3Q25 Value Plus Commentary Podcast

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Michael Kops: Hello, I'm Michael Kops, Vice President at Heartland Advisors. I'm here with Andy Fleming and Mike Warecki, Portfolio Managers for the Heartland Value Plus Strategy.

Andy, I know for a long time now we've always conveyed to our clients that one of the key components of stock analysis is a self-help catalyst, or a company essentially controlling its own destiny by looking inward. But it certainly doesn't hurt when more broadly small cap stocks are doing well. What are your thoughts on that in the current environment?

Andy: Yeah, in the third quarter, we finally saw signs that conditions are starting to improve. Companies in the S&P 600 small cap index are finally starting to see the first signs of year-over-year growth. This is the first growth in three years and the strongest profit outlook since the end of the global pandemic. It seems as though we might finally be through the worst of the earnings trough. 

Mike: Yeah, the third quarter turned out to be strong for small caps, with the Russell 2000® up 12.39% versus 8.12% for the S&P 500.

Has the time finally arrived for small cap stocks?

Warecki: We don't know for certain how small cap relative performance will play out from here, but we are seeing signs of sustained improvement. Given the macro and policy uncertainty in recent months, most of the companies we own tend to prepare for the worst and hope for the best. But the good news is the market often prepares for the worst as well. 

The economic backdrop so far has been somewhat stagnant from a broad cyclical rebound perspective, but we are seeing continued momentum as we get more clarity on policy and a potential for lower rates. This will likely pay dividends for companies who've been making sound capital allocation decisions and executing on margin improvement initiatives while we wait for confirmation of a more robust economic environment.

Mike: The Value Plus Strategy gained 8.7% in the third quarter, compared to 12.6% for the Russell 2000® Value. Andy, what do you attribute the performance to?

Andy: Our stock selection was positive in several sectors, led by Financials, IT, Utilities, and Materials. On the flip side, selection was negative in Health Care, Energy, Real Estate, Industrials, Staples, and Discretionary.

Mike: So what are you looking for specifically when it comes to stock selection?

Andy: It all starts with our 10 Principles of Value Investing™. This leads us to financially sound, well-run businesses with positive profit dynamics that are also trading at attractive prices relative to earnings, book value, and cash flow. We also want our optimisms surrounding the improving fundamentals to be confirmed by the actions of management. This can come in several forms, most notably active share buybacks, insider buying, and growing dividends.

Mike: And so what are you seeing in terms of these confirmation signals from management teams?

Warecki: Currently, one-third of our holdings in the strategy have insider buying. 84% of our companies are actively repurchasing their own stock. And 61% have increased their dividend payment over the past 12 months.

Mike: Could you share a good specific example?

Warecki: Brady Corp. (BRC) is a good example. They're a leading manufacturer of ID solutions and workplace safety products.

In our view, the company's allocating capital extremely well. They're actively buying back stock, consistently increasing dividends, and pursuing tuck-in M&A, which complements the core business, all while maintaining a healthy balance sheet.

Mike: And what's the company's story more broadly? 

Warecki: So far, it's been a year of restructuring and cost-cutting for Brady. That's part of the company's self-help story and strategy. But recently, management has called out strong growth in aerospace and data center end markets, with the data center strength centered around the company's wire-making business.

Mike: What's your timeline for the self-help strategy to take hold?

Warecki: We expect the company will reap the benefits of these efforts in a meaningful manner within the next year. During their most recent earnings call, Brady reported '26 guidance that was ahead of expectations.

Mike: Great. Is there another example?

Andy: Yes, Phinia (PHIN) is an auto parts company that was spun off from Borg Warner in 2023. It makes fuel systems for vehicle manufacturers and the aftermarket. Following the spinoff, management has executed on self-help cost savings initiatives to improve margins and has used free cash flow to consistently buy back stock and deliver the balance sheet. Phinia is also hitting on all three of the main capital allocation criteria we look for, raising its dividend, buying back stock, and insider buying. This gives us even more confidence.

Mike: And how about the managing this position, given the uncertainty in the auto industry?

Andy: Yeah, good question. There are a lot of moving parts in the auto industry right now.

What gives us comfort at Phinia is that it is a relatively stable end market in that 40% of the company's revenue, close to half of its operating profits, come from the aftermarket. We believe Phinia’s aftermarket business can grow at a mid-single-digit growth cater going forward with less cyclicality. This is because this part of the business is based on the replacement of critical engine components. 

Additionally, the company has multiple revenue growth opportunities in under-penetrated end markets, such as aerospace, off-highway vehicle, and hybrid vehicles. These opportunities were overlooked when the company was part of a much larger Borg Warner.

Mike: And how about valuation on the stock? It's a cheap stock.

Andy: Phinia’s trading at a modest six times EV to EBITDA. We believe the stock is being valued by the market as strictly an OEM auto parts manufacturer, despite the fact that exposure to this end market is only 30% of revenue.

As the company's aftermarket and industrial end market exposures continue to grow, we believe that Phinia should receive a multiple closer to that of aftermarket auto parts and industrial companies. These companies generally trade in the 8 to 12 times EV to EBTA range.

Mike: Mike, can you share a little bit about the top performer for the quarter?

Warecki: Yeah, the top performer in the quarter was Materion (MTRN). They're a vertically integrated producer of high-performance materials using beryllium as a key input.

Mike: What's beryllium? Good question.

Warecki: Beryllium is a rare metal that's one-third lighter than aluminum while offering six times the stiffness of steel. Given these compelling traits, it's used in a variety of applications within industries such as autos, industrials, and life sciences.

Mike: And what's Materion's story more broadly? 

Warecki: They've been taking several steps to improve operations and bolster margins during a slower period for some of their end markets.

Over the past year, as demands been subdued, managements divested an unprofitable architectural glass business that was located in New Mexico, while coincidentally expanding high-margin capacity for advanced semiconductor capabilities in South Korea.

Mike: And how have tariffs impacted the business?

Warecki: They haven't impacted the business as severely as the market was initially anticipating. The stock recently experienced outsized strength post-tariff fears as they delivered record margins, along with reiterated guidance for accelerating growth for this fiscal year. And they have several end markets that are now demonstrating signs of a sustained rebound.

Mike: Andy, not everything was a winner for the quarter. Maybe you could give us a little background on an underperformer. 

Andy: Sure. Prestige Consumer Healthcare (PBH), this is a company with familiar over-the-counter medical products such as Dramamine, Ludens Cough Drops, and Clear Eye Eye Drops. PBH missed its earnings forecasts and took down its full-year EPS guide due to supply chain issues experienced in the quarter related to its eye care business.

Mike: And what were the supply chain issues and have they been addressed?

Andy: The company's core supplier was not able to ship enough product to meet demand for its Clear Eyes franchise. The company took immediate action to fix this issue, opting to acquire the supplier for $100 million to ensure that this supplier will focus exclusively on supplying to prestige going forward.

We expect 2027 earnings to bounce back nicely as the core business at PBH is operating well, and we expect a rebound in the company's eye care business as PBH's customers look to restock in this coming year.

Mike: Excellent. Any final thoughts? 

Andy: While we're starting to see signs of hope, this is not a time to overreact. Despite eventual signs of improvement in demand dynamics, we are not looking to catch falling knives. We're still committed to identifying good companies with strong capital allocation plans in place that are reducing costs, improving their margins, and taking market share, regardless of how well the economy is doing.

Mike: Andy and Mike, thank you for your time.