TCBI - Heartland Value Fund Q3 2022 Commentary
Summary
- As fears of a Federal Reserve-induced recession have risen, speculative areas of the market have been crushed.
- In this volatile environment, value continued to outperform growth.
- Bear markets can be difficult, but often set up opportunities for the enterprising, patient value investor.
- Historically, our Ten Principles of Value Investing™ have helped identify such opportunities.
“An era can be said to end when its basic illusions are exhausted.”
???????—Arthur Miller
In the third quarter, equity markets were highly volatile with a strong summer rally followed by a dramatic decline. In addition to the continuing war in Ukraine and supply chain bottlenecks, another negative was the Federal Reserve’s more hawkish stance.
The Fed set a record by increasing rates +75 basis points for the third time this year and telegraphed its intent to keep hiking aggressively to combat inflation. All this, in the face of a dramatic decline in CEO confidence, an inverted yield curve, and long-term mortgage rates doubling to over 6%. The result: economic activity has slowed, fears over a Fed-induced deep recession have risen, and equity valuations have come down markedly.
As the playwright Arthur Miller noted, eras only come to an end when its myths are extinguished. Well, the speculative mindset, fueled by a decade of “easy money” that led many equity investors to turn a blind eye toward valuations and leverage, seems to be over. As the chart below shows, the percentage of companies expected to see improving earnings over the next year is likely to be extremely low.
| Source: Piper Sandler Portfolio Strategy, Monthly data 12/31/1985 to 9/30/2022. The data in this chart represents the S&P 500 Positive Earnings Revisions (% of total) being led by The 2 Year Change in Basis Points Of The 10 yr. Yield. IBES Aggregates S&P 500 Analyst Earnings Revisions (Up – Down / Total), and Bloomberg US Generic 10 Yr Yield (USGG10YR In Bloomberg). Higher interest rates lead to fewer positive earnings revisions from sell side analysts. All indices are unmanaged. Past performance does not guarantee future results. There is no guarantee that a particular investment strategy will be successful. |
Advantage: Value
In our opinion, this is precisely the time to be an active, selective investor. We also believe this is a backdrop in which value, after being out of favor for many years, can continue to outperform. Year-to-date, the Russell 2000 Value® Index is off 21%, while the Russell 2000 Growth® is down 29%. The valuation disparity between value stocks and growth/momentum favorites has narrowed, and with higher interest rates likely to compress further.
Patient investors should be rewarded for owning high quality assets with balance sheet strength and low price-to-earnings. But remaining disciplined will be key, as a combination of materially lower earnings estimates and stock prices will likely be needed to improve the risk-return profile of many companies on our research “watch list.”
Attribution Analysis
The Long Game in Energy
This is not to say that we weren’t buyers in the quarter. Where opportunities presented themselves, we initiated and added to positions as appropriate.
In the third quarter, recession-related concerns weighed on crude oil as the price sank from $110/barrel to $80 at quarter’s end, causing the energy sector rally to wane. But there seems to be a longer-term trend at play. Traditional oil and gas spending peaked in 2014, and since then, multiple forces—including fears over peak oil demand, the rise of ESG focus, and capital discipline by producers—have delayed an upcycle in traditional oil and gas spending.
Post Covid, the demand for oil has been strong, expected to exceed 100 million barrels a day. Our sense is that energy service-related companies have entered the early innings of a positive earnings revision cycle, a rarity in the markets. To take advantage of this, we own NOV, Inc. ( NOV ) , a leading oilfield services company that provides technical expertise, advanced equipment, and operational support for the oil and gas industry. NOV generated $4.6B in EBITDA in 2014, but just $230M last year, which speaks to the under investment in the broader energy patch. NOV’s outlook continues to improve though, as the company is now forecasted to produce over $600M and nearly $900M in 2022 and 2023, respectively. Interestingly, estimates are up ~10% since the start of the year and maintain an upward bias.
Being Patient with Healthcare
We continue to have a meaningful allocation to healthcare, but it proved to be a challenging quarter for the sector. Yet we remain patient in situations where we believe investors have overreacted.
Case in point: Patterson Companies ( PDCO ) , a leading distributor of dental and animal health related products, reported first quarter results that included a sequential decline in dental equipment-related sales and price deflation in consumables. The former is in part a hangover from a strong fourth quarter while price deflation is being driven by inventory build-ups during COVID. With a healthy 4% dividend yield and attractive valuation, only 11X estimated earnings, we continue to hold Patterson. Notably too, a competitor in the dental space, Henry Schein, Inc., trades at a 1.5x+ premium to PDCO on estimated EBITDA while Covetrus, Inc., an animal health player, was acquired for 14.0x EBITDA in May.
Financial Opportunities
Banks have been buoyed by rising interest rates that offer larger spreads. The question is, ‘How bad will credit get during the current downturn?’
Texas Capital Bancshares ( TCBI ) is a Dallas-based middle market commercial lender with a particular focus on the four major Texas markets of Dallas-Fort Worth, Houston, San Antonio, and Austin. TCBI is a classic self-help story: Prior management ran the bank as a “growth at all cost” institution. When the bank was small and rates were at historic lows, it was easy to sustain growth by booking new loans and growing deposits regardless of the quality of either relationship. Credit problems began to percolate after the company downgraded several levered loan credits in 2019. Last year, a new CEO was brought in from J.P.Morgan Chase who quickly exited risky loans and reoriented TCBI as a local Texas commercial lender with a niche focus on deep customer relationships.
A position was initiated due to our belief that under new management’s focused strategy, the bank is on the verge of improving its returns and market perception. The stock trades at only 1.1 times tangible book value, compared to 1.8 times for regional banks in general. Granted its return on assets is below the average for peers. In our opinion, over time TCBI will close the return gap with valuations likely to follow suit.
Outlook
Our purchase of TCBI demonstrates the Team’s focus on the margin of safety in all of your investments. This focus requires understanding the fundamentals, both the qualitative and quantitative, through the application of our Ten Principles of Value Investing™. We believe the output from this process produces a portfolio that exhibits balance sheet strength and below market valuations, two attributes that could offer relative downside protection as the markets move on from an era of speculation and irrationality.
We are encouraged by the renewed interest in value investing and the Fund’s relative performance. Based on valuations, we remain optimistic on the long-term outlook.
Thank you for your continued trust and confidence.
Value Fund Valuations
| Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 9/30/2022. Price/Earnings and EV/EBITDA are calculated as weighted harmonic average. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Certain outliers may be excluded. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future returns. |
Fund Returns
9/30/2022
| Since Inception (%) | 20-Year (%) | 15-Year (%) | 10-Year (%) | 5-Year (%) | 3-Year (%) | 1-Year (%) | YTD* (%) | QTD* (%) | |
|---|---|---|---|---|---|---|---|---|---|
| Value Investor Class | |||||||||
| 10.76 | |||||||||
| 8.30 | |||||||||
| 4.41 | |||||||||
| 6.13 | |||||||||
| 3.47 | |||||||||
| 6.71 | |||||||||
| -12.02 | |||||||||
| -17.70 | |||||||||
| -4.12 | |||||||||
| Value Institutional Class | |||||||||
| 10.83 | |||||||||
| 8.44 | |||||||||
| 4.59 | |||||||||
| 6.30 | |||||||||
| 3.62 | |||||||||
| 6.85 | |||||||||
| -11.94 | |||||||||
| -17.63 | |||||||||
| -4.09 | |||||||||
| Russell 2000® Value | |||||||||
| 10.24 | |||||||||
| 8.81 | |||||||||
| 5.70 | |||||||||
| 7.94 | |||||||||
| 2.87 | |||||||||
| 4.72 | |||||||||
| -17.69 | |||||||||
| -21.12 | |||||||||
| -4.61 |
| *Not annualized Source: FactSet Research Systems Inc., Russell®, and Heartland Advisors, Inc. The inception date for the Value Fund is 12/28/1984 for the investor class and 5/1/2008 for the institutional class. |
| In the prospectus dated 5/1/2022, the Gross Fund Operating Expenses for the investor and institutional classes of the Value Fund are 1.04% and 0.92%, respectively. The Advisor has voluntarily agreed to waive fees and/or reimburse expenses with respect to the institutional class, to the extent necessary to maintain the institutional class’ “Net Annual Operating Expenses” at a ratio not to exceed 0.99% of average daily net assets. This voluntary waiver/ reimbursement may be discontinued at any time. Without such waivers and/or reimbursements, total returns may have been lower. Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance for institutional class shares prior to their initial offering is based on the performance of investor class shares. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. All returns reflect reinvested dividends and capital gains distributions, but do not reflect the deduction of taxes that an investor would pay on distributions or redemptions. Subject to certain exceptions, shares of a Fund redeemed or exchanged within 10 days of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual's return. To obtain performance through the most recent month end, call 800-432-7856 or visit heartlandadvisors.com . An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the Funds' prospectus . To obtain a prospectus, please call 800-432-7856 or visit heartlandadvisors.com . Please read the prospectus carefully before investing. As of 9/30/2022, NOV Inc. ( NOV ), Patterson Companies, Inc. ( PDCO ), Texas Capital Bancshares, Inc. ( TCBI ) represented 1.90%, 1.41%, and 1.98% of the Value Fund’s net assets, respectively. Statements regarding securities are not recommendations to buy or sell. Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk. The Value Fund primarily invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies. Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market. The Value Fund seeks long-term capital appreciation through investing in small companies. The above individuals are registered representatives of ALPS Distributors, Inc. The Heartland Funds are distributed by ALPS Distributors, Inc. The statements and opinions expressed in this article are those of the presenter((s)). Any discussion of investments and investment strategies represents the presenters’ views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change. There is no guarantee that a particular investment strategy will be successful. Sector and Industry classifications are sourced from GICS®.The Global Industry Classification Standard (GICS®) is the exclusive intellectual property of MSCI Inc. ( MSCI ) and S&P Global Market Intelligence (“S&P”). Neither MSCI, S&P, their affiliates, nor any of their third party providers (“GICS Parties”) makes any representations or warranties, express or implied, with respect to GICS or the results to be obtained by the use thereof, and expressly disclaim all warranties, including warranties of accuracy, completeness, merchantability and fitness for a particular purpose. The GICS Parties shall not have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of such damages. Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®. Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued. Because of ongoing market volatility, performance may be subject to substantial short-term changes. Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time. There is no assurance that dividend-paying stocks will mitigate volatility. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indices. Russell® is a trademark of the Frank Russell Investment Group. Data sourced from FactSet: Copyright 2022 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved. Heartland’s investing glossary provides definitions for several terms used on this page. |
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Heartland Value Fund Q3 2022 Commentary