What a wonderful time it is to be an enterprising value investor.
This might seem like an odd thing to say at the moment, when a quick glance of the markets reveals a considerable amount of carnage. Despite a bounce in the first half of the fourth quarter, the Nasdaq composite is still down more than 30% in 2022 while the S&P 500 has lost more than 18%. Consumer confidence remains lower than it was during the global financial crisis. And investors are similarly glum, with nearly $5 trillion sitting on the sidelines, weary of risk-taking.
Yet as some of the smartest people in the world have pointed out, it’s in difficult times when opportunities present themselves. We believe that even in a bear market, there’s a bull emerging somewhere. If a recession is on the horizon, there are still companies with competitive advantages that set them apart. It is our job, as bottoms-up stock pickers, to use this environment to find well-run businesses with secular tailwinds, when they are sufficiently undervalued.
Which brings us to another bit of good news: valuations and balance sheet strength appear to matter again.
This shouldn’t come as a surprise, especially now that the cost of money is no longer free, and finances are being stressed by the one-two punch of higher rates and a weaker economy. After aggressive Federal Reserve tightening throughout the year, the yield on the 1-year Treasury has shot up from 0.38% to 4.7%. Tough competition for lofty valuations and speculation. In this environment, value stocks generally outperform growth, and we expect this trend to continue.
The likelihood of finding value seems greater in small caps than large companies. After an historic run for name-brand growth stocks in recent years, small-cap’s share of total market value remains lower today than in the dotcom era of the late 1990s, as demonstrated in the chart below.
Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies, Monthly data 12/1/1930 to 11/30/2022. The data in this chart represents small cap’s percentage of the US equity market. Note: Small is represented by deciles 6-10 based on market cap. All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.
Attribution Analysis & Portfolio Activity
Throughout the year, we’ve been looking for a combination of lower earnings estimates and stock prices to improve the risk-return profile of companies on our “watch list.” Some of those opportunities presented themselves recently. It was bottoms-up selectivity — not top-down sector bets — that instigated those decisions. Security selection also drove our performance throughout 2022, particularly among Financials, Real Estate, Information Technology, and Industrials.
A good example of that selectivity was Aerojet Rocketdyne Holdings (AJRD), a producer of products for space, defense, and weapons systems. We purchased the stock this Spring, after AJRD shares tumbled following Lockheed Martin’s decision to terminate its agreement to acquire AJRD amid anti-trust challenges. That was around the time, though, that demand for Aerojet’s missile motors was rising amid Ukraine’s effort to defend itself against Russia. In late December, L3Harris Technologies agreed to purchase the company for $58 a share, 38% above our purchase price.
Normally, success doesn’t materialize that quickly. Here are more traditional examples of our stock selection:
Consumer Discretionary. It’s hard to think of a stiffer economic headwind than what the housing market has been facing. After starting the year at just over 3%, the average rate on a 30-year fixed mortgage jumped above 7% midway into the fourth quarter. Not surprisingly, sales of existing homes have fallen for 10 straight months and are down 35% year over year.
Century Communities (CCS), a homebuilder based in Denver, Colorado, hasn’t been immune. Sell-side analysts now believe CCSs’ 2023 sales will fall to 2020 levels, which is 33% below what they expected at the start of 2022. The stock is down around 38% year to date. We believe this is an example of short-term fear providing an excellent opportunity for the patient long-term investor. CCS is trading at just 78% of book value, thus providing a margin of safety.
Meanwhile, we are constructive on the supply-demand prospects for CCS’s core product. Approximately 80% of CCS’s sales are made to entry-level buyers. Supply of starter homes is tight after nearly a decade of below-average building activity. At the same time, millennials are reaching their first-time homebuyer age and forming households, providing a long-term buoy for demand.
Century’s management team has guided the company to more than 20 straight years of profitability. We think they should be able to successfully navigate a housing slowdown and close its discount to book value over time.
Industrials. Shyft Group (SHYF) is a leader in specialty vehicles, including “last mile” delivery vans used in ecommerce. More than a year ago, the company announced plans to develop an electric parcel-delivery vehicle, investing $75 million at launch. Concern over the elevated operational risks and spending associated with the program weighed on the stock sending shares down almost 49% this year.
The company has unique growth opportunities, and we believe the EV expenditures will ultimately be money well spent, as it expands the addressable market and protect against competitive offerings. The business is priced at only 8.2X our estimate for Enterprise Value to EBITDA, substantially below its intrinsic worth.
Consumer Staples. A new addition to the portfolio last quarter was Primo Water (PRMW), one of the largest providers of multi-gallon bottled drinking water for consumers and businesses in North America and Europe. While water isn’t necessarily considered economically sensitive, investors have underappreciated the stock partially due to fears that the downturn could hurt sales since the alternative—tap water—is free.
PRMW’s business model, which includes direct delivery, refills, exchanges, and the sale of in-home dispensers, should prove recession resistant and durable. The company benefits from concerns over the quality of tap water, given the aging municipal infrastructure and the phasing out of single-use plastic bottles. We felt comfortable initiating a position after the company raised its revenue and earnings guidance and the CEO aggressively purchased shares. Plus, the stock trades at just 8.7X EV/EBITDA, a significant discount to its peer group and true worth.
Outlook
More so than others, value investors seem to appreciate that opportunities can be found in difficult times. Over two decades ago, value came back into favor after a prolonged period of underperformance amid the bursting of the dotcom bubble. Back then, all the headlines focused on the carnage in the tech sector, yet there were pockets of strength led by small-cap value.
Today feels a lot like 2000. While stocks are broadly in a bear market, we are encouraged by renewed interest in value investing and the opportunities we are identifying in the small-cap space. If that market taught investors anything, it was that patience is required to take advantage of these extended runs, including the discipline to stick with the strategy and allow it to unfold over time. The big mistake investors made back then was giving up too quickly on value shortly after the tech bubble burst and assuming, incorrectly, that beaten-down speculative stocks offered real bargains.
We believe patient investors will be rewarded for buying and holding financially sound, well-managed assets at low prices relative to their earnings, cash flows, and book values. In other words, real value investing, and not just ‘buying on the dips.’ These quality and valuation traits are core to Heartland’s 10 Principles of Value Investing™, which guide our investments irrespective of market conditions.
Thank you for your continued trust and confidence.