Unusual Lessons From Unusual Times

Unusual times call for unusual measures, and the run for momentum/growth stocks has been anything but normal. With that in mind, we thought we’d let the market speak for itself. Based on the past several months, this is what investors seem to be saying. 
 

Newton was wrong—what goes up doesn’t have to come down

Don’t believe it? Just look at the performance of the top 10 names in the NASDAQ 100. The group was up 9% for the quarter and an eye-popping 165% over the past three years. If reversion to the mean—gravity in the investment world—actually existed, we doubt investors would continue to pour money into these businesses.
 

Debt is a four-letter word but only to investment prudes 

With the average debt-to-capital ratio of the S&P 500 hitting nearly 48% this quarter, it’s clear that value investors who worry about things like balance sheet strength have been getting it all wrong. Financial leverage means nothing. If it did, Tesla, Inc. (TSLA) couldn’t raise cash despite missing production goals and burning through $4.2 billion during the past 12 months.
 

It’s better to be popular than healthy

Some of the most widely held Index funds are loaded with zombie companies. For example, nearly 8% of the companies in the Russell 3000® have failed to generate enough cash flow during the past three years to make interest payments on outstanding debt. In past cycles, businesses like these would be forced to restructure or simply close up shop, but in today’s credit market, they simply borrow more money to pay interest on existing debt.
 

A different perspective

Maybe it’s our contrarian streak but from where we sit, the lessons above ring hollow. While following the crowd above all else, has worked in an era of easy Fed money and strong momentum, we sense a change is coming. Here’s why:
  • Changes to the tax code should reduce the burden on small companies and encourage business investment. In our view, this should translate to greater manufacturing activity and make domestic companies more competitive on a global scale.
  • Interest rates are rising—and so are borrowing costs. As rates continue to climb, we expect companies that have played fast and loose with their balance sheets will face earnings pressure as more cash flow needs to be used to service existing debt.
  • Regulatory relief. For the past several years, companies have faced headwinds from heightened regulatory oversight. As the current Administration continues to review and revise existing policies, we expect businesses will find the environment more conducive to growth.
With the above catalysts in mind, the future, in our view, is much brighter for reasonably valued companies. Growth has had its time in the sun, as the chart shows, and after more than eight years, we think the tide has begun to turn.
 
Ripe for a Reversal?
Russell 3000® Value Less Russell 3000® Growth Index
Heartland Advisors Value Investing Market Insight R3V R3G Chart
Source: Furey Research Partners, LLC and Russell®, 12/31/1978 to 12/31/2017, annualized return over rolling 10-year periods. Additional information for indices shown at end of material. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
 
When the current trend unwinds, we will be ready, leveraging our hard work and disciplined process. Until then, the team believes market inefficiencies have created dramatic opportunities, for prudent, fundamental investors. 
 
We thank you for your continued trust and confidence.
 
Sincerely,
Your Heartland Team

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Additional Information for Indexes in Chart (calendar year returns %):

    1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016  2017
Russell 3000® Growth Index   12.00 34.68 -1.31 41.66 5.22 3.69 2.20 36.57 21.88 28.74 35.02 33.83 -22.42 -19.63 -28.03 30.97 6.93 5.17 9.46 11.40 -38.44 37.01 17.64 2.18 15.22 34.24 12.44 5.09 7.39 29.59
Russell 3000® Value Index   23.63 24.22 -8.85 25.41 14.90 18.65 -1.95 37.03 21.59 34.83 13.50 6.65 8.04 -4.33 -15.18 31.14 16.94 6.85 22.34 -1.01 -36.25 19.76 16.23 -0.10 17.56 32.69 12.69 -4.13 18.40 13.19

Source: FactSet Research Systems Inc. and Russell®

Past performance does not guarantee future results.

An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the prospectus (pdf). To obtain a print prospectus, call 800-432-7856. Please read the prospectus carefully before investing.

Investing involves risk, including the potential loss of principal.

There is no guarantee that a particular investment strategy will be successful.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

As of 12/31/2017, Heartland Advisors on behalf of its clients did not hold any of the total shares outstanding of Tesla, Inc.

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