Given the reemergence of meme stock madness this quarter, we can only imagine what Mr. Graham’s reaction would be to the current investment landscape. Poking fun at the day-trader darlings, such as AMC Entertainment Holdings Inc. (AMC) and GameStop Corp (GME), is almost too easy. However, stock performance for the two marginal businesses over the past year serves as a vivid example of what the father of value investing meant by silliness.
AMC is up a whopping 2,500% since the beginning of the year. Even AMC management seems stunned by the mind-boggling rise in its shares as witnessed by the following quote from a prospectus the company filed to issue more shares.
“We believe that the recent volatility and our current market prices reflect market and trading dynamics unrelated to our underlying business, or macro or industry fundamentals, and we do not know how long these dynamics will last.”
We too don’t believe that prices are tied to valuation metrics for the theater and entertainment company. At current levels, shares of AMC are trading at roughly 63X sales. It’s a steep price for a company that has been losing money for years and isn’t expected to turn a profit in the coming year. No wonder insiders have cashed in on the mania and unloaded over $200 million in stock since March.
Hope is not a strategy
While valuations for AMC are an extreme example, speculative fever is running rampant. Investors have been clamoring to pay premium prices in hopes that the current goldilocks moment of low interest rates, easy sales comparisons and low inflation will go on forever. The appetite for pricey unicorns in a quest for quick gains was a drag on performance for your portfolio, and the Strategy underperformed the benchmark for the period.
Despite stratospheric valuations in many areas of the market, attractive valuations still exist if you know where to look. A good place to start is among small caps.
Looking at price to sales metrics, as shown below, smaller businesses are trading at discount levels versus their large counterparts not seen since the dotcom bubble. Price to sales is one of the metrics we look at when examining businesses. Over the years, it has served as an effective tool in identifying compelling opportunities when incorporated with other fundamentals.
Small Caps on Sale
Source: Kailash Capital, LLC and Compustat. The data in this chart represents R1000 market cap weighted price to sales less R2000 market cap weighted price to sales on a monthly basis from 4/30/1989 to 6/30/2021. All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.
The foundation laid by Heartland’s 10 Principles of Value Investing continues to lead us to well-managed businesses that are financially strong and have what we view as compelling prospects for bottom-line growth independent of fiscal stimulus and cheap debt. The following are just a few examples.
Here comes the neighborhood
A recently announced acquisition of one of our holdings appears to confirm our investment thesis that attractive valuations are the basis of good investing.
Portfolio holding Monmouth Real Estate Investment (MNR) announced in early May that it had agreed to be purchased by Equity Commonwealth (EQC), an office real estate trust chaired by legendary investor Sam Zell. We originally took a stake in Monmouth, which specializes in warehouses and distribution centers, last year as the sector was still recovering from the steep COVID-19 selloff.
Our confidence came from management’s history of prudent capital allocation, a growing list of Fortune 500 customers and a focus on warehouse properties where demand was likely to balloon to meet the growing needs of online retailers. Perhaps due to its smaller market cap, the business was priced at a significant discount to larger competitors while sporting a handsome cap rate and well-financed dividend.
In mid-December of 2020, Monmouth rebuffed a buyout offer from another peer, holding out instead for a more lucrative offer, which arrived this spring.
With interest rates near all-time lows, we believe the search for under-appreciated assets and sustainable dividends will intensify. The portfolio should be a beneficiary.
A winning smile
Patterson Companies Inc. (PDCO) is a leading distributor of dental and animal health products. Sales have been on the rise and the company reported a record $6.1 billion in revenue for the year ending in April. Shares of the business are up through the first half of the year, and the holding has been a contributor to performance.
Management at Patterson has done an impressive job of expanding operating margins and making strategic acquisitions that have fit with the business’ core competencies since coming aboard in 2017. However, shares set back late in the quarter, after the company reported better than expected earnings but issued guidance that was more conservative than Wall Street expectations. Due to the ongoing unwinding of pent-up demand in dental services and the strength of Patterson’s animal health line, we believe recent earnings guidance will prove to be overly cautious.
We view recent softness in shares of Patterson as an overreaction and remain constructive on this industry leader that is priced at just .5X sales.
Beyond the hype
The gyrations of story stocks touted on message boards have resulted in distortions in the market but on rare occasions have also swept up a few compelling opportunities. Bed Bath & Beyond (BBBY), a national retailer of home goods, babywear and health and beauty products, is one example.
Even before Bed Bath & Beyond made headlines earlier this year when day traders drove the price of shares up in an effort to squeeze short sellers, the company had caught our attention for the results its new management team was delivering since taking over in late 2019.
CEO Mark Tritton, who came to BBBY after a successful tenure at Target, quickly got to work installing new corporate leadership, closing underperforming stores, selling non-core businesses to firm up the balance sheet, and implementing retail best practices across the company. He also worked to improve store efficiency and revamped the company’s online presence.
The moves by Tritton made an impact. In its 2020 fiscal year, BBBY closed 144 under-performing stores, grew new digital customers by 95%, reduced debt by $1 billion, and returned $375 million of capital to shareholders. Despite the meaningful improvements, and the strong performance year-to-date, shares of the retailer are trading at just .35X sales and less than 5X estimated 2022 earnings before interest, taxes, depreciation, and amortization—roughly half of the multiple commanded by peer Williams- Sonoma Inc.
At current valuations, we view BBBY as offering attractive upside as recent improvements gain traction. It appears we’re not alone as executives have also been buying shares in recent months.
A Source of optimism
As displayed in the bar charts below, the disparity in valuations between holdings in the portfolio and those in the major indices remains extreme with attractive value still available in small-cap land. We believe these valuations coupled with strong balance sheets position the portfolio to capitalize on what could be continued strength in the markets.
Small Cap Value Composite Valuations
Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 6/30/2021. 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.
Not distracted by the frivolous
The market excesses of the past few months have been frustrating for dedicated value investors. Yet one thing we’ve learned in our decades-long history of managing money is that what Mr. Graham may refer to as silly seasons come and go and can be most harmful to those who try to cash in on the next “can’t miss” theme, sector, or stock.
Instead, we take the long view and seek to capitalize on mispriced businesses that we believe will produce superior results over the long-term—not just days or weeks. We believe this fundamental approach can require patience but also is the best way to help our clients achieve their goal of capital appreciation.
In the past several quarters, our process and attention to detail has led us to winners in a wide range of industries. While the portfolio’s top performers have varied, they’ve shared the common trait of valuations that we found far more compelling than the multiples commanded by a handful of meme stocks.
Thank you for your continued confidence. We look forward to a return of clear-headed objectivity and an appreciation for value investing.