Heartland International Value Fund 1Q16 Portfolio Manager Commentary

 Executive Summary

  • Strength in Emerging Markets couldn’t overcome weakness elsewhere and the Fund lagged its benchmark, the Russell Global® ex-US Small Cap Index, returning –1.07% versus 0.92%.
  • Europe struggled as investors remain anxious about deflation; we believe these concerns will persist as the region slowly reduces its debt load.
  • We view the next three to six months as critical to the staying power of the recent rally in Emerging Markets, and will be watching for positive earnings revisions.

Market Discussion

Widespread selling gave way to an uneven rebound with markets tied to oil, commodities, and emerging economies benefiting. Equities in developed countries linked to central bank policies struggled.

The inflection point came in late January and coincided with the Bank of Japan adopting negative interest rates. Investors viewed the move as evidence that Prime Minister Abe Shinzo’s efforts to normalize the country’s economy were stalling. An unexpected offshoot of the policy was a stronger Yen. 

The stronger Japanese currency and resulting softening of the U.S. dollar gave a lift to Emerging Markets (EM). The relief came on two fronts—it eased pressure for leveraged countries that hold dollar denominated debt and it provided a boost to materials and oil.

Despite moves by China’s central bank to spur consumer borrowing and spending, investors remained concerned about the country’s transition from a manufacturing to service economy. We continue to monitor the transition and have taken weakness as an opportunity to selectively add to our holdings.

Europe struggled as a new wave of stimulative measures by the European Central Bank (ECB) were viewed as a sign that deflation remains a concern for the region. We believe that worries related to falling prices will persist as the region slowly reduces its debt load. We continue to monitor the situation and despite the tepid economic environment in Europe, the valuations adequately reflect this phenomenon and it remains a fertile hunting ground for investment ideas.

Attribution Analysis

A weakening U.S. dollar and firming oil prices benefited Emerging Markets, including many of our holdings. Inflation fears fueled by a softer dollar led to strong performance by precious metals. As a result, our Materials holdings were among the top performers for the period. Security selection detracted with most of the weakness coming from stocks in Financials and Information Technology (IT). The Fund lagged its benchmark, the Russell Global® ex-US Small Cap Index.

Strong stock selection in Industrials bolstered results despite the sector being essentially flat for the Index. We’ve found several attractive opportunities among Machinery companies, and the industry contained a top contributor.

Hitting on all cylinders. DEUTZ AG (DEZ GY), a manufacturer of diesel engines primarily for the European market with more than 35% of its sales tied to construction equipment, was a top performer. The company reported earnings in line with analysts’ estimates, but expects margins to increase moderately in the year ahead. Trading at book value and 4x enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA), we believe DEUTZ is attractively valued and its low cost position will make it an early beneficiary once economic growth improves.

A Canadian boost. On a regional basis, Canada was a source of positive performance. Much of the strength was tied to rising gold and oil prices but a rising Canadian dollar also helped. While the strengthening currency is a recent development, it will be a welcomed change if it continues for businesses such as Reitmans Ltd. (RET.A), a women’s retailer. The company was a solid contributor, but its impact was tempered when it stumbled at the end of the quarter.  The previously weak Canadian dollar negatively impacted its gross margin causing an earnings shortfall.

Despite the lackluster earnings results, we have been encouraged by management’s progress in closing a number of locations and an increase in same store sales. Trading at approximately 80% of book value and with a dividend yield of more than 4%, we believe the stock remains attractive. Additionally, margins should increase when the consumer loosens her purse strings.

Delayed recognition. More than half of the weakness in IT was tied to a single holding, Wasion Group Holdings, Ltd. (3393 HK), a Hong Kong-based manufacturer of electronic power meters and data collection terminals. The stock sold off in part due to general weakness in China’s economy and was further hurt by a delay in a contract award from the Chinese government. Because the contract wasn’t approved until late in 2015, payments were pushed into the new year and revenues fell short of expectations for the most recent quarter.

Given its strong appreciation, we aggressively trimmed our exposure in the back half of last year; however, we began buying after this quarter’s sell-off. The stock is compelling, having fallen nearly 60% from its 2015 high and trading at 1.1x book value and 8.5x trailing earnings.

Outlook and Positioning

Economic challenges continue to create attractive valuations globally; we are taking advantage of pricing pressure by upgrading our holdings opportunistically. We exited nine positions this quarter and added three. Our exposure to Energy is down modestly and we’ve reduced our allocation to Consumer Staples.

The turnaround for EM countries is welcomed, but we won’t be convinced it has staying power until we begin to see a pattern of positive earnings revisions. As such, we view the next three to six months as critical to the staying power of the recent rally.

While we acknowledge that an uptick in strength of the U.S. dollar may be a setback for the group, we believe valuations, as shown, have returned to the levels that previously coincided with substantial double digit returns over the next ten years.

Compelling Valuations in Emerging Markets
Cyclically-Adjusted Price/Earnings Ratio*

Heartland International Value Fund Portfolio Manager Commentary Valuations Chart

Source: © BCA Research 2016, 12/31/1987 to 3/31/2016
*Calculated using Emerging Market stock prices and the six-month moving average of earnings per share in U.S. dollar terms, and then deflating by U.S. consumer price inflation (source of data MSCI Inc.)
Past performance does not guarantee future results.

China appears poised for continued challenges in its quest to become a consumption-based economy. We expect this will result in slower growth in the near-term. The chance for a policy mistake also remains during this transition period.  However, if weakness continues, it should provide an opportunity for investors to gain exposure to the region at discounted levels.

We continue to focus on finding sound businesses with strong management teams that have a history of prudent capital allocation decisions. We believe owning dividend paying companies with robust balance sheets provides downside protection while allowing for upside potential.

Thank you for the opportunity to manage your capital.

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Portfolio Manager

Heartland Advisors Value Investing Portfolio Manager Michael Jolin

Michael Jolin

Jolin, CFA, is Vice President and Portfolio Manager for the Heartland International Value Fund. He has 13 years of industry experience, 7 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Robert Sharpe

Robert C. Sharpe

Sharpe is Vice President and Portfolio Manager of the International Value Fund. He has 33 years of industry experience, 3 at Heartland.

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In the prospectus (pdf) dated 5/1/2016, the Total Annual Fund Operating Expenses After Fee Waiver and/or Expense Reimbursement for the International Value Fund is 1.49%. The Advisor has contractually agreed to waive its management fees and/or reimburse expenses of the Fund to ensure that Total Annual Fund Operating Expenses for the Fund do not exceed 1.49% of the Fund’s average net assets, through at least 5/1/2017, and subject thereafter to annual reapproval of the agreement by the Board of Directors. Without such waiver and/or reimbursements, the Total Annual Fund Operating Expenses would be 1.81%.

Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance information for institutional class shares of Funds that existed prior to 5/1/2008, 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 (90 days for the International Value Fund) of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual's return.

Due to the discontinuation of the Russell® Global ex-US Small Cap Value Index, the International Value Fund changed its benchmark to the Russell® Global ex-US Small Cap Index on 3/18/2016.

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 prospectus (pdf). To obtain a print prospectus, call 800-432-7856. Please read the prospectus carefully before investing.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.

The International Value Fund invests primarily in small foreign companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies. Foreign securities have additional risk, including but not limited to exchange rate changes, political and economic upheaval, and relatively low market liquidity. These risks are magnified in emerging markets.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

As of 3/31/2016, DEUTZ AG, Reitmans Ltd., and Wasion Group Holdings, Ltd. represented 2.75%, 1.82%, and 2.84% of the International Value Fund’s net assets, respectively.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

The statements and opinions expressed in the articles or appearances are those of the presenter. 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 above, 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.

Sector and industry classifications as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems, Inc. or the Global Industry Classification Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

Foreign country classifications are generally determined by referencing country of domicile sourced from FactSet Research Systems Inc.

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®.

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