First Quarter Market Discussion
The first quarter of 2023 will undoubtedly be remembered for the bank failures in March, brought about by the Federal Reserve’s rate hikes and poor asset-liability management. Fears of a full-blown crisis following the collapse of Silicon Valley Bank, Signature Bank, and Silvergate Capital dominated the market at the end of the quarter, putting an end to the speculative rally at the start of the year.
Yet the biggest story during the period was the reawakening of the market’s respect for risk, owing to the banking crisis. As credit spreads widen and lending standards tighten, the market’s focus is now shifting to other banks that may be vulnerable and other businesses that face either a liquidity crunch or could face a weaker demand environment.
This is a great environment for active value investors who care not only about valuations, but also about a company’s balance sheet strength, reliance on the capital markets, and its ability to self-fund operations and organic growth through free cash flow generation. At a time when balance sheet strength matters more, we note that our passive benchmark does not incorporate balance sheet considerations in their construction of the mid cap value universe. At Heartland, financial soundness and debt levels are directly applied to 3 of our 10 Principles of Value Investing™ and integral to the overall stock selection process.
This is also a time for investors to consider a balanced approach that plays both offense and defense. Part of our portfolio is comprised of companies that offer something the market isn’t seeing much of lately: stable fundamentals and improving earnings. On the other hand, we have used pockets of volatility to build positions in holdings that offer a compelling risk/reward proposition over 1 to 3 years, even if some of these companies face less certain business prospects in the near future.
Whatever happens, the banking crisis is likely to accelerate the current credit cycle. As the chart below illustrates, there are three stages to a credit cycle. First, the Federal Reserve begins tightening monetary policy in response to rising inflation and falling unemployment (red line). Next, lenders begin tightening credit standards (green line). And finally, loan losses rise and lenders write off bad credits (blue line). We believe we’re in stage 2 now, but it’s important to note that stage 2 and 3 generally peak after the Fed begins to cut policy rates.
Source: FactSet Research Systems Inc., monthly data from 1/31/1992 to 3/31/2023. The chart illustrates the three stages of the credit cycle. Stage one is Federal Reserve tightening monetary policy in response to rising inflation and falling unemployment. Stage Two is lenders tightening credit standards and stage three is when loan losses rise, and leaders write off bad credit. The seasonal adjusted Charge-Off Rate is calculated using all United States commercial banks, commercial & industrial loans. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Attribution Analysis
In the first quarter, our portfolio outperformed the Russell Mid-Cap® Value Index. The outperformance was largely due to stock selection in the Industrial, Information Technology, and Financial sectors.
Heading into the quarter, we had shifted our purchase activity toward beaten-down shares of well-run businesses that we believed would benefit if the market became less fearful of the business cycle. However, after the “risk on” rally that started the year, which drove up prices throughout most cyclical areas of the market, mispricing opportunities were harder to find, and this became less of a priority. Yet another reason to implement a balanced approach.
Portfolio Activity
Among value investors, there are those who prefer owning high-quality companies trading at decent bargains (“value”) and others who focus on deeply discounted companies that have produced poor economic returns over time (“deep value”). Just as growth and value take turns outperforming, these two styles within value investing also tend to alternate market leadership. Within the mid-cap space, choosing one while ignoring the other does not seem prudent, as this can cause a top-down bet to be introduced into the portfolio. We aim to have stock selection drive our results, which we believe can only be achieved if the uncontrollable is somewhat mitigated.
Deep Value Bucket
Health Care. During the quarter, we added to our existing position in Centene Corporation (CNC), one of the largest managed health care insurance providers in the U.S. and the largest player in Medicaid.
The stock has underperformed lately, as CNC faces headwinds on the reimbursement front, including a reduction in its 2024 Medicare Advantage reimbursements. The market also seems to fear a potential loss of insured lives when Medicaid eligibility, which was expanded during the pandemic, gets redetermined in 2023-2024.
CNC hasn’t historically delivered consistent results compared to other premier managed care companies. More recently, the company upgraded its leadership ranks, including the addition of a CEO, CFO, and COO from better-managed companies with a track record of value creation. The company is undertaking a series of self-help efforts, including expense reductions, divesting noncore assets, share buybacks, and operational improvements.
Despite this, the stock trades at just 10 times 2023 earnings and 9 times 2024 profits. We consider that valuation too punitive for a company that we expect to continue growing EPS at a 12-15% compound annual growth rate.
Consumer Staples. We also established a new position in Ingredion Inc. (INGR), a global food products company that converts corn, tapioca, potatoes, grains, fruits, and vegetables into ingredients and biomaterials for the food, beverage, and other industries. Ingredion’s business has been under pressure in recent years. High-fructose corn syrup has been in secular decline because of shifting dietary preferences toward natural sweeteners. Moreover, inflationary pressures in recent years have put downward pressure on margins largely due to a spike in agricultural commodity prices.
However, INGR has begun demonstrating its ability to raise prices in order to offset rising production costs, albeit with a lag. We expect this trend to continue going forward, allowing for continued margin recovery. The company’s self-help drivers also give us confidence. Ingredion has been increasing its high-margin specialty segment as a percentage of its overall sales. Within the company’s lower growth ingredients segment, management is repurposing production capacity toward higher-value products.
INGR has historically traded at a 20-30% discount to its sector peers. Today, INGR trades at 7.9 times consensus EV/EBITDA over the next 12 months, which is around a 40% discount.
Value Bucket
Financials. Unlike the broader financial sector, which sank in the quarter, Interactive Brokers (IBKR), a fully digital brokerage platform, gained 14.24% in the first three months of the year.
Interactive Brokers’ differentiated business model shined because the company’s management team built the business to avoid the two risks that came to the forefront for sector peers this quarter, credit and interest-rate risk. IBKR is a prime example of why analyzing businesses under multiple scenarios, both good and bad, is so important. In late 2021, when we began purchasing IBKR, the market was not pricing credit or interest-rate risk into the sector. Banks appeared optically “cheap” on P/E multiples, but after adjusting for downside risks, the upside versus downside potential was far more compelling in Interactive Brokers than in banks. Today that gap has narrowed, however, we continue to hold a position in IBKR given its lack of credit risk, which has yet to be fully priced into many banks.
IBKR enjoys industry- and sector-leading pre-tax margins thanks to its highly automated platform that drives scale efficiencies, which are partially passed on to customers in the form of attractive interest rates on cash balances. For this reason, clients have little incentive to move deposits as interest rates rise. IBKR’s management team has refused to take duration risk thereby significantly lowering the chances of a “run on the bank” scenario that proved disastrous for several banks this year. Credit risk is limited to margin loans that are over-collateralized and marked to market in real time thereby significantly reducing any loss given default.
Technology. We added to our existing position in Teradata Corp. (TDC), the largest provider of enterprise data analytics for complex workloads. Companies use TDC to predict a variety of events, such as when customers might switch to rivals, when parts are about to fail, or if transactions look suspicious for fraud.
While other enterprise IT companies have been reporting decelerating results, TDC continues to progress on growing recurring revenue from the cloud. The company’s hybrid/multi-cloud offering should position it well to help customers transition to the cloud. The stock remains undervalued, with a free cash flow yield above 9%.
Outlook
To the growing list of external uncertainties, the market was facing — including rising rates, inflation, and deteriorating earnings — we can now throw on a banking crisis. In our opinion, this is a time to seek the right balance between caution and the willingness to (selectively) capitalize on the rising fears that create better stock valuations. In an environment where tailwinds are difficult to count on, we will use our 10 Principles of Value Investing™ to help us strike this balance, focusing on company-specific catalysts, management teams and business strategies that can help drive operational execution and improved valuations.
Fundamentally Yours, the Heartland Team.