Mike Kops: Hello, I'm Michael Kops, Vice President at Heartland Advisors. I'm joined by Will Nasgovitz, Portfolio Manager for the Heartland Value Fund.
Will, the market's been looking forward to the Federal Reserve finally reversing course and bringing rates back down. The third quarter brought a 50 basis point cut and a suggestion there could be more to come. What are your thoughts?
Will Nasgovitz: Well, it's great to be here, Mike. Thanks for tuning in, everyone.
The third quarter showed how easy it is to get caught up in the horse race aspects of investing. Traders, rather than investors, look for immediate winners and losers and the opportunity for short-term success.
Being value investors, we realize additional patience may be required, as growth doesn't typically relinquish its advantage until midway into an easing cycle. We also understand the Fed can cut rates because things are getting better on the inflation front or worse for the economy. It's not always crystal clear this soon.
Mike: What gives you optimism about small cap value?
Will: If you're willing to accept the long-term returns of small and large are likely to hold over time in the future, then small has been so bad, it's good. Relative returns over the past three years sets the bar pretty low for this group. We like that setup.
Mike: For the quarter, the Heartland Value Fund gained 9.83%. trailing the Russell 2000® Value Index, which returned 10.15%. To what do you attribute that underperformance?
Will: Sure. Security selection was mixed over the past three months with the strategy outperforming the benchmark in Consumer Discretionary, Consumer Staples, Energy, Financials, and Materials. We lagged in other areas, though, such as Information Technology where semiconductor stocks dragged performance as well as Health Care.
Mike: Yet year-to-date, the fund continues to beat the Russell 2000® Value Index. What's driven that success?
Will: Security selection was the primary reason the fund has beaten the index so far this year. But beating the index over any specific time period isn't the only way we measure success.
Hall of Fame quarterback Roger Staubach argued that, “winning isn't getting ahead of others, it's getting ahead of yourself.” We agree. Success can be measured by how much you grow and evolve your thinking and perspective.
At Heartland, our 10 Principles of Value Investing™ guide every investment decision we make. While those rules are unwavering, we are committed to looking for new and more effective ways to put our beliefs into practice with the goal of delivering consistent performance over time.
Mike: Will, can you describe how you go about selecting stocks?
Will: Great question. We are constantly assessing risk, looking for ideas that are both attractive from an upside-downside perspective and can play a key role in properly constructing the portfolio. This awareness is a critical part of the process, is akin to constructing a winning football team. You cannot just draft the best quarterback coming out of college if you already have a franchise QB and need to shore up your defense. That's how we go about picking stocks. We look for situations where our needs and opportunities converge.
Mike: Is there a good example of a stock that fit your needs and represented an attractive opportunity?
Will: Alexander and Baldwin (ALEX), is a good one. Entering the quarter, Real Estate was among our largest underweights, so we were aware of the potential need to boost our exposure. We began reviewing Alexander and Baldwin two years ago, but held off on the commercial real estate firm because of a rogue construction business we felt muddled their investment case. The company has since divested that nine-core asset, making Alex a pure-play REIT with retail, industrial, and office properties exclusively in Hawaii.
For every investment under consideration, we keep track of a grid of attributes that gives us a better sense of the comparative prospects for that investment. With Hawaii's strong household income, low unemployment, and high proportion of stable government spending, Alex's state-focused approach has improved the stock's grid score of 7 out of 10, putting it at the upper end of our real estate holdings. Priced well below our assessment of intrinsic worth, plus a robust dividend yield of 4.6%, we added the stock to the fund.
Mike: What happens if a holding's grid score worsens?
Will: Sure, Osisko Gold Royalties (OR) is a successful holding, which we exited this year because its grid score deteriorated.
As interest in gold has grown, shares of the company, which acquires and manages precious metal royalties worldwide, appreciated substantially. However, production difficulties at one of their key producing mines surface, thus reducing our estimates of earnings and cash flows. These increased the risk while lessening the reward potential for Osisko. A rich valuation of 20 times cash flow and a new grid score of just 5 out of 10 led us to move on.
Mike: Where did you see those better values?
Will: Our research indicated the outlook for New Gold (NGD), a pure Canadian gold and copper producer, was steadily improving. New Gold has met guidance for eight consecutive quarters as both of its mines are hitting their production stride. Under a new CEO, New Gold is enjoying financial flexibility that allows for exploration to grow reserves and extend the life of their minds. Increased production, cost cuts, and strong free cash flows have boosted our confidence in management's execution. Strong insider buying shows they believe in their prospects as well. Yet, despite the doubling in value, new gold was priced at eight times our estimated 2025 earnings, less than six and a half times free cash flow, and scored eight out of 10 on our research grid.
Mike: That's a great illustration of your process. The color around the quarter is appreciated, and we look forward to future updates.