Jason Stipp: I'm Jason Stipp for Morningstar. The Heartland Select Value Fund is a value-seeking investment that can look across the market-cap spectrum to find value.
We are checking in today with Will Nasgovitz, a manager on that fund, to learn where they have been finding value recently, and also get his thoughts on what's coming up ahead.
Thanks for joining me, Will.
Will Nasgovitz: Thanks for having me.
Stipp: So the first question for you: Heartland Select Value Fund falls into the mid-cap style box, but actually you folks invest across the market-cap spectrum. It's an all-cap fund. So I was wondering, according to your recent portfolio data, you have about 40% in large caps, 26% in mid-caps, and 33% in the smaller and the micro-caps. Can we interpret that as a signal that you're seeing more values in the bigger companies today?
Nasgovitz: That's a great question. As you mentioned, the Select Value Fund is a go-anywhere, best-ideas, best-values-in-the-marketplace fund, and we have found more value in large caps here most recently. It's been at the expense, Jason, more of the mid-cap area. You mentioned, [mid-caps are] about 26% of the portfolio. Mid-caps up until last year were a really, really strong area of the market; valuations, in our view, are perhaps a little stretched, so we have seen some more allocation up into large caps.
We still do have a healthy dose in small caps. If you peel back the onion a little bit and look at the Russell 2000, for instance. Some of the higher-quality companies within the Russell 2000 as measured by return on invested capital, are trading below higher-quality large-caps. So we still think there is value in small-caps as well.
Stipp: And I know that you are looking issue by issue, and you are doing that bottom-up analysis on the companies, but I would like to pick your brain a little about this trend in large-caps, because conventional wisdom would suggest that the bigger companies are more widely followed, the market is more efficient in pricing them, but you guys have seen it, other managers we've talked to have seen it, our own analysts have seen that large-caps actually like pretty good values, and high quality as well. Why is that? Why is it that in a market that's been so volatile recently, we're finding these what would normally be considered safer stocks trading at good valuations?
Nasgovitz: Well, it's a good question. So I think if you look at the S&P 500 or the S&P 100, yes, a very low multiple of estimated earnings versus historical time periods for sure. So maybe the market might be questioning growth, for instance. If you look at the retail sector, for instance, and the large department stores, etc., what opportunities are there for them to grow? So perhaps the markets afford them a lower multiple.
Also, large-cap stocks, all companies in the United States have done a great job, increasing margins in what has still been a challenging top-line environment, but large-cap companies in particular have. So perhaps the market has a bit of skepticism in terms of maintaining that margin structure here going forward. So again, they are affording them a low multiple.
And as it relates to small-caps, there could be a bit of a bid in those shares because we have record cash on the books of the S&P 500 [companies]. There is a lot of financial money still sitting on the sidelines. So there could be some anticipation dipping down into small-cap securities, bringing up those valuations, perhaps.
Stipp: I want to dig in as well and talk about your analysis on individual companies. I have read some reports on your website, indicating that you have a heavy focus on financial health, and that's obviously an important issue as we've seen over the last four or five years. Can you talk a little bit about the hallmarks of financial health that you look for when you are analyzing companies?
Nasgovitz: We just think investing in companies with low amounts of leverage is a common-sense way to invest at Heartland. We are looking at total debt relative to total capital, but ideally we want to buy companies that have that ratio of less than 25%, understanding that some industries are more capital intensive in nature. So, they are going to have more leverage.
So if they do have leverage, Jason, understanding the debt-to-EBITDA composition of that debt, the maturity structure of that debt, is it fixed, is it variable, is there a convertible component to it, where does it trade in the marketplace? So, those are some of the things that we gauge to understand the overall financial soundness of a company. It's a really important attribute of our investment process.
Stipp: It would seem that, especially in the volatile markets that we've seen and after coming out of the crisis that we've seen, that a lot of investors would be searching for these more fundamentally sound companies, strong balance sheets. You are also a value fund, so you don't want to pay up for something like that. Have you been able to find good values among these financially sound companies?
Nasgovitz: That's a great question. I think there are. You have to dig a little bit deeper. You have to continue to do that rigorous fundamental research that we do at Heartland. And I think there are opportunities. I think you can find leaders in the marketplace. So, I'd point to one of our smaller, or smid-cap holdings, Tidewater, ticker TDW. Roughly a $3 billion market cap. It's a leader in the supply of offshore, supply vessels for deepwater drilling for oil and gas. They have the best fleet. They have the youngest fleet. They have a very high-caliber management team.
So, here is a company in terms of financially sound, total debt to capital of 25% trading right around book value, which is historically its low level, and we see a nice earnings outlook, especially when we get into their next year, which starts April 1 of 2012. So, trading around 10 to 12 times next year's earnings is a very attractive valuation as well.
Stipp: Another sign of financial strength, and I know our analyst take a look at, is the dividend, consistency of the dividend, dividend growth. It shows a certain financial discipline among corporations.
You actually did a video on your website recently speaking about dividends. Can you talk a bit about the role of dividends in your process? I know you hold a lot of dividend-payers, and I'm sure that our readers would be interested in knowing any dividend ideas you've had recently, any dividend picks.
Nasgovitz: Sure. So, dividends, as you know, are a big contributor to the S&P's total return since inception. 40% of return is due to the reinvestment of dividends. Some decades, it's even higher, perhaps this decade it will be that case. We are in a very challenging economic environment. So, yeah, we are looking for ways to bolster our total return profile, but also dampen the volatility, and dividends are one way to do that.
So, a company we purchased last year in the health-care space that did not pay a dividend, but we anticipation of the likelihood that it could, would be Zimmer Holdings, ticker ZMH, a larger-cap holding, perhaps, in the Select Value Fund with a market cap of about $10 billion. They did not pay a dividend. Just here recently announced an 18% share quarterly dividend. So, they had the free cash flow characteristic.
So, we are sure we are looking for yield, but we want to see the opportunity for companies that don't pay a dividend and have the potential to do it, and those who pay it can increase it. We think that's a real important attribute you want to look for in this marketplace.
Stipp: I want to dig into your portfolio a little bit as well. Among your top holdings, at least according to our most recent data, was a gold miner. I was wondering if this is a company-specific play for you guys or if do you see a role for gold, the metal, in the portfolio in some sense?
Nasgovitz: We own two gold stocks today in the Select Value Fund; the one you are referring to, I believe, is AuRico Gold, it was formerly called Gammon Gold. We've owned it for a couple of years. We liked it because it just met a lot of the criteria that we look for at Heartland. When we purchased it, it was out-of-favor with the sell-side community. We liked that; we are contrarians. We think that's how you create wealth for your shareholders in the long run.
The valuation was very attractive to us on a forward EBITDA and EPS basis. Good value of book, but a great balance sheet as well. But really the catalyst we saw was we liked their production profile here in Canada ... and also down in Mexico, safe reserves in our view. And we didn't think that was reflected in the price of that stock.
Stipp: Last question for you: We've seen financials really take a big hit recently. Financials have been underweighted in your portfolio compared to certain benchmarks. So, certainly a good thing to have in a year like we had in 2011, given their performance. I'm wondering from your perspective given that we've seen a lot of financials companies sell off, do any of them start to look attractive to you at this point?
Nasgovitz: We own some commercial banks. We own some capital market-related companies, but one that we've owned for probably the longest would be Raymond James Financial, ticker RJF. It trades at attractive forward-multiple of earnings, about one and a half times book, good valuation in our view, great balance sheet. And we think the catalyst here is, we've had a lot of turbulence in the financial markets. We think people are going to still look for solid advice, and we think Raymond James is right up that avenue. It will give us a little bank exposure as well. So, there are some ideas within financials, despite being underweight in that group, that we think can create alpha for our shareholders.
Stipp: Will Nasgovitz of Heartland Value Funds, thanks so much for joining us today and for your insights.
Nasgovitz: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.