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The Icing on the Cake in Stock Selection

The managers of Heartland Select Value are seeing more value in small and large caps, and their technical analysis helps them know when pull the trigger.

Liana Madura, assistant site editor, 08/17/2011

Ted Baszler, Hugh Denison, David Fondrie, and Will Nasgovitz are co-managers of Heartland Select Value HRSVX. They recently explained why small- and large-cap stocks currently offer greater opportunities in the marketplace over mid-cap stocks, as well as competitive advantages, also known as a "catalyst for recognition," that certain securities have, which make them valuable.

They also talked to us about the pockets of the financials sector that hold many undervalued and neglected stocks, the slow pace of economic expansion, and why it's important to use both fundamental and technical analysis in stock selection.

1. Where across the market-cap spectrum are you finding value today?
Small- and large-cap stocks currently offer better value than mid-cap stocks, which are coming off a strong run, as illustrated in the chart below showing the price/earnings multiples of mid-cap stocks relative to the S&P 500 Index as a whole. During the last 18 months, mid-caps have climbed against the broader index by a factor of 1.3. Large-cap stocks, on the other hand, have yet to proportionately participate in market increases. As for the small-cap space, we are nearly always able to find value, given our history of fundamental research in that area.

It's important to note that our process begins with bottom-up stock selection, not top-down decisions about where to find value across capitalization ranges. We are first stock-pickers, and our disciplines and team structure are built to reflect this approach. Therefore, when we sell a stock, the natural effect on the portfolio is generally to reduce our exposure to an overvalued part of the market. That capital will then be reallocated to a more undervalued range. So the weightings across the capitalization ranges are directly a function of valuations among individual names, and that natural process does cause meaningful variation over time across capitalization ranges as shown in the second chart below, which provides a history of capitalization-range concentrations over time in the Select Value fund. Note that our current posture is light on mid-cap stocks, which represent only 21% of the fund.

2. One of your 10 Principles of Value Investing is to identify catalysts that could drive stock prices higher. What do you expect will help close the value gap in your holdings like Cloud Peak Energy CLD or Lowe's LOW?
When we apply the 10 Principles to any stock--which we do for every stock, every time--we look for what we call a catalyst for recognition. We ask what could happen to this company or its industry that will make investors take note. That's the discipline that helps avoid value traps, where a company may indeed be undervalued but just keep trading that way indefinitely. In the case of Cloud Peak Energy, a coal mining company, the catalyst might be increased prices for coal and access to new markets. With an enterprise value/EBITDA ratio of 4.3 times, the stock currently trades at a discount to its peers.

Cloud Peak is the only pure play in the Powder River Basin, and though some investors might react negatively to this concentration of assets, we believe the company would ultimately benefit from an increase in prices given the potential for a West Coast coal outlet. Also, Cloud Peak's coal deposits have the environmental advantage of relatively low sulfur. Test burns are being conducted in Europe now with Cloud Peak coal shipped through the St. Lawrence seaway. Also, Cloud Peak management has recently had success in extending the reserve life for the company.

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