Mike Kops: Hi, I’m Michael Kops, Vice President at Heartland Advisors.
Today, we’re here with Andy Fleming, portfolio manager for the Heartland Value Plus Strategy, which looks for well-run U.S. businesses in the small-cap space that are trading at compelling valuations and that allocate capital wisely.
Andy, in the second quarter, you were also looking for something else, right?
Andy Fleming: We were, we spent the quarter looking for ‘green shoots’. What I mean by this is companies that have flat or flatish year-over-year sales that should soon see an uptick in earnings, either because pricing dynamics are moving their way or because the self-help strategies they’ve implemented are gaining traction.
Mike: Have you been looking in any specific part of the market?
Andy: We are looking across a variety of industries, though more of these prospects are likely to be found in cyclical parts of the market that benefit in the early stages of a recovery, industries such as Industrials and Consumer Discretionary companies. Regardless of the business, the ultimate goal is to identify management teams with strong capital allocation policies as a foundation for delivering shareholder returns.
Mike: Have you found any of these ‘green shoots’ recently?
Andy: We have. An example is Kennametal (KMT), a manufacturer of industrial cutting tools and components, that’s emerging from trough demand and has seen EBITDA contract on a year-over-year basis in 5 of the last 7 quarters. But the company has been undergoing extensive self-help during the past 5 years, taking out over $200 million in structural costs, cutting its headcount by 20%, and closing 6 plants as part of an extensive restructuring.
The key here is that the heavy lifting/investment phase is now in the rearview mirror. While demand has not yet inflected higher, sales are stabilizing. If Kennametal sees even a slight pickup in demand in its end markets, that could provide an immediate and robust boost to its operating margins. Furthering our confidence, the newly appointed CEO purchased shares in the quarter and the company is active on its buyback program.
Mike: Are there other examples?
Andy: Yes, we see a similar opportunity in Science Applications International Corp. (SAIC), which offers a range of IT and cybersecurity services to the US government.
SAIC has faced recent challenges with lower-than-average government contract renewals and lower demand for their IT services, prompting the employment of new management to address business development concerns. We purchased shares of SAIC in the second quarter on the premise that the new management team, led by a CEO previously with Microsoft, will be able to succeed in two key self-help efforts: increasing the volume of SAIC bids and improving the firm’s below-average industry "recompete rates," which consist of rebidding on previously awarded expiring government contracts that are typically 5 years in length.
These efforts, coupled with internally focused capital allocation strategies that include dividend growth and active share buybacks, are likely to drive price appreciation for the stock. In the meantime, SAIC shares trade at a modest 13 times forecast earnings with a strong 8% free cash flow/enterprise value yield.
Mike: In the second quarter, the Value Plus Strategy was down 7.17%, trailing the Russell 2000® Value Index, which fell 3.64%. What do you attribute that underperformance to?
Andy: Stock selection, particularly in the Energy, Consumer Discretionary, and Financial sectors, contributed to our underperformance in the quarter. However, selectionhelped the Strategy outperform the benchmark in the IT, Health Care, and Utilities sectors.
We also initiated positions in several new holdings while exiting or reducing our exposure in a handful of others. We believe our portfolio is well represented by secular winners that exhibit defensive attributes. We are trying to balance this out by adding exposure to higher-quality companies with more cyclical characteristics trading at trough multiples while at trough earnings. If management knows how to allocate capital effectively and self-help is sprinkled in, these are businesses where even modest demand growth could lead to a material improvement in their operating performance.
This effort has led to a slight uptick in turnover, but we remain steadfast in focusing on well-managed small-cap companies with low leverage, solid balance sheets, and a strong capital allocation process in place, which are part of our 10 Principles of Value Investing™.
Mike: There’s another attribute you like to see, right?
Andy: That’s right, we gravitate towards companies and management teams providing signals — in the form of either buybacks and/or insider buying — suggesting that they believe their shares are undervalued. More than 85% of our holdings are currently engaged in active buybacks, which is the highest percentage in recent memory, and many of our holdings had insider buying during this past quarter.
Mike: That’s a hopeful sign. We’re looking forward to seeing how those green shoots play out. Thanks for your time, Andy.