Heartland Small Cap Value Strategy 1Q21 Portfolio Manager Commentary

 Executive Summary

  • The Small Cap Strategy was up nearly double digits, as small value stocks trounced mega-cap growth companies.
  • Increased interest in value stocks could signal a long-term unwinding of growth-at-any-price delirium. 
  • As evidence of widespread earnings growth mounts, we expect the focus on the price paid for a business will continue. 
“All overnight success takes about 10 years.”
​​​​​​
—Jeff Bezos
 

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. 

Patience Rewarded?
Russell 2000® Value Less Russell 2000® Growth Index

Heartland Advisors Value Investing R2V Less R2G Chart

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.”

What Happened?

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
Heartland Advisors Value Investing Small Cap Value Composite Valuations Chart

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.

Favorable Footprint

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.

Now What? 

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.

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Portfolio Management Team

Bill Nasgovitz

Nasgovitz is Chairman and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He has 52 years of industry experience, 38 at Heartland.

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Opportunistic Value Equity Strategy, as well as the Mid Cap Value Fund, the Value Fund, and their corresponding Mid Cap Value and Small Cap Value Strategies. He also is President and Director of Heartland Funds. He has 20 years of industry experience, 17 at Heartland.

Composite Returns*

3/31/2021

Scroll over to view complete data

Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Small Cap Value Composite (Net of Advisory Fees)**11.313.8010.3111.69102.539.929.92
Small Cap Value Composite (Net of Bundled Fees)9.723.149.9811.36101.959.849.84
Russell 2000® Value10.7610.0613.5611.5797.0521.1721.17

Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 10/1/1988. 
**Shown as supplemental information. 

The US Dollar is the currency used to express performance. Returns are presented net of advisory fees and net of bundled fees and include the reinvestment of all income. The returns net of bundled fees were calculated by subtracting the highest applicable sponsor portion of the separately managed wrap account fee from the net of advisor fees return.

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©2021 Heartland Advisors | 790 N. Water Street, Suite 1200, Milwaukee, WI 53202 | Business Office: 414-347-7777 | Financial Professionals: 888-505-5180 | Individual Investors: 800-432-7856

†Composite return is net of advisory fees.

Past performance does not guarantee future results.

The Small Cap Value Strategy seeks long-term capital appreciation by investing in micro- and small-cap companies, generally with market capitalizations of less than $2.5 billion at the time of purchase. The micro- and small-cap segment of the stock market is robust with thousands of publicly traded issues, many of which lack traditional Wall Street research coverage. Thus, we believe this market is often inefficient, mispricing businesses and offering opportunities for fundamental research-minded investors such as Heartland.

The Small Cap Value Strategy invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

Heartland Advisors, Inc. (the “Firm”) claims compliance with the Global Investment Performance Standards (GIPS®). The Firm is a wholly owned subsidiary of Heartland Holdings, Inc. and is registered with the Securities and Exchange Commission. For a complete list and description of Heartland Advisors composites and/or a presentation that adheres to the GIPS® standards, contact Institutional Sales at Heartland Advisors, Inc. at the address listed below.

As of 3/31/2021, Capital City Bank Group, Inc., Centerra Gold, Inc., and National Fuel Gas Company represented 2.18%, 2.83%, and 2.12% of the Small Cap Value Composite, respectively. Amazon.com, Inc. and General Motors were unowned. 

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

Separately managed accounts and related investment advisory services are provided by Heartland Advisors, Inc., a federally registered investment advisor. ALPS Distributors, Inc., is not affiliated with Heartland Advisors, Inc.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

Economic predictions are based on estimates and are subject to change.

There is no guarantee that a particular investment strategy will be successful.

Sector and Industry classifications are sourced from GICS®.The Global Industry Classification Standard (GICS®) is the exclusive intellectual property of MSCI Inc. (MSCI) and S&P Global Market Intelligence (“S&P”).  Neither MSCI, S&P, their affiliates, nor any of their third party providers (“GICS Parties”) makes any representations or warranties, express or implied, with respect to GICS or the results to be obtained by the use thereof, and expressly disclaim all warranties, including warranties of accuracy, completeness, merchantability and fitness for a particular purpose.  The GICS Parties shall not have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of such damages.

Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.

Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

There is no assurance that dividend-paying stocks will mitigate volatility.

Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued.

CFA® is a registered trademark owned by the CFA Institute.

Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indices. Russell® is a trademark of the Frank Russell Investment Group.

Data sourced from FactSet: Copyright 2021 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

Heartland’s investing glossary provides definitions for several terms used on this page.

Bitcoin is a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. Cyclical Stocks cover Basic Materials, Capital Goods, Communications, Consumer Cyclical, Energy, Financial, Technology, and Transportation which tend to react to a variety of market conditions that can send them up or down and often relate to business cycles. Earnings Before Interest and Tax (EBIT) is an indicator of a company’s profitability, calculated as revenue minus expenses, excluding tax and interest to eliminate the effect of different capital structures and tax rates used by different companies. Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA) Ratio is a financial indicator used to determine the value of a company and is calculated by dividing the entire economic value of the company (enterprise value) by its earnings before interest, taxes, depreciation, and amortization (EBITDA). Free Cash Flow is the amount of cash a company has after expenses, debt service, capital expenditures, and dividends. The higher the free cash flow, the stronger the company’s balance sheet. Price/Book Ratio of a company is calculated by dividing the market price of its stock by the company's per-share book value. Price/Earnings Ratio of a stock is calculated by dividing the current price of the stock by its trailing or its forward 12 months’ earnings per share. Return on Equity is a measure of the net income after taxes that a firm is able to earn as a percent of stockholders equity. Russell 2000® Value Index measures the performance of those Russell 2000® companies with lower price/book ratios and lower forecasted growth characteristics. S&P 500 Index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index. Volatility is a statistical measure of the dispersion of returns for a given security or market index which can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security. Yield is the income return on an investment.

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