Transcript
Michael Kops: Hello, I’m Michael Kops, Vice President at Heartland Advisors. I’m here with Colin McWey, Co-Manager for the Heartland Mid Cap Value Strategy.
Colin, the GOP’s clean sweep of the White House, Senate, and House of Representatives in the November election seemed to throw fuel on the market’s speculative fire.
Colin McWey: That’s right. At least the initial gut reaction was for the market to take considerations of risk and largely push them to the back burner. Investors really just focused on future economic growth that could be spurred by the potential for deregulation, tax cuts, and alike.
Mike: As a fundamentally driven investor, how would you describe the market?
Colin: This has been an extraordinarily challenging environment, as we are unwilling to chase stocks that we consider speculative or priced for perfection. That’s not our cup of tea. This includes companies with historically high multiples on cyclically elevated margins. In our opinion, such opportunities have ample downside risk if any prevailing assumption about this environment doesn’t materialize.
Mike: But it’s possible that deregulation could take place?
Colin: Yes, absolutely it can take place. It’s possible deregulation could come to pass, but there are no guarantees that the incoming administration’s efforts will succeed in accelerating GDP growth to the degree the market now expects. If these efforts fall short or fail to be realized, there are downside risks to consider.
For instance, long-term Treasury yields, which act like gravity on valuations. Meaning when they go higher it tends to compress multiples. Treasury yields rose meaningfully in response to the pro-growth and protectionist strategies outlined by the incoming administration. The 10-year Treasury yield rose from approximately 3.8% heading into the fourth quarter to approximately 4.5% by year end, and interest rate-sensitive industries like housing are suffering in real time and we can see this data coming out in recent earnings reports and such.
Mike: Your stock-picking hit rate has been below normal lately. The Heartland Mid Cap Value Portfolio was down 5.42% in the fourth quarter, trailing the Russell Midcap® Value Index, which fell 1.75%. What do you attribute it to?
Colin: It may be helpful to explore a unique aspect of our process — the two-bucket approach that we use when we construct the portfolio. So, at all times, we seek to own both high-quality companies trading at decent bargains, that’s our “quality value” bucket. And then deeply discounted companies that have produced poor economic returns over time; that’s our deep value sleeve of the portfolio. We do this because these two styles within value investing, these two sub universes tend to alternate market leadership.
In the fourth quarter, on a trailing one-year basis, deep value outperformed quality value by about 270bps. While there is an estimated 70% probability that divergence would be meaningfully higher using more than 150 trailing quarterly measurements, we’re encouraged to see some performance variation after witnessing the lowest reading in forty years of measuring the performance of these two sub universes. Our two-bucket approach typically gives us the upper hand over peers who end up being overweight in one lagging bucket. But when the two buckets perform similarly and both go up a lot, the advantage goes away — which is the case for the moment.
Mike: Do you think you need to do anything different in this type of market?
Colin: While our stock picking in 2024 did not live up to our standards or the level demonstrated over the last several years, we believe that we have to stay true to our process and have a better hit rate going forward, and we are confident we can do that. That means utilizing our 10 Principles of Value Investing™ in concert with our two-bucket approach.
Mike: Where’s that process been directing your attention lately?
Colin: Our 10 Principles require us to be patient and wait for a combination of factors to fall into place before committing to a stock. Among them are attractive valuations, sound finances, capable management teams, good business strategies, catalysts for recognition, and positive earnings dynamics.
A great example is Willis Tower Watson (WTW). Back in 2020, a competitor Aon Plc attempted to acquire Willis in an all-stock merger that would have created the world’s largest insurance brokerage. However, the Department of Justice sued to block the merger, and it was ultimately called off in the middle of 2021. The turmoil from the split caused the company to significantly underperform its peers on critical metrics including organic revenue, earnings growth, margins, and free cash flow conversion.
In 2022, CEO Carl Hess was brought in to turn the business around. As turnaround stories often take time, this is another example. He implemented a restructuring plan to transition the business from a roll-up with disparate systems into a streamlined operating company. Since then, organic growth has accelerated to peer-like performance.
We expect Willis’ operating margin and free cash flow, which still trails that of its peers, to narrow driven by the sale of its underperforming Medicare brokers business along with continued operational streamlining efforts.
Mike: Is there an example of a holding that hasn’t been doing so well lately?
Colin: Centene (CNC) is still a good example, and it is one we are still confident in, and I will lay out some reasons why. It was one of our worst performing holdings in the quarter. This a giant managed health insurer that provides coverage to 25 million Americans, including 14 million Medicaid enrollees in 30 States.
The stock suffered a one-two punch last year: First, it underperformed due to an ongoing ‘price vs. cost’ margin squeeze related to high utilization from Medicaid enrollees after a two-year process of redetermining program eligibility. Medicaid is by far the most meaningful segment of Centene’s business. The stock also received another blow purely on negative sentiment after the election on the theory that CNC’s Affordable Care Act health exchange business, which represents the second-largest business line, may not enjoy as much support under a Trump White House and GOP-controlled Congress.
Mike: So, what gives you confidence to stay patient with the stock?
Colin: Well, some important rebuttals to the bear cases that we’ve subscribed to. The company had a very comprehensive investor day on December 12th and it really amplified on some of those rebuttals to the negative narrative. Management confidently called a peak in their Medicaid medical loss ratios, with a 4.5%-5% payment increases from state partners in recent months and further rate increases on the docket throughout 2025.
Regarding the ACA exchange business line, Centene clarified that even in a “worst case” scenario where enrollee tax credits expire at the end of 2025 and have no further support. Even in that scenario, the earnings risk is no more than $1 per share, that compares to $3-$4 per share of earnings recovery potential across Centene’s Medicaid and Medicare Advantage product lines. We think this combination is really noteworthy for a company that trades at 8.5X earnings. They’ve executed numerous operational streamlining initiatives in recent years, and they’ve aggressively repurchased shares at discounted valuations.
Furthermore, we do not expect the ‘worst case’ Affordable Care Act scenario to transpire. The reality is that ACA exchanges have become a critical outlet to fill coverage gaps for individuals and small business. Some of the strongest growth in utilization in the ACA has come in Republican-stronghold states and rural communities, critical to Trump’s base. This has resulted in much stronger bipartisan support for ACA exchanges today compared to when Trump was first in office last time around.
Mike: Is there any evidence that growth in Republican-leaning states and communities will affect policy?
Colin: We found it interesting that shortly after Centene’s investor day, the Congressional Budget Office released several proposals. It included 76 policy options to reduce the Federal deficit in the coming decade. 14 of those proposals were health related, yet none of them contemplated eliminating the exchange tax credits, not one of them.
Also, at a time when we have observed as much insider selling by corporate executives across the marketplace as we can recall, we would note that several CNC executives and directors are buying shares with their own money. That indicates to us that they also consider the stock’s valuation and prospects to be compelling.
Mike: Are you confident about how your portfolio is positioned overall?
Colin: While many of our core holdings underperformed during the fourth quarter, we are confident they will perform better on a relative basis over the next year and beyond, regardless of how the economy unfolds.
Temporary overhangs in these holdings have been magnified in a market where risk-aversion has dissipated, and multiple expansion has become quite extreme. But there are many reasons why these conditions seem to be unsustainable to us. That is why we believe it will ultimately pay not to chase excessive valuations and speculative behavior and stay true to our 10 Principles of Value Investing™ and demonstrate a better hit rate on our catalysts coming in fruition in the next year and beyond.
Mike: Thanks for sharing your outlook, Colin, and thanks for your time.