Recently, we have been focusing our attention on companies with two levers of potential growth. These are businesses proactively taking steps to improve their own financial strength and competitive standing to boost their profitability. Once demand dynamics improve, these firms should be better positioned to take advantage of accelerating growth, lifting their profitability even more. At the end of last year, hopes for that economic lever grew amid widespread belief that stimulative fiscal policies and reduced regulations espoused by the incoming administration would set the stage for a growing economy.
In the first quarter, however, those assumptions were put on hold, as fears over a global trade war clouded the business climate. Adding to the uncertainty, many companies have been holding off making big investments and new hires amid the flurry of new policies being proposed by Washington, including the enactment of tariffs and significant federal spending cuts.
U.S. GDP is now expected to shrink 2.4% in the first quarter, according to the Federal Reserve Bank of Atlanta’s GDPNow forecasting model, after growing 2.3% in the fourth quarter of 2024 and 3.1% in the third. This turn of events has been particularly hard on small stocks, with the Russell 2000® Index down 9.5% in the quarter versus the 4.3% loss for the S&P 500 Index.
It is difficult to tell whether slowdown fears will persist. But as it is becoming harder to rely on demand dynamics improving, even greater emphasis will be placed on companies that are successfully undertaking “self-help” strategies to improve their standing. Even if these businesses only tread water for the time being, that could be considered a temporary victory in the current environment.
This also places greater importance on the need for a balanced approach. The range of possible economic outcomes widened at the start of the year. An example of this can be seen through one of our holdings, FirstCash Holdings, Inc., a leading operator of pawn shops and lending locations geared toward credit-constrained consumers. As the chart below shows, the company’s pawn loan balances have risen considerably in recent quarters.
Source: Heartland Advisors, Inc., FirstCash Holdings, Inc.(FCFS) Financial Statements. Quarterly data from 3/31/2022 to 12/31/2024. This chart represents the Pawn Loan Balances of FCFS on a quarterly basis ($mm). Past performance does not guarantee future results.
As these are a lending source of last resort, this would suggest lower-income consumers are stretched. This alone may not be enough to trigger a ‘risk-off’ view of the market, but it does indicate the need to be cautious. Whether we are playing offense or defense, we continue to look for companies embracing ‘self-help’ that also adhere to our 10 Principles of Value Investing™, which focus on attractively priced, well-managed companies with high-quality balance sheets, low debt, and positive earnings dynamics.
Attribution Analysis & Portfolio Activity
The Value Plus Strategy lost 8.23% in the first quarter, compared with the 7.7% decline for the Russell 2000® Value Index. Stock selection was positive in four sectors, led by Real Estate, Energy, Industrials, and Utilities. Not surprisingly, those segments of the market accounted for eight of the ten top stocks contributing to our Strategy’s returns in the first quarter.
A key focus of our selectivity has been driven by self-help. An example is The Hanover Insurance Group, Inc. (THG), a property and casualty insurer. The company stumbled in recent years, thanks to heavy exposure to the upper Midwest, which has been hit with severe weather including deadly hailstorms. After falling short of earnings estimates recently due to the cost of damaging storms, the company has been taking steps to reduce its exposure to catastrophic events — for instance by writing less insurance in at-risk geographies and raising deductibles. THG has also made other money-saving moves, such as requiring customers to use sensors for early detection of water leaks in their homes. Those efforts led to strong fourth quarter results. In Q4, catastrophic losses contributed just 2.1% of Hanover’s combined ratio, a key measure of profitability. That was substantially less than it has been in recent years.
Meanwhile, Hanover has restructured its investment portfolio, which accounts for 60% of its earnings, to benefit from higher yields. This should go a long way toward boosting its net investment income this year. Yet despite these positive steps, the stock, with a steadily growing dividend, still trades at approximately 12 times 2025 earnings per share.
Another defensive holding is FirstCash Holdings Inc. (FCFS), a leading operator of pawn shops in the U.S. and Latin America whose core driver of earnings is pawn loan balances. But unlike THG, which can thrive despite economic circumstances, FirstCash is positioned to do well because of the challenging economy.
Traditionally, when the consumer discretionary sector is doing poorly, as was the case in the first quarter, FirstCash often has done well. In the first quarter, the stock rose over 16.5%, making it among the top performers among our holdings. Stretched by inflation, consumers are increasingly utilizing pawn loans to cover their financial needs. Contrary to popular belief, though, pawn businesses have limited credit risk, as companies can simply keep the collateral items being held if consumers fail to pay back their loans. The stock is trading at nearly 15 times earnings and just 11 times EBITDA with a growing dividend and an active buyback program in place. We believe this valuation represents a material discount to its historical multiple.
We consider Gates Industrial Corporation plc (GTES), one of the leading global manufacturers of belts and hoses used in vehicles and industrial machines, to be an all-weather stock set up to perform well relative to small-cap Industrials in all types of macro environments. Yet the shares have fallen 21.7% since Feb. 19 along with the entire Industrial sector amid concerns of a trade war.
Ironically, the company’s biggest end market is auto replacement parts, representing 36% of sales. The threat of tariffs significantly boosting the overall price of new cars should make consumers hold onto their existing vehicles longer, which should be good for Gates. If the macro environment deteriorates, we believe the company will face less downside pressure than most Industrials owing to the large percentage of revenues it derives from the less-cyclical replacement markets. On the other hand, should the macro environment improve, Gates could see significant revenue upside as cyclical Industrial end-markets have been pressured by a weak economy for multiple quarters.
The company’s recent self-help efforts have also led to margin improvement through material cost reduction and footprint optimization. Those moves should help offset any margin pressure that could occur from end-market weakness. The company appears to have significantly improved its balance sheet, with leverage currently at 2.2 times net debt to EBITDA, down from its pre-COVID-19 levels of 3-4 times. At this current leverage profile, Gates should be positioned to return more of its free cash flow to shareholders in the form of share repurchases. Yet the stock trades at just 13 times earnings and 9 times EBITDA, which is relatively low compared to other Industrial businesses with a similar margin profile.
Outlook
We believe this is a market that requires patience and a long-term mindset. Ideally, we would love to take advantage of the one-two punch of self-help strategies setting up companies for faster earnings growth once demand dynamics improve. The fact that this second punch has less sting today does not detract from the overall strategy — it simply puts greater emphasis on companies that are doing what they can to strengthen their own position. That is why our 10 Principles of Value Investing™ are more important than ever in times like these, as traits such as attractive prices, high-quality balance sheets, and competitive advantages are useful regardless of economic conditions.
Thank you for your continued trust and confidence in us.