Transcript
Michael Kops: Hello, I'm Michael Kops, Vice President at Heartland Advisors. Today I'm joined by Troy McGlone, Portfolio Manager for the Heartland Mid-Cap Value Strategy.
Troy, in the third quarter, the markets seemed to be fixated on when the Federal Reserve would cut interest rates and by how much. Did the Fed's decision to cut rates in September change market dynamics?
Troy McGlone: Yeah, good question. Thanks for having me. The anticipation of rate cuts certainly helped lift the Russell Midcap® Index in the quarter. But now that the easing cycle has begun, the knee-jerk risk-on reaction seems to have shifted to a greater emphasis on risk.
Mike: How are you thinking about risk in that context?
Troy: Fed Chairman Jerome Powell made it clear that combating weakness in the labor market is now a bigger concern for the central bank than fighting inflation. Going forward, this suggests to us that payroll data will be more important to the mood of the markets than monthly updates of inflation indicators, including the CPI. On the jobs front, the employment outlook is likely to get worse before it gets better.
Historically, there's been a strong correlation between the unemployment rate and the NFIB Small Business Optimism Index. Ongoing weakness in the NFIB suggests unemployment could climb from 4.2% today to around 6%.
Mike: Should investors be worried?
Troy: Well, many investors will be looking to see if there's more collateral economic damage to come in the near term. But down the road, there's a potential silver lining in all of this because prospective stock returns are better from higher unemployment rates than lower.
Mike: Why might stock returns be better with higher unemployment?
Troy: Well, genuine economic concern in the short to medium term often leads to attractive asset prices for long-term investors.
Mike: The Mid Cap Value portfolio returned 8.45% in the quarter, trailing the Russell Midcap® Value Index, which gained approximately 10.1%. What accounted for that underperformance?
Troy: Well, stock selection was positive in 6 of 11 sectors led by Materials, Financials, and Real Estate. However, a few more concentrated positions were material underperformers, a rare issue in our portfolio historically.
Mike: The strategy is outperformed over most time periods primarily due to stock selection, correct?
Troy: Yes, that's right. How do you work to make that happen? We start with a bottoms-up approach driven by the 10 Principles. Overlaying that, we implement a two-bucket strategy by seeking to own both high-quality companies trading at a decent bargain, what we call quality value, and deeply discounted companies that have produced poor economic returns over time, what we call deep value. However, within deep value, we aim for companies that have identified an internal change agent that could help the business achieve its potential from an intrinsic value perspective.
For every business we consider, we also establish four price targets that allow us to consider how the market might value each of those companies under different scenarios. This gives us a framework for assessing stocks under various market conditions so that as circumstances change quickly, we can act decisively to take advantage of the opportunities. This is particularly useful for stocks we keep on our watch list. where a resumption of volatility could improve the risk-reward profile of the company.
Mike: Is there an example of a company that you added from the watch list?
Troy: Yes. In the third quarter, we added Robert Half (RHI), a leading temporary staffing and consulting firm that places finance, accounting, and technology experts at small and medium-sized businesses.
Robert Half is an example of a quality value bucket company that we have owned in the past and that we can buy with confidence in the face of a business cycle slowdown.
Mike: What gives you that confidence?
Troy: Well, it stems from a belief in the company's competitive positioning, balance sheet strength, capital allocation, and proven ability to compound economic value for owners over time. This is a playbook we've applied many times before when good businesses are going through a soft patch.
We revisited Robert Half in the third quarter of this year after the company's latest earnings call, in which management indicated that temporary staffing revenues have been lower on a year-over-year basis for seven consecutive quarters. The duration of this decline is comparable to recessionary conditions experienced in prior significant economic downturns.
We believe the durability of Robert Half's cash flows should prove greater what the market is pricing in, and we are confident the company is under-earning relative to normalized profitability. Half enjoys industry-leading profitability and free cash flow generation. The company has no debt and more than $5 per share of cash on its balance sheet.
Mike: Robert Half is in the staffing business. You mentioned the unemployment rate could jump to 6%.
Troy: Yeah, it goes without saying that staffing is a deeply cyclical business and unemployment is going the wrong way. Despite that reality, Robert Half actually tends to outperform the Russell Midcap® Value Index when the job market worsens.
The stock is currently trading at a relatively high earnings multiple, but we're okay with that because we consider it a function of depressed profits. The company's free cash flow to enterprise value yield stands at more than 5% today and greater than 10% based on what we believe is mid-cycle profitability. Meanwhile, 100% of the company's free cash flow is being returned to shareholders through dividends and buybacks.
Mike: Are there companies that you're watching for other reasons?
Troy: Yes, a convenience store operator was the worst performer during the quarter. The retailer with more than 19,000 stores, 80% of which are in rural towns with populations less than 20,000, recently slashed its 2024 earnings guidance, sparking a late-summer sell-off.
Same-store comparable sales and margin guidance were cut meaningfully, implying a significant slowdown in the second half of this year. While some of the troubles may be due to the financial challenges of its core customers, the company is also losing market share because of Walmart's initiative to reduce entry-level pricing.
Our strategy exited the position and harvested tax losses, but we continue to monitor the company's financials. We're looking for comp sales to stabilize driven by promotional activity, a boost in labor investments, and management to downsize store expansion plans to improve free cashflow generation and accelerate deleveraging efforts.
Mike: You're willing to be patient. You want to see those things take place before revisiting this holding, right?
Troy: Yes, that's right. It's like what Warren Buffett says. We don't have to be smarter than the rest. We just have to be more disciplined. For us, that means not overreacting to current news while still staying true to our 10 principles of value investing™.
Mike: Thanks, Troy. we look forward to hearing how the next 10 years unfold.