Earnings for companies in the small cap S&P 600 Index have finally begun to rebound. This comes just as the Federal Reserve started to cut short-term interest rates. Historically, both developments have been tailwinds for small stocks, lending credence to our sense of optimism throughout the year. Yet we’ve been doing this long enough to know that there’s never an all-clear signal given by the markets.
Consider the mixed signals the market has been sending lately. For instance, more than half of all U.S. industries have been shedding jobs, which historically has been a precursor for a recession. But the broad market, which is itself a leading indicator of the health of the economy, has been hitting new highs, driven in part by optimism surrounding artificial intelligence (AI). Similarly, if you were to just look at the ISM Manufacturing Purchasing Managers’ Index, you’d think that the Industrial sector has been contracting for nearly three years. Yet Caterpillar, one of the world’s leading makers of construction equipment, has been on a record run, which is a bit of a headscratcher.
Then there’s small company confidence. Traditionally, small-cap outperformance coincides with rising business optimism, as measured by a survey tracked by the National Federation of Independent Business. Emerging from past recessions in 2009 and 2020, improving sentiment was followed by strong rallies in the Russell 2000® Value Index. Until recently, that’s not been the case this year, though a significant rally seems to be underway (see the chart below).
Source: FactSet Research Systems Inc. Monthly data from 8/31/2005 to 8/29/2025. The data in this chart represents a year-over-year percentage change in the NFIB Small Business Index compared to the Total Return of the Russell 2000® Value Index relative to the S&P 500 Index. Russell 2000® Value Index measures the performance of those Russell 2000® companies with lower price/book ratios and lower forecasted growth characteristics. 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. 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. Past performance does not guarantee future results.
All of this evokes the words of Edward R. Murrow: "Anyone who isn’t confused really doesn’t understand the situation.” For us, this is a reminder that no matter how optimistic we might be about the current circumstances for small value, our attention must be constantly directed inward on things that are controllable and improvable.
For example, one of the easiest ways for us to address conflicting signals is to plan for as wide a range of outcomes as possible. This is why we establish four price targets for every company under consideration. One price reflects expectations under the best circumstances. Another is established around our base-case scenario. A third focuses on potential downside risks. The fourth centers on how much the stock might drop under the worst outcomes.
Going through this exercise helps prepare us for a potential change in circumstances. We try to build in an even greater margin of safety by relying on the 10 Principles of Value Investing™, which emphasizes attractively priced, well-run companies with strong balance sheets, sound business strategies and promising earnings catalysts. These factors serve as the guiding principles for the Firm’s investment strategy.
Attribution Analysis & Portfolio Activity
For the quarter, the Heartland Small Cap Strategy gained 12.15%, compared with the 12.60% return for the Russell 2000® Value Index. The Strategy has outperformed its benchmark on a year-to-date basis as well as over the past one, three, five, and 10 years.
Stock picking was negative in 6 of 11 sectors, led by underperformance in Health Care, Energy, and Consumer Discretionary. Over the past one, three, and five years, however, security selection accounted for almost all the Strategy’s outperformance.
As value investors in a richly priced equity market that’s dominated by passivity and investors’ love affair with AI, we are able, remarkably, to uncover solid businesses priced at attractive valuations. Many are leaders in their respective industries, overlooked by the momentum crowd. Our focus remains on the 10 Principles of Value Investing™, which have stood the test of time. If this can be bolstered by macro tailwinds, all the better. But the investment process starts with fundamentally driven, bottoms-up stock research.
A good example is a sub sandwich chain, which had been a long-term winner for us before it was acquired during the quarter by the convenience store operator RaceTrac at a +32% premium.
We purchased the stock years ago, a time when the environment for the restaurant sector was uncertain with depressed sales. It was the fundamentals and strong insider buying that caught our attention. The new CEO at the time, Bob Wright, came out of retirement to turn around a strong brand that had been mismanaged and was no longer growing. He had a long career in restaurants including prior stints as chief operating officer of Wendy’s and as chief executive officer of Charley’s Cheesesteaks. He surrounded himself with an executive team that had successful restaurant careers, many of whom he worked with in prior roles.
The team focused on improving operations through a long list of initiatives. The efforts resulted in consistent same-store growth above restaurant peers and a structural improvement in margins. With operations stabilized, the company is pivoting to growth mode with a target of 2,000 shops from its current footprint of 454. The transformation from a mismanaged restaurant company to a fast-growing franchise worth acquiring proved fruitful for investors.
Another industry leader that caught our attention in early 2024 is Calavo (CVGW), which is headquartered in Santa Paula, California. Their unique health-conscious food products were intriguing, but they were in the midst of a management transition, so it was put on our watch list. After a series of research calls uncovering an improving outlook, we began to accumulate the stock early this year.
CVGW is a leading marketer and distributor of avocados and guacamole. After a multi-year period of mismanagement that included several CEOs, the long-time former chief executive came out of retirement to stabilize operations. He is aligned with shareholders receiving large equity grants that vest significantly higher than current stock levels and has purchased a sizeable number of shares in the open market.
Since returning to the business, he has focused on exiting low-margin business lines and growing the prepared guacamole business that was 10% of total sales last year but has double the gross margin of the core business. This business grew +40% YOY in the latest quarter. CVGW believes they can double the size of this business within the next two years, which would be fruitful for Calavo’s earnings potential. The evolving narrative positions Calavo less as a commodity-dependent packer and more as a growing “fresh + value-added” food company. If management can scale the prepared guacamole business, control costs, and navigate tax/regulatory risks, we believe shareholders will be rewarded.
We aren’t the only believers. Calavo received an unsolicited buyout offer for $32 a share in July. Further, the downside risk seems to be limited, supported by a solid balance sheet that includes around $3.50 per share of net cash plus $3 a share of cash potentially from the resolution of a long-standing dispute with Mexican tax authorities.
Last quarter, we discussed how management at Dentsply Sirona, Inc. (XRAY), one of the world’s leading suppliers of dental equipment and supplies, had been laying the groundwork for a turnaround for more than two years. Those efforts had yet to be reflected in the stock price.
In the third quarter, CEO Simon Campion stepped down after three years at the helm and was replaced by Daniel Scavilla. Under Campion, XRAY focused on SKU rationalization and other cost initiatives but failed to keep up with its peers in terms of top-line growth. CEO Scavilla has a record of sales success at Globus Medical Inc. and Johnson & Johnson. We are encouraged by his initial strategies to arm the sales force better to go to market with the company’s existing portfolio and near-term goals to improve margins and free cash flows.
Dentsply was among the Strategy’s worst performers for the quarter, however trading at 6.7X estimated earnings, its valuation seems extremely discounted. Thus, we will remain patient and sit tight with the position believing that the upside potential far outweighs the downside risk. However, our patience has a limit, and we will closely monitor XRAY’s progress.
Outlook
The past quarter has confirmed our optimism about the improving opportunities for small cap value investors. However, it has also reinforced the importance of having the right process in place, regardless of circumstances. We believe sound security selection, informed by thorough research and implemented with process discipline, will guide performance, as it has been for more than 40 years.
Thank you for your loyalty and continued confidence.
Fundamentally yours,
The Heartland Investment Team