Fear returned to the market in a big way in the first quarter. And for selective, long-term value investors, this was welcome news.
Whether or not bank failures in March wind up sparking a full-fledged financial crisis, one thing seems clear: A year into the Federal Reserves’ tightening cycle, rising rates are putting balance sheets under pressure, leading to tighter lending standards, widening credit spreads, and a growing perception of risk.
An important change is that fundamentals matter again, as investors are now demanding evidence of financial strength in the aftermath of the recent collapse of Silicon Valley Bank, Signature Bank, and Silvergate Capital. For value investors looking to own well-run businesses at reasonable prices, this is a heartening turn.
Of course, this change in mindset comes at a cost, reflected by rising volatility and risk in the market. After an early-year risk-on rally that pushed the Russell 2000® Index of small- cap stocks up nearly 10% through the start of March, concerns over a banking crisis sent the benchmark down more than 7% for the month. For the quarter, the Heartland Small Cap Value Strategy outperformed the Russell 2000® Value Index.
Risk, it should be noted, isn’t just a reflection of external forces like rising rates and inflation. It is also a function of what investors know — or more to the point, don’t know — about the companies they own, as Warren Buffett famously noted. At a time when financial, market, and economic risks are all on the rise, minimizing investor risk by knowing what you own is more critical than ever.
At Heartland, this notion of having strict standards and maintaining discipline is ingrained in our 10 Principles of Value Investing™, which demands that we focus on compelling valuations, balance sheet strength, and sound business strategies. The fact that many investors only recognized the strategic vulnerabilities of Silicon Valley Bank after it collapsed speaks volumes about how real the risk of blissful ignorance can be.
Heartland’s principles are reflected in the fundamental characteristics of our holdings relative to the small-cap benchmark. Our portfolio, for instance, is underweight leverage and approximately 5% of our holdings are unprofitable based on forward earnings, versus more than 25% for the Russell 2000® Index. We prefer companies with positive earnings dynamics, including upwardly trending estimates. Given that the percentage of non-earners in the small-cap benchmark remains at uncomfortable levels, as seen in the chart below, this is a time for active value investors to be extremely selective in their investment allocations.
Source: FactSet; FTSE Russell; Jefferies, monthly data from 1/31/1985 to 3/31/2023. This chart represents the small cap’s percentage of the US equity market by trailing earnings and forward earnings. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Attribution Analysis & Portfolio Activity
In what was another challenging quarter marked by shifting investor sentiment, stock selection played a critical role in our performance, as is typically the case. This was particularly true in financials. Our selectivity in this sector, coupled with our underweight allocation, allowed us to outperform the benchmark in a challenging part of the market.
Financials. As the banking sector has sold off across the board, the market is now pricing in the odds of many banks needing to raise capital. This chaos creates fear, but an opportunity to discover potential opportunities through in-depth fundamental research. For instance, we were able to take advantage of markdowns in the quarter to add to companies with strategic and competitive advantages.
First Interstate BancSystem (FIBK), a community bank headquartered in Billings, MT, is a good example. The banks that failed in early March lent money to specific customer bases that were high risk. Silicon Valley Bank lent money to venture-backed startups that often generated no cash flow. In the case of Silvergate, it lent money to crypto currency market participants.
That’s not the case with First Interstate. The company operates outside the spotlight in the Northwest. It maintains the second largest share of deposits in Montana and Wyoming and has executed strategic acquisitions to gain access to contiguous states including Idaho, Oregon, Washington, and South Dakota. These are markets that tend to be more consolidated and less competitive, resulting in higher margins and returns relative to industry peers.
FIBK enjoys a high-quality deposit base with clients who are largely using their accounts for transactional purposes — not to chase yield. The bank only lends to traditional borrowers including local business owners and consumers, and it takes a conservative approach to loan underwriting. We believe First Interstate will be a share gainer throughout this downturn.
First Interstate underperformed other regional banks emerging from the COVID-19 recession, when investors gravitated to lower-quality lenders beaten up during the pandemic. The stock, which has historically traded at a median P/E ratio of 13.6 based on forward earnings, is currently trading at just 9.7 times our FY23 estimates.
Materials. In a world of depreciating currencies, we are fans of hard assets, in particular gold miners. In our view, miners will be beneficiaries of the Federal Reserve eventually pausing, reverting to an easy money policy to stem a banking liquidity crisis. Money printing, increased deficits, and a weaker dollar are likely to increase demand for the historical storehouse of value, gold, and for those that produce it.
We own two miners, one of which is Centerra Gold (CGAU). Centerra headquartered in Toronto, operates the Mount Milligan mine producing gold and copper and is awaiting the restart of its Oksut, Turkish mine. Due to a startup delay, the stock has been a laggard, currently priced below book value and net asset value. However, Centerra is debt free with substantial cash and ore reserves. Plus, the stock offers a 3.25% dividend yield. Under new leadership and with the restart of Oksut, we believe the earning power, at current metal prices, could approach $0.80 per share.
Real Estate. In a market filled with uncertainty, stocks that offer investors an added margin of safety stand out. For National Storage Affiliates Trust (NSA), which was a new addition in the quarter, that comes in the form of strong insider buying.
National Storage is a real estate investment trust that owns self-storage properties, with two thirds of its facilities located in the Sun Belt. The stock has pulled back significantly, which is not surprising given the deteriorating fundamentals in real estate amid rising interest rates and cap rates. We viewed this as an opportunity to purchase a high-quality REIT at a discounted valuation.
Giving us added confidence: Storage REITs are among the best performers in the real estate sector, with net operating income margins north of 70% and the lowest recurring capital requirements. We also like the fact that NSA’s insiders share in our optimism. Late last year, National Storage’s executive chairman/founder and three directors were significant buyers of the stock.
Outlook
Dramatically rising interest rates were challenging enough. But now the markets are having to weigh the consequences of a banking crisis brought about by those higher rates and perhaps aggressive lending. In the long run, current anxieties are creating promising opportunities for long-term investors to identify businesses trading at discounted prices that are financially strong enough to withstand and thrive in this environment.
In the near term, though, this is a time to have a balanced approach and take what the market is giving, both on the buy and sell side. Knowing exactly what you own and setting strict standards on fundamental characteristics are, as Buffett noted, integral to reducing risk. They also happen to be rooted in Heartland’s 10 Principles of Value Investing™. We believe patient investors will be ultimately rewarded.
Fundamentally Yours, the Heartland Team.