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Q2 Market Discussion

Nervous investors entered the quarter expecting another shoe to drop, and it did. As the Federal Reserve aggressively raised interest rates to cool inflation that was higher than in four decades, stocks fell into an official bear market. Today, those same investors are wondering if the force with which the Federal Reserve has held back monetary policy could lead the economy into recession.

But with declining consumer confidence and the explosion of consumer credit, this question may be moot. The consumer economy already appears to be effectively in recession, which resets market expectations. From our perspective, the real next development to watch is when market concerns escalate to the point where investors finally begin to focus on balance sheet strength again, as they did briefly in the first quarter of 2020 in start of COVID-19. recession and in 2007 the onset of the global financial panic.

In our view, we are not there yet, but we remain very watchful as this would signal the next leg of the recession, which we believe will refocus attention on attractively priced, well-managed companies with high-quality balance sheets that benefit from a margin of safety both from an operational and valuation point of view.

The best offense can be a good defense

Given this economic backdrop, we don’t expect strong stock market performance for some time. Yet history has shown that active managers can find promising opportunities in otherwise weak markets. Many pockets of the small cap universe, for example, eclipsed large caps for several years in the 1970s in a sluggish economic environment. And the stock outperformed broad indices in the years immediately following the bursting of the dotcom bubble. Today’s economy is not an exact repeat of those times. Nonetheless, we believe we are in a different stock picking market.

What characteristics should stock pickers look for? Balance sheet strength is always our first consideration, even before income statements, because we approach companies like credit analysts. In the current environment, this mindset seems particularly helpful as we believe markets are about to enter a period of negative earnings revisions, with analyst estimates still looking far too optimistic. Indeed, investors will likely have difficulty identifying corporate earnings – or the “E” in the price-to-earnings ratio – so investors should not let P/E ratios be their primary guide. In addition, the percentage of unprofitable stocks has reached an all-time high. (see table below)

Negative revenue growth

chart shows percentage of Russell 2500 companies with negative earnings

Source: Kailash Capital, LLC, Yale University, Compustat. https://kailashconcepts.com

The chart above shows the percentage of Russell 2500 companies with negative earnings. Monthly data from 12/31/1978 to 6/30/2022. Not all indexes are maintained. It is not possible to invest directly in an index. Past performance does not guarantee future results.

In our view, if credit markets tighten, as one would expect in a recession, companies that can self-finance their growth will be much more attractive. That’s why we favor well-managed companies with strong balance sheets and consistent free cash flow generation. It’s also why we tend to prefer dividend payers and producers, but not the most productive producers, because the ability to consistently increase dividends, even in tough economic times, signals management’s skills in managing. capital allocation.

For similar reasons, we prefer companies with little or no leverage, which is a constant in our Ten Principles of Value Investing™. Although the markets haven’t rewarded companies with low leverage, that could soon change in today’s “risk-free” market, especially if the economy slows. In June, the median net debt to EBITDA (earnings before interest, tax, depreciation and amortization) ratio of our portfolio was just 0.8x, compared to around 2.9x for our benchmark. This gap between our net debt to EBITDA ratio and that of our benchmark index is the largest in nearly four years.

Attribution analysis

Even with multiple layers of safety nets, strong balance sheets, and cash flow generation, investors probably can’t protect themselves against short-term stock market losses. In the second quarter, for example, the portfolio declined slightly, although less than the Russell 2000 Value Index, partly due to stock selection and a focus on quality.

industrial strength

Heartland Advisors Value Investing Consumer Discretionary Icon

To cope with long-term inflation, we believe the economy will need to expand its capacity by relocating industrial production to the United States. Several of our holdings should benefit if this theme develops. Powell Industries (POWL), for example, develops, manufactures and services custom equipment systems used in oil and gas refining, mining and metals, electric utilities and other markets around the world. ‘heavy industry.

Until last quarter, Powell shares appeared to be acting like they were in their own mini-recession after hitting a series of headwinds, including COVID-19 shutdowns, supply chain issues when reopening the economy and inflation in the post-COVID -19 environment. While the company returned to profitability, the stock traded below book value with an attractive dividend yield. In the last quarter, Powell saw very strong bookings, an indicator of future revenue, while benefiting from the tailwind of infrastructure construction while being able to raise prices.

Healthy healthcare

Heartland Advisors Value Investing Consumer Discretionary Icon

Like Powell, many healthcare stocks never benefited from the post-COVID-19 rally in the stock market. As a result, our healthcare stocks are among our least expensive holdings. Haemonetics (HAE) and Phibro Animal Health (PAHC) are two good examples. Haemonetics, which provides disposables and devices used for blood and plasma collection, appears to be a recession-friendly stock because its products are not economically dependent. Additionally, as households feel economic pressures, they are more likely to donate plasma, for which they are compensated.

Phibro’s strength lies in its animal health franchise, with medical feed additives and nutritional products for production animals. The company is also working on early-stage opportunities in its pet business, which could not only diversify its revenue but potentially provide a catalyst for the stock. Phibro trades at around 1x the sell, and the stock has benefited from insider buying.

Outlook and positioning

We believe we are well positioned for the current environment. Well before last quarter, we started looking for opportunities in high-quality, battered stocks with defensive attributes. If we reach rockier shores, the attractive valuation of these companies should provide some downside protection. And if credit markets start to close, those assets shouldn’t need to access debt funding to fund themselves.

This speaks to the nature of our portfolio. In the big moments, we try to exceed expectations. In less good times, we try to win by avoiding big drawdowns. And in all types of markets, we look for investments that demonstrate financial strength, capable management teams with sound capital allocation policies and solid business strategies at attractive prices, which is more possible now, after the slowdown than a year ago.

Thank you for the opportunity to manage your capital.


Fund returns (30/06/2022)

Since inception (%) 20 years (%) 15 years (%) 10 years (%) 5 years (%) 3 years (%) 1 year (%) YTD* (%) QTD* (%)
Value more

Investor class

9.77 9.11 6.65 8.07 8.92 9.89 -11.34 -11.57 -7.97
Value more

Institutional class

9.91 9:30 a.m. 6.90 8.32 9.17 10.14 -11.16 -11.47 -7.92
Russell 2000® value 9:20 a.m. 7.77 5.58 9.05 4.89 6.18 -16.28 -17.31 -15.28

*Not annualized

Source: FactSet Research Systems Inc., Russell® and Heartland Advisors, Inc.

The launch date of the Value Plus Fund is 26/10/1993 for the investor class and 01/05/2008 for the institutional class.


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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.