Michael Kops: Hello, I'm Michael Kops, Vice President at Heartland Advisors. Today I'm here with Andy Fleming, Portfolio Manager for the Heartland Value Plus Strategy.
Andy, the second quarter was another challenging period for small stocks, yet you seemed genuinely optimistic. What gives you that hopefulness?
Andy Fleming: The earnings calls of the companies in our portfolio were generally positive, and our follow-up calls with management teams were positive as well, and the outlooks they provided, on the whole, were fairly upbeat.
Mike: Why the sudden upturn in earnings?
Andy: In sum, demand held in better than expected and better than feared. Across the board, demand was pretty solid.
Mike: In the second quarter, the Value Plus Strategy was up 2.04% compared with the 4.97% gain for the Russell 2000® Value Index. What do you attribute that to?
Andy: Stock selection was responsible for most of the underperformance. Stock selection was positive in just two sectors, Health Care and Financials.
Mike: Is there any part of the small cap universe that gives you pause?
Andy: Yes. During the quarter, we made a conscious decision to pivot away from cyclical volume-dependent businesses that are simply waiting for demand dynamics to improve. Instead, we are focusing on self-help strategies that could lead to margin improvements regardless of the economic backdrop.
Mike: Are there some examples?
Andy: Yeah. Gates Industrial Corp (GTES) is a good example. Gates is undergoing an 80-20 analysis right now. So, the management team is continuing to focus on the most profitable pieces of business and de-emphasize the less profitable pieces of business.
And Gates is unique where 70% of its business is replacement or aftermarket. So that's going to be very stable demand there. And specifically, Gates focuses on belts for power transmission industries. And they've done a lot of internal investment that's allowed them to reduce the cost of their products. This is really material sciences that they've been investing in. So what they've been able to do is they're replacing legacy chains with their belts and due to their investments they're now at cost parity with the legacy product and when they become at cost parity becomes a no-brainer for customers as their belts are quieter and more energy efficient than legacy chains.
Mike: Excellent, are there some other examples.
Andy: Yeah, Silicon Motion Technology Corp. (SIMO) is another example.
So, SIMO produces controllers for memory chips. And this was a company that there was a lot of fear going into the quarter. And management helped quell those fears by calling out a trough in their core consumer market and reasons for optimism in the second half in their industrial end market. Specifically calling out NVIDIA as one of their large customers where they expect to ramp a data set or related product in the second half of the year.
Mike: What about tariff risks? Are there specific things companies are doing to mitigate those risks?
Andy: Yes, tariff risks are definitely out there, but the important thing to remember here is that the companies that we're investing in are not robots. They're going to react in a profitable and smart way to the tariffs. Example within Envista (NVST) is with their core Nobel product. So Envista manufactures dental products.
Their core product is dental implants. That's their most profitable business. And this business serves the Chinese market. And I think a lot of investors were concerned going into the quarter about this. And they helped reduce concerns in the quarter by giving a simple explanation of how they're going to handle the matter.
They have two core manufacturing sites. They have a U.S. site and a Sweden site. Historically, they've manufactured in the U.S., and then exported to China. But with tariffs, they're going to change that. They're now going to manufacture in Sweden and transfer from Sweden to China for that market. So as you can see, pretty simple solutions, but it was good to see Envista report that in the quarter.
Mike: So what's your biggest takeaway for the second quarter?
Andy: The biggest takeaway is that demand is held in better than expected. And our companies are reacting in a smart and efficient way to the issues that are stemming from tariffs.
Mike: Excellent. Thank you for your time, Andy.
Andy: Thanks, Mike.