“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”
- Rudiger Dornbusch,
Economist and Professor
Second Quarter Market Discussion
Valuation focused investors received a double dose of good news this quarter: Market breadth expanded and small-cap value outpaced growth.
A closer look at Russell 2000® Value Index performance shows size seems to be the difference between the winners and losers. Grouping the Index holdings into market capitalization deciles highlights the sharp contrast. Since January, as shown, the largest 30% of names were up twice as much as the smallest 30%. To us, the focus on such a narrow section of small-cap land means significant opportunities are being overlooked. Things have gotten better lately, but too many good companies aren’t getting their due.
Largest Names in Russell 2000® Value Driving Results
Source: FactSet Research Systems, Inc., Heartland Advisors, Inc., and Russell®, 1/4/2016 to 6/30/2016
Deciles are organized by market capitalization with 1 representing the largest and 10 representing the smallest.
Past performance does not guarantee future results.
Breadth should continue to improve as the market starts to slowly take notice of smaller names with strong fundamentals and opportunities to grow faster than the average company in the S&P 500. As you can see, nearly 60% of stocks in the Russell 2000® Value Index have broken above their 200-day moving average. Historically, this has been very good for small-cap value investors such as Heartland.
Broadening Strength in the Russell 2000® Value
Source: Bloomberg L.P. and Russell®, 3/20/2000 to 6/30/2016
Economic predictions are based on estimates and subject to change.
Past performance does not guarantee future results.
Stock selection was strong with holdings in Materials and Industrials leading the way. Information Technology detracted and caused the Strategy to lag its benchmark. Although smaller names were weak performers for the Index, some of the Portfolio’s top contributors were microcaps with market caps less than $400 million.
Small tech, big potential
Recent addition RadiSys Corporation (RSYS) is an example of a small company that should receive increased investor interest. The Oregon-based company makes software and embedded servers that help manage internet and telecom traffic as well as allow industrial machines to receive information remotely.
Continued growth in its higher margin software products and the introduction of a new hardware product are being embraced by clients. Verizon chose RadiSys’ products over much larger global players and placed a $50 million order, which should boost annual revenues by 25%! The purchase may be the first of many as competitors take notice of the new product offerings.
Trading at .9x estimated 2017 enterprise value-to-sales versus a peer group average of 2x and cash on the balance sheet, the company still represents a significant value in our view.
Banking on the overlooked
As expectations of a rate hike have faded, banks have become a forgotten sector. In the near-term, credit quality of borrowers is unlikely to get better and lending spreads are expected to remain flat. However, we continue to find overlooked gems like TriState Capital Holdings, Inc. (TSC).
The holding company of TriState Capital Bank offers commercial and private banking services to middle markets, and also has an investment management group with $10 billion in assets under management.
The company has leveraged a branchless distribution model to grow its loan book in the mid to high teens annually. The success has led to it outpacing peers in organic growth. Additionally, its investment management line generates significant fees and helps offset some of the pressures on lending spreads due to low interest rates.
We initiated a stake in the $3.4 billion Pittsburg-based bank when it was trading near book value. Valuations were compelling and so was the management team led by Chief Executive Officer (CEO) James Getz. Before founding TriState, Mr. Getz was a President/CEO of Federated Bank and Trust and President/Sales Manager of Federated Securities Corp., helping build Federated into a $1.1 trillion financial services enterprise.
Under his leadership, TriState, in less than five years, has almost doubled in size to $3.4 billion. The stock has a track record of producing organic growth, yet still trades at just 1.3x tangible book value a discount to the 1.6x peer group average of branchless banks. In our view, TriState is a growth bank available at value prices.
A play for the road ahead
We remain constructive on Sonic Automotive Inc. (SAH). The country’s third largest automotive retailer, despite its $755 million market cap, has 118 franchises in 13 states and $10 billion in sales. The business operates in two segments—traditional new and used car sales locations and its EchoPark segment that operates standalone used cars sales outlets. Management has implemented a “One Sonic, One Experience” strategy that utilizes set rate pricing and relies on so-called experience guides in place of traditional sales people. The strategy has taken hold in the company’s home territory of Charlotte, NC, and has helped boost market share. Its customer-centric outlets have received glowing reviews and should help the company draw millennial customers.
Sonic is actively buying back shares and purchased 7% of those outstanding during the first quarter. Trading at an estimated 2016 price-to-earnings ratio of 7.65x, investors seem to be more focused on near-term sales volatility and overlooking an opportunity to own a franchise positioned to endure.
How we plan to capitalize in Small Cap Value
We have been finding compelling investments among small-caps of all sizes, but many recent opportunities we’ve uncovered have been in names over $1 billion. Businesses where catalysts have not played out or valuations are too rich are being trimmed to fund new purchases.
During our decades of investment experience, there have been periods where markets have been more distorted, but we don’t recall a time when a disregard for valuations has remained in place for so long. The road has been rough, but signs that the worst may be over are appearing. The economy continues to move forward, wage inflation is picking up, and many small-cap names are trade at meaningful discounts to their historic averages. After a long drought, patient investors should be well positioned to have their perseverance rewarded.
Thank you for the opportunity to manage your capital.