A Shot of Over Exuberance?

“Nothing sedates rationality like large doses of effortless money”
— Warren Buffett
 
 
The major indices charged higher as investors responded to the rollout of two COVID vaccines and assurances by the Federal Reserve that it would continue to pump money into the economy for the foreseeable future. 

The growing sense that a return to pre-pandemic life was on the horizon led investors to bid up cyclical areas, companies that were most impacted by the COVID-induced recession, and businesses that would benefit from inflation. Many troubled businesses with high debt levels also rose during the period.  

Based on the aftermath of previous recessions, investors who have been chasing momentum stocks and mega-cap names may end up disappointed. As the chart below shows, historically, small cap companies have had outsized performance gains coming out of recessions. 

 

Small-Cap/Large-Cap Ratio Around Post-War Recession End Dates

Source: Copyright 2020 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. This chart shows monthly data from 1/1/1947 to 12/31/2020. The data included in this chart is an aggregate of all recession periods noted.

The outsized movements in the markets caused by COVID-19 and advancements in treating the virus has resulted in some investors adopting a trade-first-analyze-later mentality. Instead of weighing opportunities based on valuations and long-term prospects, some buyers snapped up businesses based on blue-sky scenarios that rely on interest rates hovering near zero and inflation remaining subdued for the foreseeable future. The strong showing for the broad market has stretched valuations for many stocks but opportunities remain. 

In the face of extreme volatility for much of 2020, our focus has remained on finding businesses where we believe valuations reflect a misunderstanding of risk and those businesses that are poised to succeed against a variety of backdrops. The significant strength of economically sensitive names during the past several months has left little room for error with businesses striving to meet what we view as overly optimistic earnings estimates. As a result, we have sought to own overlooked businesses where even incremental improvement should result in meaningful upside in share prices. 

This approach is consistent with what has worked over our Firm’s nearly 40-year history—clear-eyed, fundamental analysis with a focus on valuations at its foundation.

Sincerely,
Your Heartland Team

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Past performance does not guarantee future results.

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Investing involves risk, including the potential loss of principal.

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

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

Small-cap and large-cap investment strategies each have their own unique risks and potential for rewards and may not be suitable for all investors. Small-cap investment strategies emphasize the significant growth potential of small companies, however, small-cap securities, are generally more volatile and less liquid than those of larger companies. Large-cap investment strategies emphasize the stability of large companies, however, large-cap securities are more susceptible to momentum investments and may quickly become overpriced or suffer losses.

The statements and opinions expressed in this article are those of the presenter(s). Any discussion of investments and investment strategies represents the presenter’s 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. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change.

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

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