Paying Less for More

“Price is What You Pay; Value is What You Get”
— Warren Buffett
 
 
The first half of 2020 has been anything but normal. In the course of just a few months, investors have gone from panic-based selling, to aggressively bidding up stocks and pushing the major indices to double-digit gains.
 
While the second quarter’s move higher was a welcome relief for battered portfolios, a closer look painted a less optimistic picture. Breadth was weak with shares of many companies failing to recoup previous losses and large-cap names trumped small. 

Adding to our concern was the seeming indifference investors had for fundamentals. As shown below, shares of companies with low returns on equity, as a whole, materially outperformed their higher quality counterparts. Weaker businesses often lead in rallies following selloffs, but the magnitude of the bounce back was noteworthy.
 
Low-Quality Bounce
Small-Cap to Large-Cap Historical P/E RatioSource: FactSet; FTSE Russell; Jefferies. This chart shows companies held in the Russell 2000 Index. The 2020 bear market is representing data gathered during 1/16/2020 to 3/18/2020. The average bear market data is calculated based on bear markets taking place during 12/31/1985 to 6/18/2020. Bottom was on 3/18/2020. The average 3-month after bear market data is calculated based on 3 months following each bear market taking place during 12/31/1985 to 6/18/2020. Return on equity (ROE) measures the net income after taxes a firm is able to earn as a percentage of shareholders’ equity. A bear market occurs when the price of a group of securities is falling or is expected to fall. 


We’d be tempted to overlook these developments as a temporary blip if it weren’t for the picture painted by the data. Recent analysis shows that the mass herding into weak businesses and mega-caps has resulted in profitable small cap companies trading at historical discounts—the most in 30+ years--to the S&P 500 as reflected by earnings yield.  

Maybe it’s the result of our decades of experience as value investors, but we find it hard to find joy in overpaying for inferior businesses. 

Instead of chasing the allure of a quick rush from buying shares of a sinking business in hopes of eking out a few cents per share in gains, we prefer a more diligent approach. Our satisfaction comes from digging into a business, getting to know the management team, identifying a catalyst for growth and identifying where opportunities may be mispriced. 

We believe this fundamental approach is the best way to help our clients achieve their goal of capital appreciation. In our view, the valuations across each of our portfolios, are compelling, with solid sales and earnings growth which could exceed that of many ridiculously priced market darlings.    

Sincerely,
Your Heartland Team

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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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