After returning home from the annual gluttony of the Holidays, what’s the first thing most of us did? After loosening our belts, many vowed to detox, eat better, and get healthier in 2025. As investors, we need to resolve to do the same when it comes to our portfolios.
Whether it’s fatty slabs of prime rib and butter-laden mashed potatoes at Christmas or the empty calories of junk food on a daily basis, we intuitively understand that what we put into our bodies impacts our health and well-being. It doesn’t always stop us from engorging on unhealthy choices, but we understand our actions have consequences, which can manifest in the form of indigestion and heartburn in the short term and more serious conditions such as hypertension, weight gain, and heart disease over time.
Well, many investors have been binging on junk too. They’ve been stuffing their portfolios with empty speculation, through debt-laden small companies that don’t generate profits or provide any of the nutritional benefits their portfolios need to grow consistently over time. To be sure, the sugar high of jumping on emerging businesses that are riding the AI- or cryptocurrency wave may seem satisfying at the moment. But it’s important to examine the fundamentals — the investment equivalent of reading a nutritional label — to understand how unhealthy these investments can be for you in the long run.
Passive investors, who invest through a Russell 2000® or S&P 600 Index fund and therefore own the entire small-cap market, may feel they don’t have to worry, as their holdings will always include some healthier options. But this is akin to adding whole grains and leafy greens to a diet of french fries and Frappuccinos and thinking everything will be alright.
As long as you’re consuming fried foods and sugary drinks “in moderation,” isn’t that okay? However, small-cap passive investors may be fooling themselves if they think they are consuming junk in moderation. Consider that 42% of the Russell 2000® companies, one of the most widely followed small-cap index, reported negative earnings at the end of the third quarter. That’s three times the number of profitless companies that existed two decades ago. And this doesn’t simply seem to be an outgrowth of the number of tech startups in the benchmark. Even within the Materials sector of the Russell 2000® Value Index, 19 of 53 companies, or 36%, are currently unprofitable. What this means is by indexing, small-cap investors are assured that roughly two out of five holdings will be “unhealthy options.”
This is where active managers come into the picture. Just as it’s difficult to truly steer clear of unhealthy foods without the guidance of a doctor or nutritionist, it’s hard to avoid debt-laden, profitless companies without active managers who are fundamentally driven and determined to identify the “healthy” opportunities.
At Heartland, all of our managers adhere to our 10 Principles of Value Investing™, which focuses on attractively priced, well-managed businesses with low debt, strong balance sheets, sound strategies, and positive earnings dynamics. This mindset helps us identify better choices for our investors.
A good example is Sealed Air Corporation (SEE), a global packager. While over 35% of its peers in the Materials sector are profitless, SEE generates a return on equity of more than 59%. To put that in perspective, the average ROE of companies in the Russell 2000® Value Index is less than 3%. Meanwhile, Sealed Air’s free cash flow margin stands at nearly 10.9%, more than four times the average for other small cap value stocks. Despite its higher quality attributes, we believe SEE is being mispriced and selling substantially below its intrinsic worth, at less than half the market’s price/earnings ratio.
This is the type of nutritional value that can be added though our in-depth, fundamentally driven research process that’s guided by our 10 Principles. At the grocery store, shoppers can simply turn to the back of every package to see exactly what they are introducing into their diets. In the investment market, there are very few easy sources for such transparency. As a result, many investors may not know where to find healthier options. In the absence of nutritional labels identifying what makes each stock healthy or not, professional guidance from active managers can help investors stay on the financially “healthy” path.