The esteemed value investor Howard Marks wisely pointed out the fallacy of thinking you can follow the herd while expecting to outpace it at the same time. Successful investing, he noted, is “the exact opposite” of trend following. We agree.
Our willingness to steer clear of the path toward speculation by staying true to Heartland’s 10 Principles of Value Investing™ has helped us outperform the Russell 2000 Value® Index so far in 2024 and over the past 1, 3, and 5 years. The Heartland Value Fund has also outpaced a majority of its small value peers — including active and passive strategies — during these time periods, according to Morningstar, by focusing on well-managed, undervalued businesses with resilient balance sheets and sound business strategies.
Such attributes may lack flash in an era marked by the speculative frenzy surrounding artificial intelligence, yet these are precisely the types of businesses being targeted for acquisition. Canadian Western Bank, which we initially purchased in 2021 at a cost of around $22 (USD) a share, agreed to be bought last month by National Bank of Canada and was trading at more than $30 a share at the end of June. At around the same time, Poland Spring owner BlueTriton agreed to merge with Primo Water, another portfolio member.
With the typical stock in our Fund trading at just 10.5 times 2025 estimated earnings per share, versus 19.9 for the S&P 500 Index, we wouldn’t be surprised if there were more take outs to come. Even if that does not come to pass, we are confident a portfolio constructed on the merits of low price to earnings and low debt with strong earnings and revenue prospects makes sense in all markets.
What gives us this conviction? For starters, we have implemented guardrails to make sure that performance is driven by security selection, and not because we are overweight or underweight an industry relative to the index. Even if those allocations are the result of bottoms-up stock picking, and not a top-down sector bet, they could end up being more responsible for the Strategy’s results than our selection effect. To prevent this, sector exposures (with exceptions for small sectors) must be no less than 50% and not more than 150% of the benchmark’s. Our goal is to win in each area of the market so we can deliver consistent outperformance.
Another comforting factor is that when it comes to security analysis, we seek confirmation through old-fashioned “boots on the ground” examination. For more than 40 years, Heartland has engaged in active, in-person fundamental research to gain first-hand knowledge about a company’s operations and strategy. We want to see, with our own eyes, how its products stack up versus the competition’s. This is accomplished, in part, through meetings with management and customers, such as founder Bill Nasgovitz’s recent visit to the Charles LeMoyne Cancer Center, a customer of a long-term holding, Accuray Inc. (ARAY). Through his visit, Bill gathered insight into Radixact, an Accuray product, manufactured in Madison, Wisconsin, being installed in the Montreal hospital to radiate cancers (see photo below).
Visiting a company to ascertain its suitability for a portfolio seems to be becoming a lost art. In an era of passive investing, where investors feel comfortable buying an index fund or ETF without understanding what they own, we believe this on-the-ground research sets us apart from the crowd.
Attribution Analysis & Portfolio Activity
For the quarter, the Heartland Value Fund was down 3.21%, outpacing the 3.64% loss for the Russell 2000® Value Index. Stock selection was mixed during this brief period, with the Strategy outperforming the benchmark in Consumer Staples, Financials, Industrials, Information Technology, Materials, and Real Estate, while lagging in other areas including Consumer Discretionary, Energy, Health Care, and Utilities. Security selection, however, was the primary reason the Fund has beaten the index so far this year, up 3.29% versus the loss of 0.85% for the benchmark.
While opportunities aren’t necessarily plentiful, we try to take advantage of them when they arise. A good example is Hexcel Corp. (HXL), a new position added during the quarter. We didn’t have any holdings in the aerospace & defense portion of the Industrials sector entering the period. Admittedly, this is not a huge sub-industry group; in fact, it only makes up a little more than 1% of the Russell 2000 Value Index. But we are mindful that deviating from our benchmark’s weightings detracts from our stock picking and potentially adds risk and volatility to our Strategy.
The good news for us was the shares took a hit in early April, after the market reacted negatively to the announced appointment of Tom Gentile as Chief Executive Officer. Gentile formerly served as CEO of Spirit AeroSystems, a major aerospace supplier that ran into production challenges and quality issues on parts produced for Boeing. Investors clearly did not like the hire, but we felt the reaction was excessive. Gentile inherited bad contracts at Spirit, and the HXL Board of Directors has significant experience in the aerospace & defense space, so we feel confident they understand the implications of their decision.
Hexcel seems to be in the 3rd inning of a long-term recovery. The company is diversifying into new defense production, where its composites are critical for stealth platforms. The sweet spot for the business, however, is in wide-body aircrafts (such as the Airbus A350 or Boeing 787) that help airlines lower their unit costs. This segment has yet to bounce back from the global pandemic, so there is still runway for HXL’s rebound. Yet the shares are attractively priced relative to cash flow, trading below prior aerospace M&A multiples. Management seems to agree, as there has been a healthy dose of insider buying activity lately, including on the part of its outgoing CEO, who recently purchased nearly $1 million in company stock.
Another area where we are underweight is banks, but we don’t just want to add holdings in that industry to check a box. The goal is to find well-run institutions in good regions with solid population growth. Enter Seacoast Banking Corp. of Florida (SBCF).
SBCF, which provides commercial and consumer banking, wealth management, and mortgage services across Florida, has been on our watch list for some time. Investors, concerned about Seacoast’s profitability, have pushed the share price down more than 17% year to date. But we believe the bank’s net interest margin is poised to rebound in the second half of this year. Meanwhile, management has been aggressively reducing costs by closing redundant branches at the same time it has been adding bankers. If loan demand picks up even modestly, the combination should result in decent operating leverage.
An added benefit: Seacoast could be a takeout target, as it is one of the few remaining pure-play regional banks in Florida, one of the highest growth regions for financial services. Yet the stock trades at just 1.5 times tangible book value, which is one standard deviation below its 10-year average multiple.
In this volatile market, we also understand that promising long-term opportunities may already reside in our portfolio; our job is to have the discipline to stick with them, even amid short-term challenges. An example of this is Century Communities (CCS), a homebuilder based in Denver.
The stock slumped more than 15% in the second quarter along with other homebuilders as mortgage rates rose. While weakness in real estate could persist for the next few quarters, this is a case where the story is about the future. Simply put, there is a massive shortage of homes in America after building rates fell below the 50-year average following the global financial crisis. Since 2012, 7.2 million more households have been formed than single-family homes constructed.
As the median sales price on new homes sold rose to $433,500 in April, housing affordability sank to record lows, putting a strain on the lower end of the market just as millennials are forming new households. Less than 52% of millennials currently own homes, compared with 78% for Baby Boomers and 70% for Gen X. This is creating an attractive supply-demand dynamic for CCS, as approximately 94% of the homebuilder’s sales are made to entry-level buyers.
We believe Century’s management team, which has guided the company to more than 20 consecutive years of profitability, should be able to navigate the housing slowdown while taking advantage of this gap. Yet the stock trades at just under 1X book value versus 1.7X book for homebuilders and 4.3X for the S&P 500.
Outlook
We agree with Howard Marks: It doesn’t make sense to passively follow the herd like index funds. Given how richly priced the broad market is today, we are fine going in a different direction to build in a margin of safety. The fact that mega-cap tech stocks continue to outperform in the face of historically frothy prices, in our view, only makes the case for small value stronger. As value investors, our job is to be disciplined enough to avoid what the crowd is buying today while being patient enough to pounce on opportunities, which is guided by our 10 Principles of Value Investing™.
Fundamentally and patiently yours,
The Heartland Investment Team