Unwinding a Broken Clock

Median Total Debt/FY1 EBITDA
As of May 31, 2016


Source: FactSet Research Systems Inc. and Russell®    
Fiscal Year Forward 12 Months (FY1). Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). Small-Cap Holdings are represented by unique small-cap stocks held in the Small Cap Value and Small Cap Value Plus Composites.

Signs that value is coming back into favor have many frugal investors feeling giddy. 

We share that enthusiasm but don’t anticipate that a return to a normal market will take place overnight.

Through the end of May, the Russell 2000® Value Index year-to-date is outperforming its growth counterpart by 630 basis points (bps). However, looking solely at Index returns doesn’t tell the whole story.

A closer review of the data shows that after nearly a decade of depressed interest rates and slow growth, investors have embraced companies using debt to generate sales.

Analysis of the balance sheets of the top 20 contributors in the Russell 2000® Value Index quarter-to-date, as shown, highlight this point. The median debt to estimated 2016 earnings before interest, taxes, depreciation, and amortization (debt-to-EBITDA) ratio for the group is 5.75x, meaning many of these companies are highly levered. By comparison, the names we own in our two small-cap strategies have a median debt to estimated 2016 EBITDA ratio of approximately 1.68x. We typically favor low-debt companies and believe they hold a particular advantage in periods of economic uncertainty.

While we welcome the outperformance by the Index, we believe the rally into highly levered names will prove to be a precursor to a rise of financially sound businesses trading at attractive valuations.

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Author

Heartland Advisors Value Investing Research Analyst Andrew Fleming

Andrew J. Fleming

Fleming, CFA, is Vice President and Portfolio Manager of the Value Plus Fund and its corresponding separately managed account strategy. He has 7 years of industry experience, 4 at Heartland.

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The Small Cap Value Strategy invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

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