After surging around 22% in final two months of last year, the Russell 2000® Index slowed considerably in the first quarter, posting modest gains of 5.2%, underperforming the S&P 500 Index by a wide margin.
While hope that a recession has been avoided and euphoria surrounding artificial intelligence (AI) helped put a spotlight squarely back on bigger companies, there was a fundamental reason why large caps regained the market leadership at the start of the year. Thanks to positive earnings revisions, companies in the S&P 500 are on track to see their 2023 earnings grow 7.2%, versus the projected 8.9% decline in Russell 2000® Index profits.
The good news: There’s also a fundamental reason why the market may broaden out, potentially allowing small stocks to regain investor attention: In 2024, earnings for companies in the Russell 2000® Index are expected to grow 11.3%, outpacing the 10.6% forecast for large caps (see chart below).
Russell 2000® expects 11.3% ‘24E earnings growth vs 10.6% for large-caps.
Source: Furey Research Partners and FactSet, as of 3/31/2024. This chart represents the comparison between estimated Earnings Growth and Sales Growth for small companies, measured by the Russell 2000® Index, versus large companies, measured by the S&P 500 Index. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.
The fact that small caps have already been through the wringer is another reason to be encouraged. Whether the market’s expectations of a ‘soft landing’ or ‘no landing’ for the economy materializes, many small businesses have already been through recession-like downturns in a variety of industries, suggesting there could be less downside for this group than is currently assumed. At the very least, the headwinds these companies have already faced sets up an environment with greater opportunities for small stocks, given their wide valuation disparities with mega caps.
Attribution Analysis & Portfolio Activity
In the first quarter, the Value Plus Strategy was up approximately 1.5%, trailing the Russell 2000® Value Index, which was up 2.9%. Stock selection, particularly in the Health Care, Information Technology, and Materials sectors, contributed to the underperformance. However, selection effect helped the Strategy outperform the benchmark in the Consumer Discretionary, Consumer Staples, and Financials sectors.
We remain committed to Heartland’s 10 Principles of Value Investing™, which favors companies with low leverage, strong free cash flow, and a successful track record of capital allocation. We also look for companies that are deploying self-help strategies to improve their competitive standing and profitability through strategic and operational improvements.
Lately, we’ve been finding opportunities in companies that have been through their own mini recessions and have proactively adjusted so that even if the economy doesn’t improve, their outlooks hopefully will. And should demand rebound, these companies that have already course corrected and taken costs out are likely to emerge stronger with higher operating leverage.
Here are two good examples of such opportunities:
Consumer Discretionary. In the first quarter, we initiated a position in Mohawk Industries (MHK), the leading manufacturer of flooring including carpets, tiles, and wood and vinyl products for the residential and commercial markets. In recent years, Mohawk has run into difficulties owing to rising interest rates, which affects its end markets, and inflation in source materials, which cuts into margins. Between May 2021 and October 2023, the stock lost nearly two thirds of its value.
But the worst of the company’s pricing pressures may be behind it. And after suffering five consecutive quarters of negative year-over-year sales comps and eight out of nine quarters of negative year-over-year EBITDA growth, Mohawk reversed the trend in the past quarter. Meanwhile, the company has been undergoing extensive self-help in recent years — for instance, it has been investing in automation to boost luxury vinyl tile production in North America and Europe.
While companies usually trade at high multiples at the trough, thanks to diminishing earnings, Mohawk’s shares are at their lowest valuation in recent memory. The stock trades at just 6 times EBITDA and less than 11 times trough earnings while sporting a strong balance with net leverage of 1.3x.
Industrials. Kennametal (KMT), which manufactures industrial cutting tools and components, is another new position initiated during the quarter. The company operates two businesses: a metal cutting unit that sells into a variety of end markets including aerospace and defense and energy, along with an infrastructure unit that provides earth cutting and wear solutions.
The company hit a rough stretch recently, due to rising raw material costs, foreign exchange headwinds, and decreased sales volume in its infrastructure segment. KMT has also experienced contracting year-over-year EBITDA growth in six of the past seven quarters. However, the company has been undergoing extensive self-help, eliminating $200 million in structural costs, reducing its headcount by 20%, and closing six plants over the past five years.
In our opinion, the heavy lifting is done. If demand remains tepid, the company should continue to optimize capacity via additional cuts and more plant consolidation. EBITDA is likely to grow on flat to moderately declining revenue. And if Kennametal sees any slight uptick in demand in its end markets, it could provide an immediate and robust boost to its operating margins. Yet the stock trades at less than 8 times EBITDA on trough earnings, a 3% dividend yield and modest net leverage of 1.7x.
Outlook
While challenges remain in this economy, macro concerns are not preventing us from finding new opportunities. The recession-like setbacks that many small companies have already experienced - weighing on their stock prices but also promoting self-help initiatives - should be beneficial. We believe our focus on low valuations and leverage, strong free cash flow and balance sheets, and sound capital allocation and business strategies, as outlined in our 10 Principles of Value Investing™, will help guide us to solid long-term holdings.