Transcript
Michael Kops: Hello, everyone. This is Michael from Heartland. Today, I'm here with Colin and Troy from our Mid Cap Strategy.
Troy, the market here has really seemed to have been, in the short term, overcome with volatility. How are you thinking in an environment like this?
Troy McGlone: Yeah, hi, Michael. Certainly, we've witnessed a 180-degree change in the market backdrop relative to just a few months ago. So, you know, frankly, in our opinion, this is when active management is really meant to shine.
And we believe our first role is to maintain a commitment to providing our investors with a mid-cap value exposure, but then also using the market volatility to frankly take advantage of this opportunity, sticking with our, you know, bottoms up fundamental research in our investment process. The nice thing that, you know, we can hold our hat on is ultimately that Just because the market backdrop changes doesn't mean it changes the way, you know, we manage the portfolio and pick stocks.
Colin McWey: I think that's right. And to amplify on Troy's point, this is Colin McWey.
I actually think that, you know, what's happened so far is a more dramatic swing in sentiment and expectations versus reality. The million-dollar question is what happens with reality going forward? We think the truth will be somewhere in the middle. So, we went from extreme optimism post-election, a lot of anticipation that policy changes would be only favorable to a backdrop where people are suddenly questioning policy decisions and the knock-on effects on the economy, consumers, and companies.
We think there's a lot of truth to that in that there will be true hard data, real economic consequences born on companies and consumers. However, sometimes you need to try your best to use volatility as your friend. What we mean by that is in terms of stock picking, we always price companies for a range of outcomes, good and bad. And in a market where many times the market has shot first and asked questions later, based on how we value companies under a range of outcomes, risk-reward over a one-to-three-year time horizon, in our opinion, has started to skew much more favorably.
The only time you get those opportunities with the more favorable skews is typically when you're presented with near-term uncertainties and no guarantees. And so we need to kind of filter through the universe and pick our spots to play offense where warranted in order to capitalize on this.
Mike: It's funny, it feels like one of those moments where as long as you don't get caught up in the short term, it's so bad, it's good.
Troy: Yeah, I mean, last year was challenging for us because, you know, it was a, it was punitive to pay attention to downside risk because the market was very focused on upside outcomes. And like I said, 180-degree difference today seems like the opposite. And so, although there's a lot of companies that we think are essentially starting to price in an economic slowdown, if not a full-born recession, ultimately, you know, we know these companies will be reporting worse data in the short term, but the stocks are discounting mechanisms and ultimately the risk-reward profile is skewing highly asymmetric in certain circumstances.
Colin: Yeah, and this is Colin again. To amplify on Troy's point.
An observation that we made, especially last year when it was a long-running bull market, was in order to play offense or invest in a lot of companies, we either had to abandon our stringent valuation criteria or take some risk in the form of certain business models and capital structures out there when we talk about levered capital structures had to play offense in a way that told us that risk reward was not very favorable. And some companies that had very significant downside risk in the form of their stock multiples or in the form of where earnings could go under certain more draconian scenarios, we really were not comfortable with a lot of the opportunity set.
A silver lining to this recent volatile backdrop with the approach that we have to picking stocks and valuing companies is we now feel like we can step into some asymmetrically favorable opportunities and do so without taking undue risk of permanent capital loss. That's a good space to be as an active value manager.
Mike: So, what's a good example, let's say, of a quality value stock?
Troy: Yeah, so for us, quality value businesses, we like quality as much as the next person, but we are very focused on what we pay for quality. We're not willing to pay for basically buy quality at any price. And so typically when there's a market volatility, well, first of all, to step back, I guess those quality value businesses, the market's not completely inefficient, right?
Normally, those businesses are recognized by the market for their quality. And so, it really usually takes some sort of market volatility for those businesses to sell off and all of a sudden, you end up with a good business that has a durable competitive advantage. And for some reason, it's trading at an undue discount, right? And so for us, right now, that's where the opportunities are emerging first for us. And then as time goes on, we see those self-help opportunities unlock themselves we'll certainly play there in deep value but as far as quality value we still.
Like Teledyne Technologies (TDY) which is actually our largest portfolio holding this is a business that we bought when we were actually underweight industrials so it's it's classified as a Information Technology business but it's kind of an Industrial Technology company and so the reason it piqued our interest originally was because it had a lot of attributes of really good high quality businesses in the industrial sector where we were underweight. And here was Teledyne that had very similar attributes, but it was in a different sector and trading at a meaningful discount to those peers. And so that really piqued our interest. We started doing the work on it, identified the overhang, which we thought was them digesting acquisition of FLIR, which one of our other portfolios here at Heartland actually used to own FLIR. So, we were familiar with the asset and we were comfortable with the strategy. Teledyne was essentially letting go and walking away from their low margin businesses within the FLIR portfolio the market didn't like it looked like they had bought an asset that wasn't growing anymore. So, we became comfortable with the fact that this was a matter of timing and not a structural challenge and it ended up being and still is our largest absolute position in the portfolio. And so, they're executing very well, and they beat earnings in the in the fourth quarter then the stock outperformed materially because now some of those catalysts are starting to come to fruition even though their short-cycle businesses which tend to be some of their higher highest margin segments within the portfolio are still kind of facing an industrial recession. So, I think investors are getting excited about the idea now that, hey If their highest margin businesses are still in a recession, what will earnings power look like when we come out of this?
Colin: And at a portfolio level, if you look at our historical two-bucket construction approach, we're at the high end of our historical positioning in terms of an overweight to the quality value bucket. That's not a top-down decision. That's a bottoms-up decision with examples like Teledyne of taking what the market gives us.
The deep value examples in our portfolio today happen to be less economically sensitive and have very strong internally driven self-help opportunities. For the time being, we've concentrated our deep value exposure in those type of names, with Perigo (PRGO) being a great example of a company that's not terribly economically sensitive with very strong self-help that is playing out.
The more we go through volatility in terms of the market environment and, more importantly, the economic environment, combined with our intention of keeping the appropriate balance between quality value and deep value, we are deliberately picking our spots to increase deep
value exposure in the portfolio. Conveniently, the more that volatility gets visited upon the marketplace, especially with the deep value, more marginal companies in our universe, we will look to pick our spots to step lean into that.
Mike: Guys, this has been excellent color. I know our clients appreciate it.
So, thank you for taking some time out during earnings season to share your thoughts. And we look forward to next time.
Colin: Thank you, Mike.
Troy: Thanks, Michael.