Putting Macro Trends in Context: What do They Mean to a Bottom-Up Investor?
For some time now, we’ve had a generally positive economic outlook. The occasional setback is assured, but on the whole we believe that the U.S. economy is still in the early stages of a multi-year recovery.
Investors often ask how such a broad macroeconomic view factors into the fundamental, bottom-up stock selection process we employ in managing the Heartland Select Value Fund and all of the Heartland portfolios. The simple answer is that we don’t use our macro perspective as a top-down driver in our decision-making. But because the companies we research must contend with the ever-changing macroeconomic backdrop, the trends we anticipate going forward inform our research as we seek out industries and companies that could benefit.
We Can’t Predict, But We Can Look Ahead
One of the reasons we’re optimistic about the economy is that we believe the U.S. consumer is strengthening, based on signs of continued improvement in employment data, rising household net worth, and a strong outlook for domestically produced energy, among other factors.
Just as we seek to identify companies before they’ve been noticed by the Wall Street crowd, we strive to be on top of macro developments before their impact has been fully revealed. We’re intrigued by the long-term relationship we’ve found between Bank Lending Surveys—a measure of easing or tightening credit standards from bank officers issuing loans—and unemployment. Over time, we have found easier lending standards to be a leading indicator of falling unemployment.
The graph below charts Bank Lending Survey results against unemployment data. (Declining lines indicate more lax lending policies and lower unemployment; rising lines show constrained lending and rising jobless numbers.) To reflect that lending data is a leading indicator of improved employment—and better illustrate the link between the two—we have shifted the time frame for the employment line back one year.
The results show a fairly tight correlation between the figures. We believe they also show that unemployment has room to fall even further, helping to support our view of gradual economic growth in the U.S.
Why People Are Feeling Better
After a recession that saw both home prices and equity values plunge, it’s understandable that consumers have needed some time to regain their confidence. With substantial rebounds on both fronts, household net worth has risen once again to a new high. We believe this is a key building block to rebuilding confidence among consumers and investors, and it’s another of the broad factors we track.
On its own, this wealth effect doesn’t cause us to buy or sell any particular stock. But such a clear tailwind can influence the decision-making process.
Bringing Some Energy to the Table
The uptick in economic activity we anticipate appears almost certain to spark higher energy demand. Not too long ago, that could be problematic: The U.S. was more dependent on foreign sources of energy, and thus had little control over costs. Now, thanks to progress in extracting oil and natural gas from shale, the U.S. is making great strides toward energy independence.
Further, the rise in U.S. energy production is not only a beneficiary of the improving economy; it’s also helping to fuel it. Cheaper energy is driving a U.S. industrial renaissance, as manufacturers of a wide range of products are finding it less expensive to operate closer to home than it is to farm work out overseas. We believe this can be a driving force to help many of the stocks in the Select Value Fund attain their full intrinsic value.
What About Stock Picking?
Given our positive view for the U.S. consumer, Consumer Discretionary stocks might seem like an obvious hunting ground for stocks positioned to gain from the positive macroeconomic backdrop we see. Indeed, the sector as a whole was an early beneficiary of the economy’s recovery. While we have held some strong-performing stocks in the sector, overall our contrarian, value-driven approach keeps us from following the herd, and leads us to look for opportunities in different parts of the marketplace. Fortunately, in an economy that by many estimates is 70% driven by consumer spending, there are many other places to look for the consumer’s influence.
In the Industrials sector, for example, Universal Forest Products Inc. (UFPI) has benefited from a turnaround in homebuilding, and in homeowners’ renewed willingness to pay for additions and improvements to their homes. We saw the value in this stock before the recovery in homebuilding and home improvement firmly took hold. The wealth effect we described earlier is a crucial element in making homeowners ready to sink larger sums of money into their homes—whether through upgrading to a new one or improving the one they have. Universal can benefit in either case. We didn’t buy Universal solely because of positive conditions in the housing market, but we recognized that those conditions could in time help more investors recognize its intrinsic value.
Similarly, the prospect of rising energy demand creates opportunities among companies that explore for and produce oil and gas. In keeping with our tendency to look beyond the obvious, we’ve paid attention to other companies positioned to benefit. These include engineering and construction companies like KBR Incorporated (KBR). KBR constructs Liquefied Natural Gas (LNG) facilities, which are used to convert natural gas into a liquid form that facilitates export into global markets that cannot be reached by pipeline. The company has a project backlog in LNG and other hydrocarbon processing facilities that help give them pricing power, which could drive higher earnings going forward. One benefit of the Select Value Fund’s multi-cap approach is that we can seek out companies with attractive valuations wherever they fall on the market-cap spectrum. When we see solid opportunities in mid-cap companies like KBR, for example, we’re able to pursue them without facing a market-cap limitation.
Steeling for Growth
The economic impact of cheaper domestic energy extends beyond energy related industries. For example, Nucor Corporation (NUE) is a steel company positioned to benefit from improving commercial construction—the end market for much of what it makes. That’s one macro factor in its favor. And because steel production is an energy-intensive process, U.S. producers like Nucor can gain a competitive advantage when the cost of one of their major inputs—in this case, natural gas—is cheaper than that available in foreign markets.
When we first identified Nucor, we were drawn by more than its attractive valuation. The company’s A-rated credit—unusual in its industry—also attracted us*. The financial flexibility the company gains from its strong credit can provide a desirable cushion should the business experience an unexpected reversal, or give the company resources to pursue strategic partnerships that can pay off in the long run. A favorable macro environment—in the form of cheaper energy and improving commercial construction—has given support to the company’s own intrinsic strengths. And once again, we believe the result is a compelling opportunity.
A Process that has Produced Results
The trends shaping our positive outlook for the economy don’t determine our investment decisions for the Select Value Fund—or any Heartland portfolio. But they can play a meaningful role as we apply our 10 Principles of Value Investing™ in selecting stocks. Economic recovery, and the specific factors contributing to it, can help bring to fruition the catalysts that allow undervalued companies to be recognized in the marketplace. This approach does not wed us to one sector or set of sectors, but helps us to scan the broader landscape for areas where our research may prove fertile.
This marriage of bottom-up investing with careful attention to emerging macro trends has produced an attractive record of results for the Select Value Fund. For each rolling five-year period since 1997, it has outperformed its benchmark. We find this measure instructive, as we’re not interested in chasing short-term market trends, but remain focused on long-term potential in selecting stocks. Indeed, the macro backdrop will change over time—but our fundamental approach to investing will not.
Just as our investment process depends on identifying companies before they are widely recognized in the marketplace, so too do we strive to understand broader macro trends before they fully take hold. Looking at data this way helps us to anticipate changes in the economy while they’re still in their early stages—and to identify the companies that could benefit before the rest of the market has driven up their prices.
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Definitions
Bank Lending Surveys attempt to track bank lending standards within a specific economy. The survey generally measures the tightening or loosening of loan standards to both consumers and businesses and is conducted among senior loan officer’s at lending institutions. Correlation is a statistical measure of how two securities move in relation to one another. A measure of 1 means the securities are highly correlated and move in conjunction. A measure of 0 means the securities are not at all correlated and do not move in conjunction. Heartland Advisors’ 10 Principles of Value investing™ consist of the following criteria for selecting securities: (1) catalyst for recognition; (2) low price in relation to earnings; (3) low price in relation to cash flow; (4) low price in relation to book value; (5) financial soundness; (6) positive earnings dynamics; (7) sound business strategy; (8) capable management and insider ownership; (9) value of company; and (10) positive technical analysis. Households and nonprofit organizations net Worth is a Federal Reserve Economic Data series that represents the outstanding balance sheet amounts of households and nonprofit organization on a quarterly basis, measured at the end of each period and not seasonally adjusted. Liquefied natural gas (LnG) is natural gas that has been cooled to -161.5°C or -259°F and condensed into a transportable colorless and odorless liquid. Wealth Effect is the premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more. Russell 3000® Value index measures the performance of those Russell 3000® Index companies with lower price-to-book ratios and lower forecasted growth characteristics. S&P 500 index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index. Standard and Poor’s A-Rated Credit is a forward-looking opinion about credit risk. Standard & Poor’s credit ratings express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time. An ‘A’ rating indicates a strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. 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 www.heartlandfunds.com.
In the prospectus dated 5/1/13, the gross expense ratios for the Investor and InstitutionalClasses of the Select Value Fund are 1.21% and 0.89%, 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’s “Net Annual Operating Expenses” at a ratio of 0.99% of average daily net assets. This voluntary waiver/reimbursement may be discontinued at any time. Also, through 11/30/01, the Advisor voluntarily waived a portion of the Fund’s expenses. Without such waivers and/or reimbursements, total returns may have been lower.
An investor should consider the Fund’s investment objectives, risks, and charges
and expenses carefully before investing or sending money. This and other important information can be found in the Fund’s prospectus. To obtain a prospectus, please call 800-432-7856 or visit www.heartlandfunds.com. Please read the prospectus carefully before investing.
In addition to stocks of large companies, the Select Value Fund invests in small and midsized companies that are generally less liquid and more volatile than large companies.
The Fund also invests in a smaller number of stocks (generally 40 to 60) than the average mutual fund. The performance of these holdings generally will increase the volatility of the Fund’s returns. Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.
The Select Value Fund and the Russell 3000® Value Index returned respectively for the 5-year rolling period ending 9/30/2013, 10.17% and 8.89%; 9/30/2012, 1.29% and -0.72%, 9/30/2011, 1.13% and -3.50%, 9/30/2010, 4.09% and -0.39%, 9/30/2009, 6.38% and 0.96%, 9/30/2008, 10.68% and 7.29%, 9/30/2007, 20.63% and 18.10%, 9/30/2006, 15.11% and 11.18%, 9/30/2005, 14.98% and 6.42%, 9/30/2004, 14.59% and 5.03%, 9/30/2003, 12.62 and 4.45%; 9/30/2002, 3.71% and 0.30%.
The statements and opinions expressed in this article are those of the author. Any discussion of investments and investment strategies represents the portfolio manager’s views when presented, and are subject to change without notice. As of September 30, 2013, Universal Forest Products Inc., KBR, Inc., and Nucor Corporation represented 1.49%, 2.76%, and 1.09% of the Select Value Fund’s net assets, respectively. Heartland Advisors considers large-cap companies to be larger than $10 billion in market cap, mid-cap companies to be between $2 billion and $10 billion, small-cap companies to be between $300 million and $2 billion, and micro-cap companies to be less than $300 million. The above breakdown does not include short-term investments.
Sector classifications are generally determined by referencing the Global Industry
Classification Standard Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.
The recent growth in the stock market has helped to produce short-term returns
that may not be typical and may not continue in the future. Economic predictions are based on estimates and are subject to change.
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© Heartland Advisors
