Heartland Small Cap Value Strategy 2Q21 Portfolio Manager Commentary

 Executive Summary

  • In a market hungry for pricey unicorns, your portfolio was up double digits for the first half of the year. 
  • Despite stratospheric valuations in the market, attractive opportunities still exist. 
  • Heartland’s 10 Principles of Value™ Investing continues to lead us to well-managed businesses that are financially strong.  
“The sillier the market’s behavior, the greater the opportunity for the business-like investor.”
​​​​​​—Benjamin Graham

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

Heartland Advisors Value Investing Russell 1000 P/S Less Russell 2000 P/S Chart

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

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 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.

GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

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Portfolio Management Team

Will Nasgovitz

CEO and Portfolio Manager

Bill Nasgovitz

Chairman and Portfolio Manager

Composite Returns*

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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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©2022 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 6/30/2021, Bed Bath & Beyond (BBY), Monmouth Real Estate Investment Corp (MNR), and Patterson Companies, Inc. (PDCO) represented 2.78%, 1.95%, and 2.57% of the Small Cap Value Composite’s net assets, respectively. AMC Entertainment Holdings Inc. (AMC), GameStop (GME), and Equity Commonwealth (EQC) were unowned.  

Portfolio holdings are subject to change. 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 this article are those of the presenter(s). 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 2022 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

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

Earnings Per Share is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) measures a company’s financial performance. It is used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. Inflation Risk is the possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency. Price/Sales Ratio is calculated by dividing a stock's current price by its revenue per share for the trailing 12 months. Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000® represents approximately 92% of the U.S. market. Russell 2000® Index includes the 2000 firms from the Russell 3000® Index with the smallest market capitalizations. 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.