Heartland Opportunistic Value Equity Strategy 2Q24 Portfolio Manager Commentary

6/30/2024
Opportunistic Value Equity Strategy

Executive Summary

Market breadth remained historically narrow in the quarter, with just one mega cap stock accounting for 44% of the S&P 500 Index’s performance.
While there were signs the broader equity market might be taking a defensive turn, speculation on popular themes such as artificial intelligence (AI) continued to drive large-cap indices to record highs while small and mid-cap equity indices declined.
In this challenging environment for value-oriented investors, it can be just as risky to bet against stocks based on their market capitalization as it is to bet on them. Instead, we believe security selection — with a healthy dose of downside risk assessment — should drive wealth creation over the long term while mitigating permanent capital loss.

Second Quarter Market Discussion

The more things changed in the second quarter, the more they seemed to stay the same.

At first glance, equity markets appeared to take a more defensive stance in the quarter compared with the speculation that marked the latter half of 2023 and the start of this year. This was evidenced by the fact that the two Russell 3000® Value Index sectors to post gains in Q2 were the least economically sensitive parts of the market: Consumer Staples, which was up 1.18%, and Utilities, which gained 4.51%.

Yet companies tied to popular secular themes such as AI continued to attract capital throughout the quarter. Moreover, Utilities may not have been a defensive play at all. The traditionally staid sector came to be viewed by some investors as a ‘backdoor’ way to gain exposure to the AI craze, since power companies stand to benefit from the growing need for electricity by AI technologies and data centers. And if the recent roller coaster ride in shares of GameStop is any indication, the era of speculation is by no means over. During Q2, shares of GameStop, a floundering video game retailer, shot up more than 150%, only to report a Q1 operating cash burn in excess of $100 million on a double-digit decline in revenue. Management preannounced earnings so that they could issue more than $2 billion of equity to speculators. Even after the stock fell 60% from a high in mid-May, the company is valued at around $10 billion, yet analysts forecast negative free cash flow through 2026 — simply remarkable.

While large-cap indices with significant Technology sector concentration including the S&P 500 and Nasdaq Composite shot to new record highs, the Russell Midcap®, Small-Cap®, and Large-Cap Value® indices were all down during the quarter, resulting in a further narrowing of market breadth. For example, just one stock — Nvidia (NVDA), whose chips are powering AI platforms and applications — accounted for 44% of the performance of the S&P 500 in the quarter. In fact, NVDA was responsible for virtually all the Russell 1000® Index’s gains in the past three months, despite representing less than 7% of that benchmark.

Overall, the weighting of the 10 largest stocks in the S&P 500 hasn’t been this large a percentage of the benchmark in half a century, according to Ned Davis Research (see chart below).

Consumer Confidence Index v. Real GDP Growth

Source: Ned Davis Research, Inc. (NDR)., Monthly data from 1/31/1972 to 6/30/2024. This chart represents the percent that the largest 10 companies represent in the S&P 500 index. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

However, narrow market breadth doesn’t automatically suggest poor performance. And unlike past periods of concentration, such as the late 1990s, most mega caps haven’t risen for irrational reasons. Estimates of Nvidia’s forward earnings per share have risen six fold over the past year amid an explosion in demand for chips needed to build out AI infrastructure. That said, the market is now willing to ascribe abnormally high valuations to businesses deemed to benefit from AI and other secular themes.

We don’t seek to mimic a large-cap benchmark like the S&P 500. As value investors who can search for opportunities across market caps, we are willing to miss out on owning businesses where we don’t see an adequate margin of safety. It’s possible Nvidia’s share price may continue to soar, but we are comfortable ”missing” businesses that we can’t fully understand or where we can’t be confident that future growth and profit prospects justify its valuation. In our opinion, this discipline is what distinguishes successful long-term investors from momentum chasers.

Attribution Analysis

Our Strategy fell 2.12% in the second quarter, slightly outperforming the Russell 3000® Value Index, which posted a loss of 2.25%.

Stock selection was the primary driver of outperformance with positive stock selection in six sectors — Communications Services, Energy, Health Care, Information Technology, Materials, and Real Estate. At the same time, selection had a negative effect in four sectors — Consumer Discretionary, Financials, Industrials, and Utilities.

Though large caps continue to drive the broad market, their effect on our Strategy was mixed. Stocks in the Strategy’s top decile, based on market capitalization (greater than $30.5 billion), were the third-best contributor to our performance in the quarter, driven by strong quarterly performance by Alphabet (GOOGL) and Unilever (UL). But stocks in the middle of the cap spectrum, in Decile 5 with market values of $2.2 billion to $3.6 billion, were the best contributors to our performance on an absolute basis. That said, our overweight to smaller companies remained a drag on performance because we were underweight the largest decile, the best performing group in the benchmark, by more than twenty-three percentage points.

Portfolio Activity

We continue to see value down the market-cap spectrum, but we are also mindful that combined, small- and mid-cap stocks represent around 64% of our exposure, with large stocks making up roughly one-third ( update 6/28), which is less than half the benchmark’s weight. As a rule, we want security selection to drive our relative performance, not factor bets, including a bet on company size. While we could move more aggressively into smaller stocks in the future if circumstances and opportunities present themselves, that will be done selectively.

We construct our portfolio from a bottom-up perspective, as exemplified in the following holdings:

Industrials. A recent small-cap addition was Brady Corporation (BRC), a Milwaukee-based maker of ID solutions such as name tags, industrial printers, and scanning equipment, along with workplace safety products such as safety signage.

Brady, with a $3.1 billion market capitalization, has spent years de-emphasizing or exiting low margin businesses that diluted profitability. As a result, BRC’s operating margin rose to a record 17% in FY 2023. That was well above the company’s 10-year median margin of below 14%. This streamlining effort resulted in tepid organic expansion and caused the stock to underperform its sector peers.

We first purchased BRC last November, and we added to that position in February. The company’s portfolio transformation is largely complete, and we believe Brady is now well positioned to focus on maintaining strong profitability and topline acceleration. Management is reinvesting some of that margin expansion into higher-margin product development, with R&D now representing 5% of sales, up from 4.5% in FY 2023 and 3.2% in FY 2016. This heightened level of spending could accelerate organic growth and surprise the market after years of anemic growth.

Meanwhile, BRC trades at roughly a 20% discount to the sector despite higher margins and a better balance sheet. We believe this gap can close as revenues rise, especially among higher-margin industrial-identification products.

Communications. At the opposite end of the cap spectrum is Alphabet (GOOGL), with a market value of $2.2 trillion. Alphabet is a good illustration of how it is way too early to try to call winners and losers in AI.

GOOGL shares sold off significantly in the first quarter, as the tech giant underperformed amid rising concerns that the company’s dominance in search, where it enjoys a 90%-plus market share, may be threatened by the proliferation of new AI players. At the same time, management indicated that capital spending would “increase materially” as the company invests in AI infrastructure, including AI chips and datacenter capacity. That led to increasing concerns that Alphabet’s free cash flow would take a material hit this year.

As it turned out, first quarter earnings exceeded expectations, driven by better revenue growth and margin expansion. Even as capital spending nearly doubled year over year, free cash flow per share rose 2% due to greater profitability. This put to bed, at least for now, concerns that management would irrationally invest capital in AI “at any cost.”

Management is committed to streamlining the company’s cost structure to fund higher levels of targeted AI investments. To accomplish this effort, greater scrutiny is being placed on projects that aren’t generating an adequate return on investment resulting in margin expansion and greater operating cash flow. Meanwhile, we believe the company’s balance sheet is one of the strongest among all public companies, allowing for sustained, above-market growth and more capital returned to shareholders via share repurchases and a newly initiated dividend.

We expect capital spending to rise by around $18 billion to $50 billion in FY 2024 and R&D investments to increase $4 billion to around $48 billion. While we don’t know if Alphabet will be the next big winner in AI, we believe it can be a meaningful player because there are only a handful of companies on the planet capable of investing $98 billion per year. In addition to capital, another key “raw material” in any AI strategy is data. Here too, few companies have more scale.

Over the past 20 years, GOOGL has typically traded at a 25% premium to the S&P 500, but it currently is at a 5% discount, despite enjoying stronger profitability and a healthier balance sheet. We first purchased Alphabet in 2020 following the market swoon created by COVID-19, we trimmed the position in 2021 as the stock closed the gap versus our view of intrinsic value, and we added to the position in late 2022 after a sharp selloff in shares. We believe the company still trades below intrinsic value and per-share free cash flow growth should result in rising value over time.

Industrials. J.B. Hunt Transportation Services (JBHT) was one of our Strategy’s worst performers during the quarter, down more than 19%. But this is another example where self-help could set the stage to benefit from potential secular tailwinds.

J.B. Hunt is a leading intermodal shipping company. Customers hire Hunt to move freight using a variety of transportation modes to reduce cost and fuel consumption. This “agnostic” approach stands in contrast to most competitors who utilize a single mode of transportation. The company missed first quarter expectations, causing the stock to sell off in April. The truck load (TL) market is in a deep recession due to weak demand and too much capacity. Because TL is a substitute market for intermodal (normally a much-less-efficient substitute at that), the irrationally priced spot market, which tracks the cost to move single shipments by truck at current prices, has cut Hunt’s intermodal margins to their lowest levels in more than 20 years while forcing management to walk away from some contracted business as renewals occur.

With profit expectations down around 25% from the peak, Hunt is underearning. Management is planning to increase Hunt’s intermodal capacity 40% by the end of 2025 versus 2021 levels, improving asset density and efficiency, while driving further market share gains. In recognition of the soft freight market, management has elected to moderate capital spending with the goal of improving asset utilization. Importantly, we believe that a cyclical recovery is only the beginning of the story, with the company uniquely poised to structurally gain market share for the rest of the decade driven by a cost advantage relative to TL.

In the meantime, JBHT trades at 9.6 times consensus next-12-month Enterprise Value to EBITDA, representing a 25% discount to the industrial sector, even though Hunt normally trades at parity or a slight premium when economic growth is accelerating. The company’s balance sheet is in solid shape with a leverage ratio of less than 1X. We believe Hunt can fund network investments through a recession using internal cash generation without stressing the company’s balance sheet.

Outlook

An unusually narrow market that’s still being led by a handful of mega-cap stocks has created a challenging environment for value-minded, all-cap strategies like ours. In times like this, we are reminded of the words of the economist Hersh Shefrin, who said: “Reality looks much more obvious in hindsight than in foresight.” This should serve as a warning not only to those who believe what worked in the past will keep working in the future but also to investors who think they can accurately time when the market might pivot and broaden out. Instead, we will remain focused on bottoms-up stock picking driven by our 10 Principles of Value Investing™, which demands that we seek out attractively priced, well-managed businesses that can grow intrinsic value over time.

Thank you for your continued trust and confidence.

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Portfolio Management Team

Troy McGlone

Vice President and Portfolio Manager

Colin McWey

Vice President and Portfolio Manager

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Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.
*Yearly and quarterly returns are not annualized. The Strategy's inception date is 9/30/1999.
**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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Past performance does not guarantee future results.

The Opportunistic Value Equity Strategy seeks to capture long-term capital appreciation by investing in companies with market capitalizations greater than $500 million. The Strategy’s flexible pursuit of value positions it as a core holding for investors.

In addition to stocks of large companies, the Opportunistic Value Equity Strategy invests in stocks of small- and mid-cap companies that are generally less liquid than large companies. The performance of these holdings generally will increase the volatility of the strategy’s returns.

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 the Institutional Sales Team at Heartland Advisors, Inc. at the address listed below.

As of 6/30/2024, Heartland Advisors on behalf of its clients held approximately 4.45%, 1.34%, 2.56%, and 2.38% of the total shares outstanding of Alphabet Inc. (Class A) (GOOGL), Brady Corporation (Class A) (BRC), JB Hunt Transport Services Inc. (JBHT), and Unilever PLC (UL), respectively. Nvidia Corporation (NVDA) is unowned by Heartland Advisors, Inc.

The future performance of any specific investment or strategy (including the investments discussed above) should not be assumed to be profitable or equal to past results. The performance of the holdings discussed above may have been the result of unique market circumstances that are no longer relevant. The holdings identified above do not represent all of the securities purchased, sold or recommended for the Advisor’s clients.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.

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.

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.

In certain cases, dividends and earnings are reinvested.

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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.

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

Artificial intelligence (AI) is intelligence—perceiving, synthesizing, and inferring information—demonstrated by computers, as opposed to intelligence displayed by humans or by other animals. Beta is a measure of the sensitivity of a portfolio's rates of return against those of the market. A beta less than 1 indicates volatility less than that of the market. Bottom-up is an investment approach that de-emphasizes the significance of economic and market cycles. This approach focuses on the analysis of individual stocks and the investor focuses his or her attention on a specific company rather than on the industry in which that company operates or on the economy as a whole. 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. Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA) Ratio is a financial indicator used to determine the value of a company and is calculated by dividing the entire economic value of the company (enterprise value) by its earnings before interest, taxes, depreciation, and amortization (EBITDA). Free Cash Flow is the amount of cash a company has after expenses, debt service, capital expenditures, and dividends. The higher the free cash flow, the stronger the company’s balance sheet. Intrinsic Value is the actual value of a company, or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Margin of Safety is a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. NFIB Small Business Optimism Index is a small business optimism index compiled from a survey that is conducted each month by the National Federation of Independent Business (NFIB) of its members. The index is a composite of ten seasonally adjusted components based on questions on the following: plans to increase employment, plans to make capital outlays, plans to increase inventories, expect economy to improve, expect real sales higher, current inventory, current job opening, expected credit conditions, now a good time to expand, and earnings trend. Price/Earnings Ratio of a stock is calculated by dividing the current price of the stock by its trailing or its forward 12 months’ earnings per share. 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 Russell Investment Group. 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 1000® Value Index measures the performance of those Russell 1000® companies with lower price/book ratios and lower forecasted growth characteristics. All indices are unmanaged. It is not possible to invest directly in an index. 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. Russell 2000® Value Index measures the performance of those Russell 2000® companies with lower price/book ratios and lower forecasted growth characteristics. All indices are unmanaged. It is not possible to invest directly in an index. Russell 3000® Index is a market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of the entire U.S. stock market and encompasses the 3,000 largest U.S.-traded stocks, in which the underlying companies are all incorporated in the U.S. All indices are unmanaged. It is not possible to invest directly in an index. Russell 3000® Value Index measures the performance of those Russell 3000® Index companies with lower price/book ratios and lower forecasted growth characteristics. S&P 500 Index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. 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. 10 Principles of Value Investing™ consist of the following criteria for selecting securities: (1) catalyst for recognition; (2) low price in relation to earnings; (3) low price in relation to cash flow; (4) low price in relation to book value; (5) financial soundness; (6) positive earnings dynamics; (7) sound business strategy; (8) capable management and insider ownership; (9) value of company; and (10) positive technical analysis.