After years of Mr. Market seeming to have free rein to name any price he wanted, 2021 saw signs that investors were starting to say enough. Performance for the small-cap value index ended the year on equal footing with returns posted by the S&P 500 and roughly 10X the return for the small-cap growth index. The emerging trend provided a tailwind for attractively valued businesses and the Fund beat its benchmark during the fourth quarter.
Following years of small growth outpacing value in a low interest rate, low inflation era, as shown below, we view the strong performance for small cap value as the beginning of what could be a long rewarding trend for investors.
More to Come?
Source: : FactSet Research Systems Inc., Monthly data 1/1/2002 to 1/6/2022. Russell 2000® Value Index measures the performance of those Russell 2000® companies with lower price/book ratios and lower forecasted growth characteristics. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
As value investors, we cheered this budding return of reason but recognize not all investors have abandoned their spendthrift ways. Whether its sales of Manhattan’s luxury homes clocking in at 30% higher than the previous highwater mark in 2015 or investment bankers bringing a record volume of $1 billion-plus initial public offerings to market, some are still clinging to a “price is no object” mentality.
For equities, the result has been a sliver of stocks driving returns of broad indices. For instance, just five companies accounted for over 60% of the gains in the tech-heavy Nasdaq 100 Index for the year. The byproduct of investors chasing the largest names has resulted in top-heavy indices, as shown below, where a handful of names can make or break performance for passive investors.
Tail Wagging the Dog
Source: S&P Dow Jones ndices and Ned Davis Research, Monthly data from 01/31/1972 to 12/31/2021. Copyright 2021 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. All indices are unmanaged. It is not possible to invest directly in an index. The S&P provides an indication of broad market performance but is not a benchmark of the Funds. Past performance does not guarantee future results.
In response to this backdrop, we continue to focus our relentless research on identifying and owning companies that are poised to succeed against a variety of backdrops or those that are priced at significant discounts to peers regardless of the sector.
Proof of our dedicated approach is reflected in the chart below displaying the extreme valuation discount of the Fund compared to the major indices. We believe the 11 portfolio holdings snapped up this year at premiums by strategic buyers highlights that others also recognize the attractiveness of a value-driven approach.
Value Fund Valuations
Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 12/31/2021. 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.
A Strong Finish
A renewed interest in the price paid for businesses was a boon for many of the names held in the portfolio. As we look froward to what the New Year has to bring, here are a few of the companies in the Fund that we view as overlooked gems ripe for discovery by investors.
Take it to the Bank
The portfolio’s Financials holdings have been a source of strength throughout 2021. While shares of large national banks cooled late in the year on concerns that loan losses could inch higher, we continue to find well run regional players that are thriving by serving unique niches. Capital City Bank Group, Inc. (CCBG), is a prime example of our approach.
The bank serves the booming state of Florida and fast-growing Southeastern U.S. through its 57 branches. We’ve been long-term investors in Capital City, attracted by its unique position as one of the largest publicly traded financial holding institutions headquartered in Florida, conservative long-term capital allocation strategy, and significant insider ownership.
Capital City has made the most of population increases as reflected by its five-year compounded 35% annual growth rate. Additionally, management has been able to produce a 9.5% return on equity, outpacing the roughly 7% rate of regional banks on average.
Despite its high-growth footprint and strong management, shares of Capital City are priced at a nearly 10% discount to competitors.
Shares of many Health Care companies were down as the continuing threat of COVID-19 dampened demand for elective medical procedures and health care providers struggled to maintain adequate staffing in the face of burnout and resistance to vaccine mandates. The Fund’s holdings performed in line on a relative basis but detracted from absolute results.
Instead of trading on every new wrinkle in the ongoing pandemic, we’ve taken the long view by focusing on owning businesses that we believe are well positioned to drive consistent growth when the shadow of COVID-19 fades.
Perrigo Company PLC (PRGO), a pharmaceutical business and leading maker of private-label over-the-counter products, is one such opportunity. While the company is lumped in with more volatile pharma companies, we view it as a consumer-packaged goods business that offers a one-of-a-kind product platform characterized by a stable, growing, and valuable cash flow stream.
A new management team with a strong track record was hired in late 2018 to rectify stumbles made by previous leadership. We’ve been pleased with the strides taken and believe recent supply chain issues and reduced demand for its cold and cough products are directly related to COVID-19 and are, therefore, temporary. With shares trading at close to stated book value and 13X next year’s estimated earnings before interest, taxes, depreciation, and amortization (EBITDA), the team views Perrigo as a compelling opportunity for the quarters to come.
Information Technology (IT) had a strong showing for the period, and the portfolio reaped rewards from some long-time holdings, including Photronics Inc. (PLAB).
Photronics is an industry leading, global manufacturer of photomasks used to transfer circuit patterns onto semiconductor wafers and flat panel displays. During the past year, the company has met the challenge of heightened demand despite facing supply-chain bottlenecks.
Investments made a few years ago to spur growth are beginning to produce results with dramatic improvement on return on equity (ROE)—which we expect to reach 9% this coming year. Despite the strong growth, shares trade at just 1.2X book value and 13X next year’s estimated earnings.
Shares are up handsomely since we initially took a stake in the business, and we’ve taken some profits to redeploy elsewhere.
Uncertainty about economic growth in the coming quarters weighed on Energy companies in the broader market. Longer term, we believe the capital discipline oil producers have shown over the past few years will provide support for energy prices as increased incremental demand will continue to absorb modest production increases. The Fund’s holdings in the sector fared better, and the portfolio owns well managed producers with strong balance sheets. Longtime holding Berry Corporation (BRY) fits this profile.
We highlighted Berry in the third quarter commentary praising its seasoned management team and financial strength. The company maintained its record of shareholder-friendly policies during the most recent quarter.
The move, along with compelling valuations—shares trade at just 4.7X EV/EBITDA—makes Berry, in our view, an attractive opportunity. Management remains disciplined in allocating capital, reining in debt, and focusing on high-margin production. This approach, along with aggressive efforts to return capital to shareholders through share repurchases and increased dividends, should attract additional investor interest.
To a Brighter 2022
For too long, small-cap value stocks have taken a back seat to growthy darlings in the market. Yet the past year gives us optimism that investors are gradually coming around to the importance of valuations. While we would welcome a quicker return to rationality, we recognize that after roughly a dozen years of growth outperforming value it will take time to unwind some of the excesses found in the market today.
In the meantime, we will continue to adhere to our process that has led us to winners in a variety of industries. While the catalysts for the portfolio’s top performers in 2021 have varied, they shared the common trait of valuations that we found far more compelling than the multiples paid by momentum investors for a handful of glamour stocks large or small.
We acknowledge this fundamental approach isn’t always sexy but view it as the best way to achieve the long-term goal of capital appreciation.
Thank you for your continued confidence.