3Q26 Value Plus Commentary Podcast

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Michael Kops: Hello, everybody. Michael Kop's here from Heartland Advisors. I'm joined by Mike Warecki and Andy Fleming, Portfolio Managers for the Value Plus Strategy. Gentlemen, thank you for joining us.

The quarter was pretty volatile for small caps. I mean, I guess there was volatility across the board, but small caps particularly. What do you think of the small cap universe for Q3?

Andy Fleming: Yeah, you're right, Mike. It was a very volatile quarter. The AI trade went off the rails early on, bounced back a little bit later in the quarter. But the dominant theme of the quarter was higher rates and higher oil.

Kops: So, in a backdrop like that, how are you thinking about the portfolio?

Andy: It's a good time to have a very balanced portfolio. There's a lot of zing and zang in the quarter. What worked earlier in the year is not working as well now. And what was underperforming earlier in the year is performing quite well currently.

Michael Warecki: Yeah, there was a lot of changes in market leadership during the quarter. For example, Energy in Q2 was down quite significantly. And that was one of the best performing sectors on Q3 when you had oil prices rise, close to 40% after a period during Q2 where they had fallen quite substantially. And then yeah, you take oil rising close to 40% and rates rising as well you're going to have more of a risk off environment. So going into the quarter if you would have told I think any portfolio manager that what that was going to be kind of the macro backdrop I don't know that this type of performance would have been all that surprising. But yeah it's been volatile in a sense that Q2 was so strong and then we had a sharp pullback then in Q3. But I think what's reassuring is just the bottom-up research that we're doing and the risk rewards that we're finding during this period of elevated volatility. 

Kops: Maybe talk about that a little bit. Where does the opportunity lie? 

Michael: Yeah, there's been some risk management, I guess, implementations during the quarter just in terms of we had a rebalance for the Russell 2000® Value Index towards the end of June.

The constitution of the Index changed quite substantially. So, we've been spending a lot of our time in terms of developing our watchlist around names that screen well from the 10 Principles of Value Investing™, have good risk rewards, but also address some of the risk exposures that then, became more apparent after the rebalance.

So, we've been selling a lot of the names that had outsized strength in Q2 and rotating into some names that maybe we thought were over punished from elevated interest rates or oil prices during Q3.

Andy: Yeah, and throughout this kind of reshuffling of the decks, we're staying very true to the big three, where we continue to be focused on companies that have insider buying, active buybacks, and are raising their dividend.

Kops: The Strategy trailed the benchmark for the quarter. What would you attribute it to?

Andy: We got hit by some of the factors that Mike and I were just talking about. The names that are more interest rate sensitive got hit the hardest. Names that were related to that had some AI exposure got hit. Despite us taking our exposure down. And then in Energy, we had about equal weight exposure, but slightly higher quality names. And in this quarter, you wanted kind of lower quality names that were really turbocharged. 

Kops: Why did they benefit more?

Andy: You know, generally speaking, names that kind of have challenging balance sheets have outsized returns in a period of this where you see the underlying commodities spike. And we focus on companies that have stronger balance sheets. So while our Energy stocks performed quite well in the quarter, they were not able to keep up with those names that had lower quality balance sheets.

Kops: It's kind of a fascinating dynamic, you know, where you'd think that your quality bias when the market's kind of rolling over would pay off and then you find yourself in these circumstances that can happen from time to time.

What do you think about that?

Andy: Yeah, I mean, we're very comfortable with that over time, but I mean, there will be periods like this where in a particular sector. You wanted to have kind of the lowest quality possible.

Michael: Yeah, we do think going forward, there is an opportunity for higher quality stocks to exhibit stronger performance than they have in recent years.

Like if you take a look from a factor perspective, the correlation between where momentum has been and beta has been extremely high. Versus the correlation between momentum and how quality is performed has been extremely low. Like it's been almost a record over the last 20 years. So, we're starting to see some signs of those quality factors and when we look at how factors have performed during the quarter, exhibit strength starting in Q3, and I mean when we align that with our process and we're finding attractive risk rewards in a period of elevated interest rates right now elevated oil prices, we think that offers quite compelling value for investors going forward.

Kops: Excellent maybe share a name with us that you think is interesting in the backdrop.

Michael: Yeah, one name that we took some action with during the recent quarter is a name that's a software company where we found very attractive risk rewards and in an industry where the markets just feared AI disruption to find an extreme manner where you look at where valuations have come down to. But I don't know that all software companies going forward are going to outperform or perform well. You really have to do the qualitative analysis in addition to the quantitative analysis to be sure that your company has a moat around it. 

So, Tyler Technologies (TYL) is an example of a company and software that we own in the portfolio. What they do is they provide software and payment services for public institutions. These will be state governments, local governments, even schools. We don't think that the tech base of AI technology and innovation is going to move as quickly in the public markets as they historically do in the private markets. And we've seen that as well, just when we've analyzed the business model across cycles and decades. And in addition, I mean, maybe not being as prone to disruption, they also have their own AI tools, which they are implementing, and they act as consultants for their customers. A lot of these public institutions are understaffed. They don't have a big IT budget or big IT team to make these implementations, and Tyler is heavily involved with these projects.

And so they announced an investor day earlier this year where they actually believe that these AI tools can double their addressable market. They're definitely going to improve their margins from an internal efficiency perspective. And I guess from an operating leverage perspective going forward, there's a margin opportunity as well.

We're quite confident that this company will be around servicing their customers for decades to come with attractive top-line growth rate and overall earnings and free cash flow dynamic relative to the valuation.

Kops: Excellent. So, looking out to the end of the year, we talked about this a little bit with the Value Strategy as well.

Coming into the end of the year in small cap land, sometimes you can find opportunity, with people tax loss selling or pressuring stocks. You guys have any thoughts on that as we head into Q4?

Andy: Yeah, it's a good observation, Mike. There are a lot of opportunities right now in terms of, you know, very cheap valuations. The key is to make sure we're not looking at any falling knives here that have material additional downside. And the way that we avoid those situations is, again, we focus on the big three, and we're also looking at companies that have strong balance sheets that suggest that, you know, we're closer to the floor level here post-tax loss selling.

Kops: Excellent. Any other comments you'd want to make to wrap up quarter and outlook for the rest of the year?

Andy: I would just say the opportunity set looks pretty solid right now. You know, there's this real bifurcation in the market where a lot of names are overpriced, but there's a lot of names that have really gotten beat up over this past quarter and that provides a really strong opportunity set as we think about the fourth quarter and beyond.

Michael: Yeah, when it comes to finding opportunities that align with the 10 Principles of Value Investing™ in the big three from a capital allocation perspective, we're finding stocks that are able in this environment, even though it's been challenged from macro perspective, to still raise dividends, buy back stock, and they also have insider purchases happening from executives. So that's reassuring that a company will have a higher probability of executing regardless of what the macro holds.

Kops: Thank you, guys. Thank you for your thoughts and for the review of the quarter. Appreciate it.