year, the turnarounds, because you're not going to get 10% revenue growth, 15% revenue growth, unless you're really either a new industry, you've got some dynamic new products. So the bulk of the companies out there be it in growth or value are not going to have tremendous revenue growth. So if you're a JC Penney or you [inaudible], if I can only get the margins up to mediocre from where they are now, you know, that improvement is terrific. And so that's going to be a recurring theme until you see growth come back significantly, and I mean GDP growth on a global basis.

Courtney: Okay, interesting.

Chip Rewey: I think, you know, we do look at turnarounds too. But I think another area we found value is where managers are managing the business. We haven't talked about it but there's a big move in this market for activist investors. We like our CEOs to be internal activists and look at the environment where they are now and think about what has to happen in the company to be reshaped and reformed and turn around before things get bad and how to outgrow. So you know, whether it's through acquisitions, you know, we own a company, I mentioned, an apparel manufacturer, that's been taking in license of women's brands, it's G-III apparel. They've done well with the Calvin Klein brand and now they're taking in the Tommy Hilfiger brand and also the Donna Karan brand. So they have their own brands and they're not only selling to the old bricks and mortars people but they're selling to Amazon. And we like it because they're almost creating content, distribution channel agnostic. So whether it's going to be bought over the internet or be bought in the store you're going to be buying the goods that are produced by this company and by owning more of their brands, controlling more of their brands they can do that. And so having that management team with the vision to grow and to position themselves, it's just as important as being with the management team that's coming to clean up the mess of somebody that didn't have that vision. So we think strength of management is very important.

Craig Hodges: That's interesting, we're in that name as well. And it's a great example of people not understanding specific names. They made an acquisition recently that the street perceived as very expensive. But their game is taking these older brands and remarketing them in their way. And it's a great acquisition for them, but the stock has gone from 70 to, you know, the low 50s, it's now moving back up. But I think that's a and we want to be very company we don't want to own retail. We want to own the niches of retail that are working.

Chip Rewey: A perfect acquisition, when they announced Donna Karan, the stock pushed to a new low, we were able to buy a lot. And it's recovering, it might take a little while, but it's within our horizon. So that's what you have to look for, and again, have the the good management team were still there and the rationale was sound, investors didn't like it for whatever reason.

Courtney: And you mentioned that, Chip, you know, you're looking for companies with good management teams who aren't going to have the [inaudible] Connor, Eddie Lampert calling them up. How do you identify that? How do you have [inaudible] to say, "Okay, this is a company that's not going to be attacked by an activist?"

Chip Rewey: Well, we think there's every company's really activist vulnerable. And so when we talk to our management teams, and we do and we get close to them, if we see something that has to happen, we almost take the the coaching term, it's like, well, here's your plan, I think you should do this. Over a couple of years they'll typically agree and we'll say, "carpe diem, if you don't do it now an activist is going to show up and embarrass you, take the bold steps now, position yourself now otherwise someone's going to file on you and be in the paper on you. And you're going to be playing defense versus offense." So you know that's the conversation we're having. So we almost put ourselves in if we were running these businesses, what would we be recommending. Sometimes they agree, sometimes they don't, sometimes they have great counterpoints, but we have the dialogue.

Craig Hodges: What we've noticed is over years at small cap investing, management teams can think like owners or they can think like employees, where they're trying to keep their job. And when they're owners and they're making decisions like owners, those are typically the right things. And we've been, you know, in companies over the past where they were just management didn't own much stock, they were just trying to keep their job. And there is a big difference. And so I think that the ones that aren't behaving like owners and acting like owners, they are vulnerable to outside.

Andrew J. Fleming: Yeah. And that's why we're very focused on cap allocation and how management teams are allocating their capital. We want to make sure they're not chasing shiny objects. Instead we want them to be focusing on what they do best. And to Chip's point earlier, talking about turnarounds, we're less looking at turnarounds and more on self-help stories where again let's focus on what we do best.

Courtney: Interesting. So it's a lot about, you know, this is very much a boots on the ground operation versus, you know, if you were looking at large ... the large cap universe and you're dependent on the sell side for a meeting with the IRR person, you're actually having tête-à-têtes with the management teams here. Is that true across the board?

Bill Hench: And quite frankly, some of the managements are coming around too much, right, because they think that they need to have much more exposure. And you'd rather have them back at the office, right. Look, everything is available on your desktop now. And you can sit down with a management team and you could walk out of a meeting and say, "What a great group of people." Whether you like and you think they're great is meaningless, right. What you want them is to perform. So it's much more important to observe what they're doing. You listen to their calls, you see them talk to their competitors, customers, etc. But the access to management, I think in many instances today is overemphasized, okay. You're not really going to get all that much out of a 45 minute meeting.

Craig Hodges: It's important to know management, but you can't just believe management's story. They're going to tell you what they want you to have. There's a lot there that they're not going to tell you. And that's our job, is to go find out those situations.

Chip Rewey: Yeah, it's listening to what they say and what their strategy is and how they stick to that. I mean having the one off meeting, it's important. But you would hope they were saying the same thing publicly as they're saying in the meeting. And you know, absolutely, they are. But you have to hold them to that and have them where they go. But I think the situation we won't be involved in is when we have a strategy or we have a significant disagreement on the strategic direction they're taking, without any good counterpoints and without any education back on us on why it won't work, just a reluctance or an obstinateness. I'm not going to do it this way because I never have. And those are the people that can get left behind, not invest in omni-channel and in the internet for example, and not do what they need to do with their business. And those on the management teams that often throw out and create those turnaround situations. So we tend not to and we do not invest in those situations.

Andrew J. Fleming: Yeah. We like to speak with our management teams two or three times prior to making the investment. And it's pretty easy, are they doing what they said they would do, and it's pretty easy to evaluate that. Are they deploying capital as they said they would? And are they pursuing profitable growth? So it's pretty easy to evaluate them objectively rather than just listening to what they have to say.

Courtney: So it's that balance. And, Bill, when you're talking to them, how much does, you know, M&A activity come into it? Are you kind of getting an ear to the ground there?

Bill Hench: Sure. Once in a while you're happy when your companies get bought because maybe you shouldn't have bought them in the first place. But most times when you have an M&A or you have a takeout they are not doing you any favors. They make you look smart that day and your friends will call and say, "Wow, do you really own that?" And you say, "Yeah." But you know what, they're not giving you that money because there's no benevolence involved here, they're stealing your performance. And you've got to take that money and you've got to hope that you'll find another good investment to put it in. So it's nice in the short term but it's not why you want to do it, right. You want to do it, if I'm buying a turnaround, if I'm going to live with something for two years, right, that's probably going to get worse before it gets better. I don't want 20%. And I'm sure you wouldn't want 20% either. You're going to want something more than that. So when someone comes and steals your company from you, it's not great.

Courtney: And before I let you go, one last point, you like the airline stocks, Craig?

Craig Hodges: Yeah, very misunderstood underinvested industry. We did very well in railroads in the early 2000s. They were uninvestable for 30 plus years, the same thing with the airlines, they've been uninvestable since the Wright Brothers I guess you could say. But they have been right size, there's now three large airlines, and I think that you're going to see a lot less competition. You know, the whole industry trades on PRASM and things that to me don't make all that much difference. I care about cash flow, I care about return to shareholders, I care about earnings. And these companies have that. And I think they're going to have it for a long period of time. So I think it'll be an uphill climb, but they're the cheapest part of the market, most of them five, seven times earnings. And now an industry that has high barriers to entry.

Courtney: Interesting. And you just see it with these three particular airlines?

Craig Hodges: No, there's several, there's even a Mexican airline, Volaris that is, you know, having tremendous results. And there's a lot going on between US and Mexico and travel, but there are opportunities like that out there that ... and of course the three large airlines are all large cap. So we do own American Airlines but it was because we owned US Air in 2011 when they merged. And so it's a remaining asset there.

Courtney: Interesting. Alright, well, before I let you go I'd love to get everyone's last thoughts on this space, and let's start with you, Bill.

Bill Hench: Sure. You know, to us the most important thing is what you do during the [inaudible] times, what you do when things aren't working for what your part of the market is. And you know, I think what we're able to do the second half of 14 and through 15 was really take advantage of very, very good markets for us, right. So it's self-serving to say but, you know, we were really making money last year, even though we had a down year. Why do I say that? Because I was buying assets at very, very, very depressed prices, and in our world, depressed prices are really depressed because you have to add on that liquidity as well, right. The lack of liquidity really makes it much easier to outperform in years like this, right, because that liquidity reverses and I all of a sudden become the market maker because I own these things and everybody wants them. So I think, you know, I think no matter who your small cap manager is, as long as you understand what they're doing, if you can take advantage of them and visit them during the bad times that's probably when you're going to get your biggest opportunity.

Courtney: Interesting, Chip, your final thoughts.

Chip Rewey: It's interesting, I agree with that, I think you just like a stock, you have to be aggressive when you get the opportunity. And our philosophy has lasted and been successful for 25 years, because starting with a strong balance sheet, because finding those companies that can grow over time and be waiting to be patient and then buy with conviction when you can buy, that works. And then having the processes around that to harvest when you get the chance and to redeploy aggressively when you get the chance. That works, that's how you take advantage and position yourself in an up market and the down market. The markets will do what they're going to do but we feel by being focused and sticking with our philosophy it's a roadmap to outperform for the long term.

Courtney: Andrew, your final thoughts.

Andrew J. Fleming: Yeah. It's a volatile market so you want to focus on companies that control their own destiny, self-help stories with company specific catalysts, whole leverage and strong company specific catalysts.

Courtney: Okay. Craig, your final thoughts.

Craig Hodges: We talked a lot about the indexes and, you know, what makes up the indexes. We've underperformed for the last 18 months and we're getting heat from investors somewhat for that. And when you look at the Russell, a lot of is utilities and, you know, Telco and that sort of thing. And I feel very good about where we are. We outperformed for seven years, for seven years of our existence and we've underperformed for 18 months. You don't want me buying utilities at 13 times earnings, that's not what I'm supposed to be doing. I'm looking for growth. I'm looking for opportunities. And so know what you're buying, you know, I think find good managers and let them manage your money and I think that's kind of the key.

Courtney: Alright, gentlemen, thank you, this has been a great discussion about small caps. And we want to continue this conversation, follow us on our social media, on Twitter and LinkedIn, from our studios in New York, I'm Courtney Woodworth.

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