Michael Kops: Hello, I'm Michael Kops, Vice President at Heartland Advisors. Today I'm here with Will Nasgovitz, Portfolio Manager for the Heartland Value Fund.
Will, small caps rebounded in the third quarter with the Value Fund gaining 10.04%. What do you think might have sparked that?
Will Nasgovitz: Hi, Mike. Great to be here. Earnings for companies in the S&P 600, an index of small cap stocks, have finally begun to rebound. This comes just as the Federal Reserve has started to cut short-term interest rates. Historically, both developments have been tailwinds for small stocks.
Mike: How do you see those catalysts influencing small-cap performance going forward?
Will: Well, it's lending credence to our sense of optimism, but we've been doing this long enough to know that there's never an all-clear signal given by the markets.
Mike: Yeah, it certainly seems like we're seeing mixed signals. What do you make of that?
Will: More than half of all U.S. industries have been shedding jobs, which has historically been a precursor for recession. But the broad market, which itself is a leading indicator of the health of the economy, has been hitting new highs, driven in part by optimism surrounding AI.
Then there's small company confidence. Traditionally, small-cap outperformance coincides with the rising business optimism, as measured by a survey tracked by the National Federation of Independent Business. Emerging from past recessions in 2009 and 2020, improving sentiment was echoed by strong rallies in the Russell 2000® Value Index. Up until recently, that's not been the case this year, though a significant rally is underway.
Mike: So how is the Fund positioned in this environment?
Will: For us, this is a reminder that no matter how optimistic we might be, our attention must be constantly directed inward to focus on those things that are controllable and improvable.
For example, one of the easiest ways for us to address conflicting signals is to plan for as wide a range of outcomes as possible.
Mike: How do you go about doing that?
Will: We do this by establishing four price targets for every company under consideration one price reflects expectations under the best circumstances, another is established around our base case scenario a third focuses on potential downside risks the fourth centers on how much the stock might drop under the worst outcomes.
Mike: How else do you build a margin of safety?
Will: That's a great question. We rely on our 10 Principles of Value Investing™, which emphasizes attractively priced, well-run companies with strong balance sheets, sound business strategies, and promising earnings catalysts.
These factors serve as the guiding principles for the strategy and Firm and have led the Value Fund to benchmark beating performance since it was launched in 1984.
Mike: The Fund modestly lagged your benchmark for the quarter. What drove those returns?
Will: Stock picking was negative in 5 of 11 sectors, led by underperformance in Health Care, Communication Services, and Utilities. Over the past one, three, and five years, however, security selection account for almost all the Funds outperformance.
Mike: And how are you approaching new opportunities today?
Will: As value-minded investors in a richly priced equity market that's dominated by passivity and investors' love affair with AI, we've been able, remarkably, to uncover solid businesses is priced at attractive valuations. Many are leaders in their respective industries overlooked by the momentum crowd.
Mike: Is there an example you can share?
Will: There's Potbelly (PBPB), the sub sandwich chain, which was a long-term winner for us before it was acquired during the quarter by the convenience store operator Racetrack at a 32% premium.
Mike: What initially drew you to the stock?
Will: We first purchased Potbelly in March 2021, at a time when the environment for the restaurant sector was uncertain with depressed sales coming out of COVID-19 lockdowns. It was the fundamentals and strong insider buying that caught our attention. The new CEO at the time, Bob Wright, came out of retirement to turn around a strong brand that had been mismanaged and no longer growing. He surrounded himself with an executive team that had successful restaurant careers, many of whom he worked with in prior roles.
Mike: How would you describe the management team's self-help initiatives?
Will: The team focused on improving operations through a long list of initiatives, including simplifying the menu, revamping the loyalty program, improving the digital experience, and increasing operational efficiency at the restaurant level. The efforts resulted in consistent same-store growth above restaurant peers and a structural improvement in margins.
Mike: Potbelly wasn't the only holding that put itself in a position to succeed after running into some difficulties, right?
Will: That's right. Calavo (CVGW) is another industry leader that caught our attention. The company's unique health-conscious food products were intriguing, but they were in the midst of a management transition. So it was put on our watch list. After a series of research calls and covering an improvement outlook, we began to accumulate the stock early this year.
Mike: Can you tell us a little bit about the company?
Will: Calavo is a leading marketer and distributor of avocados and guacamole. After a multi-year period of mismanagement that included several CEOs, a longtime former chief executive came out of retirement to stabilize operations. He is aligned with shareholders receiving large equity grants that invest significantly higher than current stock levels and bought sizable numbers of shares in the open market.
Mike: And what has the CEO done to turn the business around?
Will: Since returning to the business, he has focused on exiting low-margin business lines and growing the prepared guacamole business that was 10% of total sales last year but has double the gross margin of the core business. This business grew 40% year-over-year in the last quarter, and management believes they can double the size of this business within the next two years, which would be fruitful for Calavo's earnings potential.
Mike: And what about the stock's potential downsides?
Will: The downside risk seems to be limited, supported by a solid balance sheet that includes around $3.50 per share of net cash, plus $3 a share of cash, potentially from the resolution of a long-standing dispute with Mexican tax authorities. We aren't the only believers. Calavo received an unsolicited buyout offer for $32 a share in July.
Mike: Any final thoughts to wrap up the third quarter?
Will: The past quarter has confirmed our optimism about the improving opportunities for small cap value investors. However, it has also reinforced the importance of having the right process in place regardless of the circumstances. We believe sound security selection, formed by thorough research and implemented with process discipline, will guide performance as it has been for more than 40 years.
Mike: Thanks for sharing your thoughts, Will.