While there are no such things as moral victories in investing, value investors can at least take solace in the fact that the shift in the markets that started to take place last year — investors paying attention to attractively valued, profitable, well-managed businesses — remains intact.
To be sure, during the first quarter rout, small cap value fell modestly amid growing anxieties over rising inflation and interest rates along with the first major land war in Europe since World War II. Yet small cap value’s first quarter setback paled in comparison to small growth, which suffered losses five times greater.
This may be cold comfort to investors who live in the real world, where paper losses still compound. Nevertheless, value-minded investors know the importance of not letting short-term gloom and doom get in the way of one’s long-term strategy. As Warren Buffet famously said: “The most common cause of low prices is pessimism… We want to do business in such an environment, not because we like pessimism but because we like the prices it produces.”
Newfound Focus on Small Value
With economic and geo-political uncertainties swirling, we believe investors are now more mindful of the price they pay for the companies they own, which had been largely ignored for years when interest rates were at record lows. This renewed focus on valuations has shifted the market’s attention from large caps to small caps.
As demonstrated in the chart below, on a Price-to-Earnings (PE) basis small cap stocks remain “on sale” in relation to large caps.
This is only the third time in the last 42 years small caps have sold at this large of a discount and in our view validates our enthusiasm for the asset class.
A Pivot Towards Small Caps?
Source: : ©2022 The Leuthold Group, 1/1/1983 to 3/31/2022. The Leuthold 3000 Universe is defined as the largest 3,000 securities traded on U.S. exchanges. Universe was segregated into large- and small-cap tiers. Blue bars identify recessionary periods of July 1990 to March 1991, March 2001 to November 2001, and December 2007 to June 2009. Price/Earnings Ratio (P/E). Past performance does not guarantee future results. There is no guarantee that a particular investment strategy will be successful.
Importantly within small caps, value seems to be at a decided advantage over small-cap growth, which based on projected 2022 earnings, remains nearly as expensive as large-cap stocks.
Another tailwind for small value: The anxious economic backdrop and the market’s growing desire for downside mitigation has been leading investors to the Energy and Utilities sectors both of which are heavily weighted in the value index and your portfolio,
Value Fund Valuations
Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 3/31/2022. 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. 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.
The Case for Active Value
While it’s always a good sign when the markets are paying attention to valuations and risks, it’s important for investors to understand that not all value strategies will lead them to the market’s most undervalued opportunities. Case in point: passive exposure to value. For instance, roughly half of the Russell 2000® Value Index’s Health Care weighting is held in Biotech stocks. How this sub-industry is classified as value is a head scratcher.
In our case, we’re focused on businesses that have the potential to hold up better in a volatile, down-trending market, which wouldn’t generally include many Biotech names. And we are finding compelling values in areas of the market that either experienced a prolonged downturn — such as energy and mining stocks, which are also benefitting from inflation’s tailwind — or that were simply overlooked after the market’s bounce back from the initial COVID downturn. The following are just a few of the quality businesses held in the fund trading at compelling prices.
Taking stock of housing
Radian Group (RDN) was a positive contributor in the quarter as shares of this mortgage insurance provider rose nearly 5%. The stock was buoyed by a strong housing market and better than expected underwriting results.
At the onset of COVID, many investors were predicting that the pandemic would lead to large increases in underwriting losses & decreased volumes due to housing slowdown for Radian and other mortgage insurers. Instead, a strong housing market buoyed by low interest rates, better capitalized consumers, and Millennials entering first-time home buyer age led to increased volumes of mortgage insurance written. Rising home equity and government forbearance programs kept foreclosures low and resulted in better than expected underwriting results for Radian.
Despite the strong recent performance, the stock currently trades at 92% of book value and just 7X estimated 2022 earnings. This lowly valuation doesn’t reflect the potential of Radian’s high growth fintech title service business, which management is targeting at $650 million to $1 billion in revenues by 2025. Further, the business is currently generating excess cash which is being returned to shareholders in the form of buybacks and dividends. RDN repurchased 9% of shares outstanding, 17.8 million shares in 2021 for a total of $399 million, at an average price of $22.48. They recently announced a new $400 million share repurchase program and raised the dividend 12% for a 3.6% dividend yield.
Also, we have been long-time holders of Century Communities (CCS), a builder of low-cost single-family homes and condos. We have been impressed with their 20-year record of profitable growth which reached a record $4.2 billion in sales and $14.47 in EPS in 2021. However, due to an increase in mortgage rates and fears of a housing slow-down, Century was one of our worst contributors, down -34.5%. While rising rates will temper a hot housing market, we remain constructive on the first-time homeowners’ market and Century’s management team. Despite a five-year average revenue growth rate of 34% and net income growth rate of 59%, the stock trades at a discount to estimated book value and an absurd 3.7X earnings. We believe the sell-off is overdone, largely discounting a potential slowdown.
Supply chain issues and inflation took their toll on a number of companies in the latter half of 2021 and the start of 2022. Americold Realty Trust (COLD) was one of them. Shares of the world’s second largest owner and operator of cold storage warehouses — which hold processed foods in temperature-controlled warehouses until they are ready to be shipped to grocery stores — came under pressure due to a sharp decline in occupancy, as its customers struggled to staff their own production lines. Meanwhile, labor costs spiked in 2021, as employers across the nation struggled to staff their own facilities. Still, cold storage warehouses are a critical link in the food supply chain, and the stock trades at a cap rate of around 6.5%, which is a measure of the rate of return based on expected income generation. To put this in perspective, REITs that exhibit meaningful barriers to entry — which Americold does — tend to trade at a 4% cap rate or lower. We believe a 5% cap rate is a fair multiple.
Americold is a defensive play, in that it does not require a strong economy to thrive. In fact, a weakening economy could be beneficial to the company by cooling the labor market and easing some margin pressures. COLD pays a 3% dividend and was added in the quarter, off approximately 30% from recent highs.
Positioned for defense — and opportunities
There are plenty of reasons to be cautious in this market. As value investors, however, we believe it comes down to individual security fundamentals and risk vs reward considerations.
For example, we took profits on an aircraft manufacturer with a seemingly stretched balance sheet and decline in outlook.
Those proceeds were added to BWX Technologies (BWXT), a specialty manufacturer of nuclear components and initiated a position in Aerojet Rocketdyne Holdings (AJRD), which manufactures systems for defense and space applications. These changes overweighted Aerospace and Defense, which is 1% of the Russell 2000® Value Index. However, we are more heavily skewed to the defensive side of the industry.
Keeping our Emotions in Check
By filtering out negative headlines and focusing on long-term opportunities that are trading at attractive short-term prices, Heartland’s 10 Principles of Value Investing™ aims to avoid paying heavy prices for meaningless reassurances. This disciplined, fundamental research approach may be the road less traveled, but we believe it’s the best way to achieve long-term capital appreciation.
Thank you for the trust you place in us to manage your capital.