Despite recent headwinds, the Value Fund handily outperformed the Russell 2000® Value Index for the quarter and through the first half of the year.
Maybe it’s too much time spent in isolation due to social distancing or it could just be something in the water. Whatever it is, there seems to be no shortage of speculative behavior among investors these days. While Mr. Portnoy has been the poster child for the new mentality in the market, a look at valuations and balance sheets of some of the big winners during the past quarter, shows his bet-first-analyze-later approach is common in the age of COVID-19. Consider the following:
- Shares of Hertz, the bankrupt rental car company, surged after management proposed flooding the market with a new issue of equity.
- Retailer JC Penney with $3.7 billion in debt saw its shares jump 55% weeks after filing for bankruptcy.
We’d be tempted to overlook these examples as outliers if it weren’t for the data below. The mass herding into weak businesses and mega-caps has resulted in profitable small cap companies trading at historical discounts—the most in 30+ years—to the S&P 500 as reflected by earnings yield.
Median Earnings Yield Spread vs. S&P 500
Profitable Companies Only
Universe is the 3,000 largest U.S. stocks by market cap according to FactSet Research, calculated monthly. Top 1000 basket includes companies ranked 1 to 1,000 by market cap. Second 2000 includes companies ranked 1,001 to 2,000 and Third 1000 includes companies ranked 2,001 to 3,000. Universe is rebalanced monthly. Earnings Yield is defined as Net Income for the last 12 months, divided by Market Cap, calculated monthly. Median Earnings Yield Spread for each basket is defined as the median company EY of each basket after excluding companies with negative income over the last 12 months, minus the median EY of S&P 500 companies after excluding money losers. Calculated monthly. Standard Deviation of Earning Yield Spread indicates how far the current EY reading deviates from the average. Negative S.D. means the EY is more expensive than average, positive S.D. means the current EY is cheaper than average. Calculations run from 12/31/1986 through 6/27/2020. Data as of June 30, 2020.
The portfolio was up nearly 30% for the quarter yet work remains to undo the damage from the pandemic-fueled selloff of spring. In a market driven by momentum and speculation, the fact that the Strategy outpaced its benchmark is encouraging given the team’s commitment to fundamental research and focus on valuations. The foundation laid by Heartland’s 10 Principles of Value Investing has led us to well managed businesses, that are financially strong and have what we view as compelling opportunities for bottom-line growth in the years ahead. The following are just a few examples.
A Home Run?
We highlighted portfolio holding MDC Holdings Inc. (MDC), as a casualty of the COVID-19 selloff earlier in the year. The company, like other homebuilders, saw its shares fall due to investor concerns about shrinking demand.
Despite the weakness, we were steadfast in our confidence in the company’s management team as well as growth prospects going forward. That commitment was rewarded as shares rebounded sharply on an uptick in orders.
We believe the homebuilding industry, and MDC in particular, are on the cusp of a surge in demand as Millennials faced with working remotely out of small, urban, apartments have started to seek more space in homes in the suburbs.
Millennials are projected to generate over 30 million additional households over the next 15 years. MDC’s expertise in meeting the needs of entry-level buyers positions the company to thrive during the coming demographic tsunami.
Despite its impressive history and exceptional management team, shares of the business are trading at 1.2X tangible book value and the company boasts a return on equity of 14% in 2019. At its current valuation the stock throws off an earnings yield of 8%.
Information Technology (IT) was a source of strength for the portfolio during the period, and we believe holdings such as Photronics Inc. (PLAB) have further room to run.
Photronics is a global manufacturer of photomasks used to transfer circuit patterns onto semiconductor wafers and flat panel displays during the fabrication process. The company operates nine manufacturing facilities throughout the world and is an established player in fast-growing markets, such as China and Korea.
We took a stake in Photronics when shares were under pressure as it was investing in expanding its capacity. While other investors were fixated on the short-term effect capital spending put on profit margins, we saw a business that was positioning itself to meet the needs of the high-growth IT industry.
Photronics is now set to reap the benefits of several years of growth investments. Along with an expected jump in sales, margins should expand as capital improvements wind down leaving the company well situated to generate robust cash flow going forward. We also view the business’ financial position, with $2.76/share of cash on the balance sheet, as a competitive advantage.
A Wolf in Sheep’s Clothing
The sleepy Utilities sector is rarely seen as a place to look for businesses with strong growth prospects. However, for investors willing to do their homework, opportunities do exist. Recent portfolio addition National Fuel Gas Company (NFG) is a prime example.
Although NFG is lumped in with plain vanilla power companies, it is much more diverse. In addition to its utility operations, a pipeline and storage division generates almost a quarter of its profits and the company generates nearly 40% of its bottom line from natural gas exploration and production. Given the current state of the energy industry, we believe NFG’s gas unit could be an overlooked source of growth.
During the first half of this year, domestic oil pumping fell significantly in response to weak demand and low crude prices. As a result, natural gas production—a byproduct of the oil drilling process—also shrank. The upshot is that the supply/demand dynamic may finally be shifting in favor of gas producers who have lacked pricing power for years.
Sensing the improved outlook, NFG opportunistically expanded its gas producing footprint when it acquired assets from a subsidiary of Royal Dutch Shell in May. The deal is expected to immediately contribute to earnings and provides the company with additional fertile acreage and room to grow its 4% dividend yield.
A Golden Rule?
As Washington D.C. pulls out all the stops to keep the economy afloat despite the ravages of COVID-19, deficits here and abroad have ballooned. As displayed below, historically, growing deficits have been a boon for the price of hard assets such as gold. Fortunately, we’ve been able to identify well-managed participants in the space priced at compelling valuations.
While 2020 may continue to be defined by its unpredictability, we remain unwavering in pursuit of investments that fit with our principles but also unrelenting in our commitment to improving.
Thank you for your continued confidence. We look forward to a return of common sense.