Michael Kops: Hello, I’m Michael Kops, Vice President at Heartland Advisors. I’m here with Will Nasgovitz, Portfolio Manager for the Heartland Value Fund. The Heartland Value Fund beat the Russell 2000® Value Index in the 2nd quarter and year to date, as well as over the one, three, five, and 10 year periods.
Will, this was a challenging quarter for small stocks, but it seems like you’re gaining confidence. Can you explain why?
Will Nasgovitz: Hi Mike, thanks for taking time to catch up on the recent quarter with me.
From an earnings and valuation standpoint, the case for small caps isn’t just historically compelling — we believe it’s getting stronger. For example, profits for this group, which had been flat in the first half of this year, are expected to climb by double-digits over the next six months.
This comes as EPS growth for the mega-cap Magnificent 7 is decelerating. Yet small stocks are still priced at a steep 26% discount to large, making only the fourth time in the past 40 years that this gap was 20% or greater.
Mike: Are there other reasons for optimism?
Will: I think so. Global liquidity is starting to improve. The yield curve is expected to steepen later this year assuming the Federal Reserve begins to cut short-term interest rates. And there’s $7 trillion sitting on the sidelines in money market accounts and short-term instruments at a time when investors are notably under-allocated to small caps.
Mike: Why do you think investors continue to underweight small stocks?
Will: One reason may have to do with misconceptions about this market. Small stocks are not all risky startups or unproven enterprises going up against established, giant industry leaders. These companies are often bigger than investors assume and, in some cases, are the dominant players within their fields.
The average small stock, since 2020, has had a market cap of $3.2 billion. This stands in contrast to the early 1990s, when the average market value of a small cap was less than $500 million.
Mike: Are there examples of small stocks among your holdings that are much bigger in size or sway than people assume?
Will: Photronics (PLAB) is a perfect example of this common misconception. It makes photomasks used to transfer circuit patterns onto semiconductor wafers during the fabrication process. The company’s modest $1.1 billion market capitalization belies the fact that it is the largest merchant photomask manufacturer in the world. Plus, their solid balance sheet, with over $550 million in cash, with minimal debt provides a strong ballast.
Another example is Dentsply Sirona (XRAY), one of the world’s biggest suppliers of dental equipment and supplies, including consumables, lab products, and orthodontics and implants.
Mike: Stock selection and the 10 Principles of Value Investing™ are critical components of what we believe to be our edge. With all the cross-currents in the market today, how do active managers prevent the macro from drowning out the relative value added by stock picking?
Will: We construct the portfolio such that the effect of our selections are idealy the primary driver of relative performance. A collection of rules and tools, sector constraints and Axioma’s risk modeling, help organize the portfolio and prevent sector weights, unintended factor exposures or macro swings, from washing out the relative benefit of our hard work.
Mike: What is the desired outcome for clients when taking this approach?
Will: We believe the name of the game is consistency. This process has contributed to a smoothing of our relative returns vs our benchmark.
Mike: For the quarter, the Heartland Value Fund gained 8.85%, compared with the 4.97% return for the Russell 2000® Value Index. This points to the benefit of active management.
Will, how would you describe the current environment?
Will: We believe this market affords active small cap value managers terrific opportunities. Unlike Russell 2000® Index funds, which must own all the stocks in the benchmark — including the 34% of companies that are unprofitable — we can focus on attractively priced companies with positive earnings dynamics.
While tariff fears subsided somewhat in the second quarter, their impact on profits remains a key concern. In general, small stocks tend to be relatively less exposed to tariff impacts because they tend to be more domestically oriented. But some companies offer an even greater natural hedge.
Mike: Is there an example of those types of companies?
Will: Quaker Chemical Corp. (KWR), a leading supplier of fluids used in metal production and metalworking, is a good example. Its key end markets are the steel industry, industrial manufacturers, and vehicle OEMs — all areas where tariff concerns remain elevated. Quaker Houghton’s exposure, though, is relatively low as the company manufactures in the U.S. and a significant portion of its revenues are derived domestically.
The company also enjoys more pricing power than other commodity chemical companies because it often works under a service model where its employees are brought on site to help customers ensure that KWR’s chemicals are applied properly.
Quaker has a higher free cash flow margins than its chemical industrial peers as its business model is less capital intensive. That free cash flow generation has historically afforded it a premium valuation, with an average P/E of 24 over the past 10 years. Today, however, the stock is trading at P/E of 16, which we view to be depressed. When industrial production levels improve, we see upside from higher earnings and the potential for a re-rating closer to its historic multiple.
Mike: That’s great insight Will. Do you have any final thoughts?
Will: For active, value managers like us, this is an exciting time, as we believe this is an environment where thorough research, sound security selection, and process discipline will guide performance.
Mike: Thanks Will, and thanks to all who listened in.