Transcript
Mike Kops: Hello, I’m Michael Kops, Vice President at Heartland Advisors. I’m here with Colin McWey, portfolio manager for the Heartland Mid Cap Value Strategy. The Strategy has outperformed its benchmark on the three- and five- year periods by sticking with bottoms-up stock selection guided by our 10 Principles of Value Investing™.
Colin, the second quarter was a bit challenging to describe. Can you tell us why?
Colin McWey: Yeah, every month of the second quarter felt a little bit different. So if you go all the way back to April, which feels a long time ago now. That was a tough stretch for the overall market with the Russell Midcap Value Index down over 5%, we actually had quite mixed relative performance across our portfolio with our holdings performing very differently from one another, in some cases it was driven by earnings reports but in other cases there didn’t seem to be a company-specific driver behind it. In May on the other hand, totally different. Stocks bounced back and exhibited some of the same ‘risk-on’ characteristics fueled by the AI craze that most of us are familiar with now. Not surprisingly, our Strategy actually lagged the benchmark that market backdrop. But then flip forward to June and then that was quite different than either month, it brought with it a little bit more fearful market where investors became increasingly concerned of potential risks to the business cycle and corporate earnings. At least Relative to our benchmark and peers, we began to outperform in this choppier backdrop.
Mike: What were some of the risks that investors began to ponder at the end of the quarter?
Colin: For starters, there were signs that demand destruction is spreading throughout the economy. So this fear of demand destruction started with concerns over the health of lower- and middle-class consumers that actually expanded into worries about the spending appetite of wealthier households. In recent months, you’ve seen luxury retailers such as Burberry and LVMH report disappointing sales and profits as demand for high-end goods from handbags to champagne have slumped.
At the same time, flipping to the industrial economy, industrial demand remains under pressure. Manufacturing shrunk in May, this marks the 19th consecutive month of contracting activity out of the past 20, that’s according to the ISM Manufacturing PMI®. So far in the current earnings season, and I’m talking about what’s been reported even after the end of the second quarter, we’ve gotten a few reports from industrial machinery and distribution companies that raise concerns about slowing demand after a period of robust growth.
Mike: Where does that leave us?
Colin: While we understand the need to be mindful of the backdrop in which we are investing, we remain focused on stock-specific risks and rewards, not top-down forecasts of the economy. Our decision-making has always been — and will remain — guided by our 10 Principles, which seeks out well-managed, financially strong businesses that can grow cash flow and value over time. Rather than trying to forecast the economy, we work to capitalize on attractive risk/reward propositions offered by the market (in other words “taking what the market gives us, instead of trying to predict everything that is outside of our control). This is done by using the 10 Principles as our guide to weigh valuations vs. fundamentals….and aiming to own those with a favorable risk/reward skew while having the discipline to avoid those that don’t fit the process….even if their stock prices can keep going higher for awhile.
Mike: The Mid Cap portfolio fell 3.97% in the second quarter, while the Russell Midcap® Value Index was down 3.40%. What accounted for that underperformance?
Colin: Most of our underperformance in the quarter was driven by the negative selection effect across seven sectors, led by Consumer Discretionary and Utilities.
This was equally attributable to stocks we own as well as those we’ve elected to avoid, including speculative bets on A.I. We refuse to chase speculative companies or overpay for businesses that we admit are good, but the stocks actually trade at recordly high multiples on cyclically elevated margins. Both types of companies have ample downside risk if any prevailing assumption about the environment changes. We do, however, care a lot about the hit rate we demonstrate in terms of seeing our companies re-valued by the market over time. We have several meaningful positions that either just showed an inflection in their fundamentals and share price performance…...or on the other hand, seem to be muddling through toward a business inflection with investor capitulation and apathy that seems to in the late innings
Mike: By design, Mid Cap Value Strategy holds both high-quality companies trading below intrinsic value and deeply discounted companies that have produced poor economic returns over time because it is difficult to know when one style will outperform the other. Within deep value, however, you don’t just look for mediocre companies that are statistically cheap, right?
Colin: That’s right. Deep value businesses are only purchased after we identify an internal change agent that we think can help close the gap between the current share price and the intrinsic value of the company based on successful execution of an improvement playbook. In other words, we are looking for deeply discounted companies that are poised to help themselves.
Mike: Are there examples of deep value stocks where you’re seeing this type of self-help?
Colin: Sure, In the second quarter, we started a new position in Fidelity Information Services (FIS), one of three major suppliers of core processing software and services utilized by banks, capital market participants, and corporations. Whenever you log into your mobile phone banking app, pay a bill, or transfer money, there is a decent chance that FIS enables that transaction. Even if you’re familiar with the J.P. Morgans and the banks that you may bank with, there’s a decent chance that FIS likely enables that transaction.
This is a classic self-help story about strategic course correction and capital allocation. The company’s prior management team took a wrong turn by following competitor Fiserv into the merchant acquiring industry when it overpaid for a company called Worldpay, this is back in 2019. Merchant acquirers stand between credit card networks like Visa or Mastercard and the card issuers like Capital One or Citi Bank. Rather than boosting FIS’s growth as planned, the acquisition proved to be a severe distraction as software startups began to take share from incumbents, including Worldpay.
Starting in 2022, new CEO Stephanie Ferris began to change course, selling a majority stake in Worldpay and using the proceeds to pay down debt, this took leverage down from more than 4 times Net Debt to EBITDA to below 2 times, so a much more financially sound balance sheet. At the same time, she refocused the business by shifting sales incentives away from new client wins and actually towards selling additional services to existing customers to make the business stickier and more profitable.
We initiated a position in FIS because we believe the fruits of this self-help strategy have yet to fully ripen. But we’re really getting to the point where investors will be able to see them more clearly. We expect accelerating revenue growth through improved sales incentives and increased technology needs for banks. Meanwhile, margin expansion should be driven by cross selling additional services, streamlining the cost structure, and eliminating the distractions from Worldpay.
Mike: FIS is an example where self-help is on track to pay off. Is there an example where this approach has already come to fruition?
Colin: Sure, there’s Stericycle (STCL), which is a holding of ours over the last couple of years. This is the largest medical waste disposal and compliance company in the U.S. After undertaking a variety of self-help strategies — and this included divesting over a dozen non-core operations over the past several years, they did this in order to focus on Stericycle’s core medical waste disposal and document destruction businesses — Stericycle actually agreed to be acquired by Waste Management at $62 per share, this was in June, so it valued the company at $7.2 billion dollars.
This is the reward Stericycle shareholders got for the company changing its game plan, turning what was a company that sought to grow through aggressive acquisitions and they actually pivoted and they turned into a business that was focused internally and on organic growth while seeking to optimize margins, capital allocation, and returns on invested capital.
Before the deal, we had actually assigned a $63 price target to Stericycle, which was almost exactly where the takeout price was. Waste Management seemed to agree with what we concluded: that Stericycle had been trading at a discount to its own history and a pretty significant discount to its waste industry peers that operate bond-like business models.
Mike: An existing holding that falls into the self-help bucket is J.B. Hunt Transportation Services (JBHT). But Hunt was the Strategy’s worst performer during the quarter, right?
Colin: Yeah, it did not help the cause in 2Q, but this is an example of a great self-help story and we also put J.B. Hunt in the group of portfolio companies I mentioned earlier that we think are in the later innings of investor capitulation and apathy.
This is the leading intermodal company in the US. 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 just one single mode of transportation.
The company missed first quarter expectations, and that caused the stock to sell off in April. The truck load market is very deep into a recession due to weak demand and too much capacity. There is access capacity in the truck load market. Because truck load is a substitute market for intermodal (normally a much-less-efficient substitute at that), the market has gotten irrationally priced, we’re talking about the spot market, real time pricing. That tracks the cost to move single shipments by truck at current prices, and this has directly impacted J.B. Hunt’s intermodal margins which have fallen to their lowest levels in more than 20 years. And has actually forced management to walk away from some contracted business as renewals occur, because the economics just don’t make sense.
With profit expectations down around 25% from peak, J.B. Hunt is absolutely underearning. Management is planning to increase Hunt’s intermodal capacity 40% by the end of 2025 if you compare that to 2021 levels. This improves asset density and efficiency, and we think it will drive further market share gains in a recovery. In recognition of the soft freight market, management has elected to moderate capital spending with the goal of improving asset utilization. That’s a move we agree with in this current backdrop.
However, we believe a cyclical recovery is only the beginning of the J.B. Hunt story, with the company uniquely positioned to structurally gain share for the rest of the decade driven by its cost advantage. In the meantime, the stock trades at just 9.6 times consensus next-12-month Enterprise Value to EBITDA, this represents a 30% discount to the industrial sector, even though if you look back over history, Hunt normally trades at parity or even a slight premium when economic growth is accelerating.
Mike: Is JB Hunt an example of how you focus on long-term potential over short-term performance?
Colin: Yes, it’s a quintessential example, we don’t measure success or failure in quarters and we are confident in how we are positioned, regardless of which direction the market or economy takes in the coming months. We believe a number of our companies are inching toward an inflection point, hinting at better days ahead.
Meanwhile, many other holdings have just hit that inflection when it comes to fundamentals or relative performance. And we believe in those cases that we could be in the very early innings of seeing their self-help strategies rewarded in the form of relative outperformance. As always, we are willing to be patient, when that patience is warranted.
Mike: That’s great perspective, Colin. Thank you for your time.