Ugly. There’s no way to sugar coat it. Large, Small, Growth, Value, it didn’t matter, equites were trashed this quarter—the worst in modern history. Small caps, especially small value, took the brunt of it. From high to intraday low, the Russell 2000® Value Index dropped 47%--unprecedented. The chart below highlights the carnage.
Russell 2000® Value Index - Price
Source: FactSet Research Systems Inc. and Russell®, 4/2/2010 to 3/27/2020 weekly
All indices are unmanaged. It is not possible to invest directly in an index
Past performance does not guarantee future results.
The Fund outperformed the Russell 2000® Value Index marginally for the first quarter.
In our view, today’s marketplace offers exceptional opportunity in small equities based on a commonsense premise–Valuations do matter.
Your portfolio is priced at stunning valuations: 94% of book value, only 8X estimated earnings, less than 3X EV/EBITDA, with a lower debt/capital than the Russell 2000® Value and S&P 500.
To enhance total return, the portfolio holds many names with attractive dividend yields.
Additionally, a significant portion of the portfolio is held in enterprises which are especially intriguing; priced at cash, or as Benjamin Graham called it net, net working capital per share.
For instance, one is leading professional staffing/consulting firm, valued at only 85% of cash/share, recently reported a 56% increase in revenues.
Management repurchased 9% of its shares during the first quarter in a private transaction at a discount to cash per share!
New leadership took control, completed a significant restructuring, heightened focus and turned profitable.
With a unique growing business, compelling valuation, coupled with no Street coverage, we believe this overlooked opportunity has outstanding risk/reward characteristics.
The above is just one example of the many held in your portfolio. Here are a few more:
Holding MDU Resources Group, Inc. (MDU), offers a unique mix of steady, recurring revenue and the potential for above average revenue growth in an expanding or recovering economy. The company derives about one-third of its earnings before interest, and taxes (EBIT) through its operations as a utility and an additional two-thirds from its construction aggregates business.
Despite the potential for downside protection and upside participation, the company trades at a roughly 40% discount on a price/earnings basis to utilities with significantly weaker sales growth potential. The discount is the largest in the company’s 20+ year history. Our confidence in the case for the company was further bolstered this quarter after senior members of the firm made a significant share purchase in the company.
Comforts of Home
After a strong 2019, homebuilders were among the first to get pinched by COVID-19 concerns. The weakness was widespread with smaller builders, including portfolio holding MDC Holdings, Inc. (MDC), taking the brunt of the pain.
As long-time investors in MDC, we have been wowed by its enviable track record of strong year-over-year growth serving first-time buyers, including a 49% jump in orders in the fourth quarter of 2019. Additionally, MDC management continues to take shareholder-friendly actions including raising its industry-high dividend to roughly 7%.
Despite its impressive history and exceptional management team, shares of the business are trading at just 60% of tangible book value–lower than its 2007-2008 level of 90% and well off its long-term historical average of 140%.
We believe the homebuilding industry, and MDC in particular, are in strong shape to quickly ramp up as COVID-19 is contained. In the quarters ahead, tailwinds such as low inventory, a production gap that still needs to be closed from the 2007-08 downturn, and a growing demand for homes by millennials should result in excellent growth potential.
Trusting the Process
In addition to keeping a keen eye on insider activity, we continue to revisit the portfolio’s holdings and are making adjustments to our earnings estimates. Staying true to our fundamental process helps us stay focused on separating our view of intrinsic worth of a company rather than being swept up by temporary distortions of share price. Take EVERTEC, Inc. (EVTC), a payment processing and services company.
The company management is in the early stages of expanding its business outside of its home base of Puerto Rico and into the underpenetrated growth market of Latin America. EVERTEC’s business operations consist of recording point of sales transactions, ATM activity, network hosting and facilitating point of purchase transactions.
With the spread of COVID-19, EVERTEC has fallen victim to the market’s recent sell-off, where small and micro-cap stocks have been hit the hardest. The company now trades at valuations not seen since Hurricane Maria devastated the island of Puerto Rico in November 2017.
We believe this presents an attractive buying opportunity as EVERTEC’s business operations are now more diversified and generate materially higher margins. Given the company’s sound balance sheet, potential acceleration in cashless payments and fiscal stimulus, we believe EVERTEC will once again emerge in a position to increase market share and create long-term economic value for shareholders through strong free cash flow generation and prudent capital allocation.
Food for Thought
Reality, to us, is clearest when viewed from a long-term perspective that allows for a full appreciation of the big picture. From this context here are just a few things feeding our optimism:
- To help weather the current storm, your portfolio emphasizes companies with strong balance sheets.
- Lower oil prices translate to lower prices at the pump, offering a break for consumers.
- Interest rates are at historical lows, which benefit borrowers in the form of cheaper mortgages & auto loans.
- Well over 100 companies around the globe are working furiously on a vaccine, treatment, & tests for COVID-19. Every day progress is being made.
- The Federal government has shown a willingness to use everything in its power to backstop the economy with more stimulus packages likely on the horizon.
The dramatic market movements of late have made it difficult for some to share our upbeat view, however, share purchases by management teams throughout the country, suggest we are not alone in seeing a brighter future in the coming months.
In it for the Long Haul
The toll from COVID-19 has been significant on both a personal and economic scale. Yet, as difficult as these times are—and we know they are plenty challenging—we’ve been here before. And each time, whether Black Monday of 1987, the tragedy of 9/11 or the Great Financial crisis last decade, our dedication to our process has served our clients well.
In the face of this current challenge, we aren’t going anywhere. We remain unwavering in pursuit of investments that fit with our principles but also unrelenting in our commitment to improving.
Our efforts are reflected in the valuations below.
Value Fund Valuations
Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 3/31/2020
Price/Earnings and EV/EBITDA are calculated as weighted harmonic average. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Certain outliers may be excluded. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change. All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future returns.
It is a dark time around the globe and fear is widespread. But just as in past crises, this too shall pass. Whether in life or investing, keeping an eye on the long term can provide some much-needed perspective and serve as a basis for a brighter, more rational tomorrow.
Thank you for your continued trust and confidence.