For value investors, there comes a point in every cycle when it becomes exceedingly difficult to be a contrarian, requiring every ounce of discipline to stay true to one’s principles. That’s where we found ourselves in the fourth quarter.
As other investors seemed to buy into the notion that they could have their cake (moderating inflation) and eat it too (ongoing growth), the wall of worry that every market must climb seemed to evaporate overnight. After falling in the first four weeks of the quarter, small-, mid-, and large-cap stocks surged starting in late October, led by speculative, highly leveraged companies that stand to benefit in the early stages of a new cycle.
Since the end of October, the broad market delivered more than a year’s worth of gains in just nine weeks, with the all-cap Russell 3000® Index up 15.1% and the Russell 2000® Index of small stocks surging 22.4%.
Never mind that Federal Reserve policy generally acts with a lag, which means bad news may yet emerge in the coming months. Forget, for the moment, that there are two major ground wars being fought with the potential to impact oil prices. And let’s also ignore the collapse of the personal savings rate and record credit card debt, which hints at further challenges for the consumer economy.
All of these concerns notwithstanding, the consensus view seems to be that the Federal Reserve will be able to stick a “soft landing” and slash interest rates aggressively this year. With the futures market pricing in six potential rate cuts in 2024, even the fixed income market is embracing this narrative, with yields on 10-Year Treasuries down from close to 5% in late October to approximately 3.9% at the end of the quarter, further emboldening risk-taking.
As demoralizing as this environment is for fundamentally driven, defensive-minded investors like us, it is risky—and late in the game—to jump on the bandwagon. Instead, we believe this is the time to look for opportunities that fit our process while sticking to our guns and making good decisions based on Heartland’s time-tested principles.
Attribution Analysis
In the fourth quarter, the Value Plus Strategy returned approximately 7%, trailing the Russell 2000® Index, which returned 15.3%. The underperformance was attributable to our defensive positioning, stock selection (particularly in Energy), and underweight exposure to early cycle parts of the market such as Financials, which were the benchmark’s best-performing sector.
The Value Plus portfolio is constructed with low-volatility, low-debt stocks that can thrive in good times and bad. Starting in late October, though, high-beta, highly leveraged, early-cycle companies came into favor, especially as investors grew convinced that a soft landing was at hand. Historically, in periods when the portfolio has been underweight to certain sectors that detracted from performance, certain overweights have compensated. In the fourth quarter, however, our allocation decisions weren’t of much assistance.
The fact is that the portfolio has been too defensively positioned given the current euphoria in the markets. But we also believe that this is a phase in the cycle where the market is pleading with contrarians to capitulate to current perspectives.
We have made some modest pivots, including aligning sector allocations more closely to benchmark weightings where possible. In a market rewarding high-beta stocks, where the portfolio has little exposure, we are also looking for beta—but only when it overlaps with our 10 Principles of Value Investing™, which require us to look for well-managed, financially strong businesses with sound balance sheets trading at attractive prices to help create a margin of safety. Our process can coincide with some higher-octane names, but we remain extremely disciplined when it comes to key considerations such as leverage, financial soundness, and valuations.
In addition to these steps, during the quarter we trimmed some positions for tax purposes, which were beaten down when self-help strategies didn’t progress as hoped—and where we now have less conviction. As we have been patiently looking for ways to deploy the proceeds of those sales, the temporary increase in cash was also a drag on performance in the fourth quarter.
Outlook
Without question, this has been a challenging environment for the Value Plus Strategy. While we can’t completely ignore the current environment—even if we disagree with some core economic assumptions—we must stay true to ourselves and our process. That’s why we believe in Heartland’s 10 Principles of Value Investing™, which are non-negotiable elements that we look for in any investment under consideration. As famed fund manager Seth Klarman has pointed out, the essential characteristics of value investing are “patience, discipline, and risk-aversion.” We believe turning our backs on those values in the short term is a sure-fire recipe for underperforming in the long run.