Where to Find Small-Cap Winners

Laura Lallos: Hi, this is Laura Lallos. I'm a mutual fund analyst here at Morningstar. And today we have with us Brad Evans from Heartland. He is the lead manager on [Bronze-rated] Heartland Value Plus and comanages [Neutral-rated] Heartland Value, as well, two funds in the small-cap space.

Brad, thanks for joining us today.

Brad Evans: Great to be here.

Lallos: I know a lot of our viewers are interested in small and micro-caps right now. They had a fabulous run last year. I'm wondering if there's more value to be had there? What is your perspective?

Evans: I think Heartland is built on a process that has stood the test of time: our 10 principles of value investing. We are dyed-in-the-wool contrarians, and for that reason, there's always opportunity to find value in the marketplace. There are always going to be sectors that are really exciting and overvalued, and there are going to be sectors and stocks, in particular, that are deeply undervalued.

Today, as always, we're not having difficulty finding opportunities to put any money to work, and I would highlight areas like for-profit education and energy stocks as being areas that are very attractive today, as well as other sectors within the materials space. Gold mining is an example of an area that has been beaten up pretty meaningfully, as well. So, there is always opportunity for a contrarian to put money to work.

Lallos: You're mentioning some areas that people are quite fearful of right now, and you're venturing in?

Evans: We are. When you look at, say, certain sectors today like energy as an example, I know as we understand right now it's very unpopular place to be investing. There's a lot of fear about around geopolitical factors globally as well as commodity prices. You have to put that aside and look at the underlying values of what the companies are and what the opportunity set is. And we're able to find companies that are deeply undervalued on their earnings, their cash flows, their book values, and net asset values with good balance sheets. Those are really the valuation criteria that we're focusing on. So, we're able to find opportunity in energy, in particular.

Lallos: A name that we discussed earlier was Commercial Metals; steel being another area that other investors are shooing. You're seeing an opportunity.

Evans: Steel has been a terrible place to invest over the last few years. There are a lot of concerns, geopolitically again, concerns about Europe and China, and oversupply. There are opportunities to find value in areas that are hated, and that's part of our process.

I mean, Commercial Metals is an example. When we made our investment in the company, we found a company that was deeply undervalued on normalized earnings, undervalued on current cash flows, and trading near book value, with a rapidly improving balance sheet, very attractive debt profile and a low debt/EBITDA ratio, significant earnings power and free cash flow, and a catalyst, to boot, which would be an improving commercial construction cycle here in the United States and an industry that's a fairly rational oligopoly, competing against companies like Gerdau and Nucor.

It's a company that is just flying below the radar screen and not well-liked by the Street with fairly limited sell-side coverage. Again, our modus operandi is to really zig when the market zags and invest in lonely areas of the marketplace and be patient. We have a two- to three-year investment horizon, and Commercial Metals is a perfect example of a Heartland stock.

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Lallos: On the flip side, I noticed that you cut back your health-care exposure considerably last year taking profits there. Are there any areas in health care that you find attractive anymore?

Evans: It's becoming really difficult. And again, as I said, we are focused on bottom-up stock-picking. We're never going to make a judgment on a sector, on a top-down basis, but our process has us casting a wide net for opportunity, screening for undervalued companies. In the current environment very few health-care companies are passing our screens at this point for further research. And that's just a function of the fact that health care has led the market for, at least in the small cap space, two years in a row and is off to a very strong start again in 2014.

There's a lot of momentum in those stocks, and our process again in a contrarian sense is that when there's a lot of excitement, we're typically going to be taking profits in those areas and reallocating to areas in the market that are far cheaper and is not as well-liked.

Lallos: I noticed you're low in financials, as well.

Evans: Well, that really is a function of, largely for both the Value fund and the Value Plus fund, really an absence of any investments in the REIT space. And it's not really a view of interest rates. I know probably a view many investors might have is, "Why would you want to own REITs with the perception that interest rates are going to go up?" But it really comes down to valuation. And when we think about the valuations on a funds-from-operations basis or an enterprise value/EBITDA basis, the only metric that I've seen more REITs look attractive is on net asset value, but that's is making an assumption that interest rates are going to stay low forever.

We kind of have a bias at Heartland to companies that have very strong balance sheets with low debt and generate free cash flow and can finance themselves. As small-cap investors, we know that the banks and the markets want to give companies capital when they don't need it, and when they do need it, the markets shutdown on them. And REITs are an example of a space that the stocks don't look incredibly undervalued. For our 10 principles, they don't pass a lot of our valuation parameters, and frankly they have leveraged balance sheets.

We can still find better value in other places of the market, but that doesn't mean we won't look for opportunity in REITs, and if they become attractive, we will be hunting for them. But that really explains our large underweighting across both of the portfolios.

Lallos: The Value Plus fund does have a dividend angle. Can you explain the significance of that and how it factors into the process?

Evans: Right. Within the Value Plus fund, our focus is on having at least 80% of the assets in the fund paying dividends, and we're not yield seekers. So, we're not targeting explicitly high-yielding stocks. We actually dislike those. We are focused on companies that pay dividends and can grow their dividends.

Think about it in the sense of dividend growers, and that's because we like the fact that it shows management's attention to returning capital to shareholders. When you pay a dividend, you get married to it. A buyback is something you date. So it's not that we don't like buybacks, but we like to see a management team have a holistic approach to returning capital to shareholders: buybacks, dividends, acquisitions, and internal investment.

The yield on the Value Plus portfolio is roughly about 1.5%, and it really has been in that range between 1% and 2%. What it tells us is why we like dividends and dividend growers is because not only for the return-of-capital aspect that is highlighted, but it also puts a governor on management's capital-allocation decision making. It tells us that they're not going to take on too much debt because the prospect of taking large amounts of debt on the balance sheet raises the probability that they might have to cut the dividend if bad things happen, if something goes wrong. And management teams are very loath to cut their dividends. Our focus, again, is on low-debt companies, financially sound companies. That discipline of paying a dividend sends a signal that management will not take on too much debt.

Lallos: Looking at the areas you're focused on now [such as energy and Commercial Metals], how long do you think it will be before these picks pay off? How patient do shareholders need to be?

Evans: It goes back to our process, and as I said before with the Heartland 10 principles, we're seeking low P/E and low price/cash flow ratios. We've a bias toward free cash flow generators, low price/book ratios, and financially sound companies, run by great management teams with simple strategies, good strategies to unlock value. And we're looking for catalysts to unlock the value.

Our process is not dissimilar to private equity investing in the public markets. We have a two- to three-year investment horizon. We can be early in some instances. But when we find a company that we deem as significantly undervalued, we understand all the businesses that we own in great depth and do a tremendous amount of due diligence.

So our job is to find those undervalued companies, understand their business and the industry, and understand what it's going to take for these headwinds that have caused the stock to be cheap to turn to tailwinds to unlock that value. And that usually takes about two- to three-year investment horizon. You must be patient.

Lallos: For investors who are patient, you are seeing opportunities today?

Evans: Absolutely. I look at our portfolios today, and yes, the market is up. There's a lot of concern that valuations are high. There is always opportunity to find undervalued companies in the marketplace. Our filters, our screens, are still robust. Our watchlists are still very highly populated with opportunities. So it is incumbent upon us to find stocks, to find our strong winners, be disciplined in selling them when they approach fair value or are overvalued, and reallocate that capital into other opportunities that are deeply undervalued. And that is happening today.