“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 sweeter. The upcoming two-year anniversary of our Mid Cap Value Fund (HRMDX)* is an example of a win that deserves notice.
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 benchmark 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.
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.
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, possibly spelling 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.
We share many of the same concerns—inflation simmering below the surface and rising and political uncertainty, among others—yet remain encouraged. 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.
Your Heartland Team