Heartland Small Cap Value Plus Strategy 4Q22 Portfolio Manager Commentary

Active and Selective

Much like those other historic periods marked by inverted yield curves, this is a market where we believe it will pay to be extremely selective. 

We have historically focused on identifying undervalued small companies with solid balance sheets that permit them to self-finance organic growth and strong free cash flow to raise their dividends over time. On top of that, we favor companies with compelling self-help strategies to provide an extra catalyst. Those principles of attractive valuations, financial soundness, compelling business strategies and catalysts for recognition are core to our 10 Principles of Value Investing™.

The markets, however, don’t always compensate investors for these traits. That changed, however, as our style of investing has recently come back into favor. Indeed, security selection was the biggest reason for our outperformance versus the Russell 2000 Value Index during the quarter. And it was the primary reason for our outperformance versus the Index in a challenging year. 

However, investors haven’t bought in completely. For example, one factor that investors aren’t being penalized for yet is leverage. But that’s likely to come — along with a renewed focus on financial soundness — now that the Federal Reserve seems to be almost done with slamming the brakes on the economy. For that final shoe to drop, we need to see signs of capitulation from management teams. We’re not there yet, but the markets are nearing that point, and we believe our Portfolio stands to benefit even further once the market finally pays attention to balance sheet strength again.

Attribution Analysis

It’s important to note that we are not just hiding out in defensive areas of the market. If that were true, we would be considerably overweight in Utilities and REITS, which we are not. And we wouldn’t be overweight in economically sensitive sectors such as Industrials, Materials, and Energy relative to the Russell 2000® Value.

It’s more accurate to say we favor companies with defensive characteristics that are likely to be secular winners, even if the economy doesn’t offer much of a tailwind. And once the next cycle begins, these are companies that stand to benefit as the economy re-accelerates.

Industrials. An example is Powell Industries (POWL), which manufactures electrical power distribution equipment and components used in pipelines, offshore drilling platforms, data centers, and large industrial facilities. After experiencing a downturn along with oil prices in recent years, Powell is now enjoying a tailwind from energy’s rebound, especially liquified natural gas related. Order activity, in fact, has risen for six consecutive quarters. And for the full year, new orders rose 78% compared to fiscal 2021. 

Powell enjoys self-help catalysts as well. The company, with significant insider ownership, has been focused on internal capital allocation moves lately to position itself for a more profitable future. In fiscal year 2022, for instance, the company divested a low-margin industrial valve repair division within Powell Canada. At the same time, the company has been investing in its higher-margin services business to improve its overall mix of revenue sources.

Yet, very few sell-side analysts cover the stock, and those who do, don’t seem to appreciate the internal and external tailwinds the company enjoys. This is where our selectivity comes into focus.

Outlook

We understand that one of our primary responsibilities is to protect investors on the downside. And while our portfolio won’t be immune to the effects of slow growth and lingering inflation, we think our companies will be less affected than the broader market. 

But another responsibility is to do what hockey great Wayne Gretzky famously espoused — skate to where the puck is going to be. That’s why we don’t just focus on companies with defensive characteristics. We also search for well-run companies that are positioned to be secular winners. So, at a time when the markets are recognizing the growing chance of a recession, we’re looking at next year’s earnings and the next cycle and beyond.

It's this type of contrarian and long-term thinking that helped us weather a challenging year. And it’s the same type of thinking that we believe will serve our clients well in the quarters and years to come.