It’s rare to see Mr. Bezos quoted in a client letter from a disciplined value investor, but in this instance, we think the Amazon.com Inc. (AMZN) founder is on to something. And not to quibble too much, but occasionally overnight success can take even longer. Take the first quarter’s meteoric rise of small cap value stocks. The double-digit gains and trouncing of mega-cap growth companies for the quarter and over the past six months has, as shown below, been a longtime coming.
Russell 2000® Value Less Russell 2000® Growth Index
Source: FactSet Research Systems Inc., Russell®, and Heartland Advisors, Inc., 1/31/1988 to 12/31/2020, annualized return over rolling 10-year periods. Standard Deviation is a measure of volatility of returns and is computed as the square root of the average squared deviation of the returns from the mean value of the return. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
The last time small value did this well on an absolute and relative basis, Alan Greenspan was Chairman of the Federal Reserve and the last Oldsmobile rolled off GM’s Michigan assembly line. The year was 2004 and tech investors were still recovering from the bursting of the internet bubble.
After a quarter like small value has had, the two questions we most commonly hear are, “What happened?” and “Can small cap value continue to perform?” Our short answers are “A lot has happened” and “It depends on the individual company.”
Investors realized that a handful of mega-cap growth stocks don’t have a corner on the market for growing earnings. To us, that reality was hiding in plain sight, but here are a few things that helped convince others to see the possibilities:
- Shots in arms. The roll out of multiple COVID-19 vaccines heightened belief that a return to normal was in sight.
- A surge in spending. While the verdict is out on the long-term consequences of federal stimulus spending, the promise of government checks has put a spring in the step of consumers. As a result, investors have been capitalizing on renewed confidence by bidding up shares of businesses most closely tied to the economy reopening.
- The trend is your friend. Earnings for a large swath of businesses big and small have met or beaten forecasts. With several observers including Fed. Chairman Jerome Powell estimating the economy could grow by 7%, or more, widespread strength allowed investors to be more cost-conscious when deciding where to invest.
- Rates on the rise. Although bond yields are still near historic lows, rates have moved materially higher. In response, investors reallocated capital away from decade-long performance leaders in mega-cap growth and technology sectors, while favoring participation in inflation sensitive, cyclical, and commodity areas.
The Small Cap Value Strategy benefited from these trends, recording a double-digit gain for the first quarter. However, after strong out-performance last year it lagged the benchmark for the period. Investors trimmed some of the biggest winners of the past several months. The current consolidation, in our view, represents opportunity.
As evidence of widespread earnings growth continues to mount, we expect markets will maintain a focus on the price paid for a business.
As displayed in the bar charts below, the disparity in valuations between holdings in the portfolio and those in the major indices remains extreme and attractive value is still available in small-cap land. We believe these valuations coupled with strong balance sheets position the portfolio to capitalize on what could be a long-term unwinding of the last decade of growth-at-any-price delirium.
Small Cap Value Composite Valuations
Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 3/31/2021. 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.
The following are just a few of the quality businesses trading at compelling prices that are held in the portfolio.
Capital City Bank Group, Inc. (CCBG), through its 57 branches serves the booming state of Florida and fast-growing Southeastern U.S. We’ve been long-term investors in the company, 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 in line with what we view as slower-growing weaker competitors.
Not Your Father’s Power Company
The ho-hum Utilities sector isn’t typically a place to hunt for strong growth prospects. However, for investors willing to do their homework, opportunities do exist. Portfolio holding National Fuel Gas Company (NFG) is a prime example.
NFG is a dividend aristocrat—50 consecutive years of dividend increases. Although the business is lumped in with run-of-the-mill 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.
Shares of NFG are trading at a mid-teens discount to their historic average based on price/book. Given the state of the energy industry over the past few years, we believe the company’s gas unit could be an overlooked source of growth. Additionally, the utility recently received regulatory approval on a natural gas pipeline expansion in Pennsylvania, which is expected to produce a windfall in free cash flow.
A Bump in the Road
The latest $1.9 trillion in stimulus, along with up to $2 trillion more in infrastructure spending, will continue to flood the economy with cash, increase the nation’s deficit leading to more Federal Reserve monetization, and possibly increase inflation—all of these have historically been a boon for the price of hard assets including precious metals.
Whether due to increased acceptance of Bitcoin (which doubled in value during the quarter to roughly $60,000) as an asset class, or market irrationality, the price of gold fell during the quarter.
As we noted at year end, one of our favorites in the sector is Centerra Gold Inc. (CAGDF & CG CN), which saw its shares set back sharply, heightened by a tax dispute with one of the countries it has partnered with on a mining operation.
Centerra is a long-term portfolio holding, and over the years we’ve been impressed by management’s conservative capital allocation, geographic diversification, and excellent record of building shareholder value. At current gold prices, the company throws off abundant free cash flow, is debt free, yet is priced at a fraction of its net asset value. We believe the market has overreacted to short-term events, severely discounting management’s ability to resolve the dispute.
Increased interest in value stocks over the past six months has us optimistic that a return to common-sense investing may be taking root. However, the sharp gains during the period has raised the stakes as the universe of attractively valued businesses has shrunk.
Balance sheet strength, excellent management, and a defendable business niche each could become even more important should the economy fail to live up to heightened expectations. However, we believe Heartland’s active approach, founded on intensive research that seeks to capitalize on the disparity between fundamental value and market price continues to offer unique opportunities. This investment philosophy runs counter to the mainstream view but is particularly prudent after recent volatility and more than a decade dominated by speculative excesses.
Thank you for your continued confidence. We look forward to a new era for Value and will be here to celebrate future “overnight successes” with you.
We appreciate the opportunity to manage your capital.