Heartland International Value Fund 2Q16 Portfolio Manager Commentary

Talking Points

  • Holdings in Materials and Health Care were top contributors and helped the Fund outperform its benchmark, the Russell Global® ex-US Small Cap Index, returning 2.39% versus 0.09%.
  • Europe struggled with much of the damage coming after the U.K.’s vote to leave the European Union.
  • Global uncertainty led to a flight to safety and strong performance among precious metals.

Market Discussion

A solid quarter for many of the world’s markets came to an abrupt halt after the surprise decision by UK voters to split with the European Union.

Prior to the referendum, a softening dollar and firming energy prices boosted prospects for commodity-rich emerging economies as well as developed markets reliant on exports. Following the final tally, investors clamored for safety and drove the dollar higher. Yields on U.S. treasuries fell. Fears that the move would push a weak global economy into recession led to heavy selling in cyclical areas. British Financials were among the hardest hit and Energy gave up strength gained during the recent months.

On a regional basis, Japan suffered in sympathy with Europe as the Yen strengthened and dealt a blow to the country’s goals of fanning inflation and making its goods more affordable abroad.

The period ended with more questions than answers. As European leaders struggled to address details of if, when, and how the political and economic divorce would take place, volatility spiked and selling pressure was broad.

Attribution Analysis

Security selection was positive with holdings in a majority of sectors contributing to the Fund outperforming the Russell Global® ex-US Small Cap Index. Global uncertainty led to a flight to safety and strong performance among precious metals. As a result, our Materials holdings were among the Fund’s top performers on a relative and absolute basis. Our Industrial stocks detracted due primarily to weakness coming from machinery names.

Health Care was a source of strength with the majority of excess performance coming from Japanese pharmaceutical company Fuji Pharma (4554 JP).

Strong medicine. Fuji Pharma, a manufacturer of generic injectable drugs and contract maker of compounds for other pharmaceutical companies, was a top contributor. During the past few years, the company has added licensed branded drugs to its lineup. The new approach is beginning to produce results. Fuji reported high single digit revenue growth and a 26% increase in operating profit improvement during the most recent quarter.

We believe its improved earnings are a sign of things to come. Trading at 1.2x book value versus a peer global average of 3.65, the company remains attractive versus its international peers; however, it is trading at a smaller discount relative to other pharma companies in Japan. As such, we will continue to monitor the stock and may trim if valuations climb significantly in the near term.

Seal of approval. In addition to strong performance by the Fund’s precious metals holdings, a chemicals company was a top contributor in the Materials space. Green Seal (1262 TT) is the dominant maker of plastic film used in food and household goods packaging. Its shares rose as it continued to make progress on expansion in China. Utilization rates for its new manufacturing lines have reached 80% and should improve margins. We anticipate the additional manufacturing capacity, along with advancements stemming from research and development efforts, will create inroads in developing higher margin customized products.

Despite being one of the most efficient manufacturers in the space, Green Seal trades at just 9.6x estimated 2017 earnings versus a peer average of 14.3x.

Getting ahead of itself. More than a quarter of weakness in Industrials was tied to a single holding, Sung Kwang Bend Co. Ltd. (014620 KS), a South Korea-based manufacturer of large industrial fittings used by petrochemical factories, ship builders, and nuclear power plants. The stock was up sharply during the first quarter, but fell back recently on profit taking. We had trimmed our exposure during the run up as we believed valuations had gotten ahead of fundamentals. Recent weakness provided an opportunity to rebuild our position at what we believe are favorable prices.

The company is one of a handful of players certified as meeting the standards to create products for fittings and valves in the highly specialized industry. The rigorous standards required to become an approved manufacturer make it difficult for new entrants to the space. Trading at just 54% of book value versus a peer average of 110%, we believe the market has gone too far in selling the name and is not fully appreciating the potential for topline improvements when the global economy strengthens.

Outlook and Positioning

Political and economic events are injecting heightened volatility in global markets, and we expect more of the same in the months ahead. Fallout from the Brexit vote highlights the dynamic. While the British Pound and European banks were among the hardest hit, effects from the vote were felt as far away as Japan and the U.S.

As bottom up investors, we cannot control macro factors, but we can capitalize on the opportunities that emerge in response to external events. This approach has led to Japan remaining a top source of compelling opportunities for the portfolio.

The country’s monetary policy has yet to produce sustained easing of the Yen and deflation remains a stubborn concern. Corporate governance has improved and there has been an uptick in share buybacks from cash-rich businesses, but progress is lagging early expectations.

Despite these macro challenges, the region boasts some of the highest average earnings growth rates, and, as shown, valuations appear much cheaper relative to other parts of the world. 

Japan: Attractive Discount Based on P/E

Heartland International Value Fund Portfolio Manager Commentary Japan Chart

Source: Bloomberg L.P. and Standard & Poor’s, 4/5/2013 to 6/30/2016
The United States, Eurozone, and Japan are represented by the S&P 500 Index, S&P Euro Index, and TOPIX Index, respectively.
Past performance does not guarantee future results.

We continue to monitor Emerging Markets, but are sensitive to the lack of economic clarity in many countries as well as the disproportionate effect U.S. dollar strength can have on these markets.

Our focus remains 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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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 their initial public offering 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.

In the prospectus (pdf) dated 5/1/2017, the Total Annual Fund Operating Expenses After Fee Waiver and/or Expense Reimbursement for the investor and institutional classes of the International Value Fund are 1.25% and 0.99%, respectively. 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 1.25% of the Fund’s average net assets for the investor class shares and 0.99% for the institutional class shares, through at least 5/1/2019, 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 1.89% for the investor class shares and 1.63% for the institutional class shares.

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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 6/30/2016, Fuji Pharma, Green Seal, and Sung Kwang Bend Co. Ltd. 2.09%, 2.87%, and 2.66% 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.

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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.

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