Heartland International Value Fund 3Q16 Portfolio Manager Commentary

Executive Summary

  • Holdings in Financials and Utilities were top contributors and helped the Fund outperform its benchmark, the Russell Global® ex-US Small Cap Index, returning 9.11% versus 7.88%.
  • Europe and Emerging Markets fared best and economically sensitive sectors were strongest.
  • Japan remains a top source for investment opportunities and the UK has become more interesting to us post Brexit.

Third Quarter Market Discussion

Global markets got a rare break from macro shocks. Central banks were largely silent, U.S. dollar strength remained benign, and the UK’s economy had yet to show damage from the country’s vote to split from the European Union (Brexit).

The lack of surprises was welcome relief and provided widespread strength for international equities. Buying was broad with economically sensitive sectors performing well. On a regional basis Europe and many Emerging Market countries fared best.

Although the markets cheered the quiet macro environment, questions continue. The fallout from the Brexit vote remains on the horizon, commodity strength has eased in recent weeks, and markets are increasingly skeptical of the effectiveness of central bank policies to stoke growth. The unsettled picture is reflected in consumer confidence surveys in Europe. As the chart shows, skepticism remains about the direction of the economy in the coming months.

Consumer Optimism Fading

Heartland International Value Fund Portfolio Manager Commentary Optimism Chart

Source: Bloomberg L.P., 1/31/2015 to 9/30/2016

Attribution Analysis

Security selection was positive with names in several sectors helping the portfolio outperform the Russell Global® ex-US Small Cap Index. The Fund’s holdings in Financials and Utilities led the way higher. An underweight to and selection in Information Technology (IT) detracted. Much of the weakness in the group came from a stock-specific issue tied to an Israeli technology company focused on security products.

Health Care was a source of strength with much of the excess performance coming from our Health Care Equipment & Supplies stocks.

Developing a strong record. Stock selection in Real Estate was flat on a relative basis, and performance at the security level varied greatly. Far East Consortium (35 HK), a property development and management company with projects in Hong Kong, Australia, UK, and China, was a top performer after it announced solid earnings. Shares trade at approximately 60% of our sum-of-the-parts estimates due in part to pessimism over prospects for the Chinese economy.

The company has a robust pipeline of projects nearing completion, which should translate into significant revenue improvements during the next two years. Barring a further downturn in the Chinese market, we believe Far East’s geographical diversity will help the firm continue to grow top-line revenue and the valuation gap should shrink further going forward.

Similar business, different results. Keck Seng Investments (184 HK), a hotel owner/operator, sold off after its earnings declined on a year-over-year basis. Much of the shortfall was the result of foreign exchange effects from revenues around the globe. Its properties’ fair value estimates also declined, which added to the sour sentiment of investors.

Keck Seng owns high-quality facilities in prime locations, and we believe the markdown of property values is short-lived. The company has a successful record of deploying capital opportunistically, which has driven earnings and should continue to do so in the future.

Grabbing market share? An overweight to and selection in Industrials were additive, but the group contained a key detractor. Semperit Holding (SEM AV) was down after announcing earnings would fall short of estimates for 2016.

The company operates two business lines—industrial products, including hoses, conveyor belts, and molded rubber products, and a medical division that supplies surgical and latex gloves throughout Europe. The shortfall stemmed from management’s decision to invest heavily in building out the medical side of the business to expand its capacity.

We expect the investment will convert to greater sales and margins should improve as the cost of new equipment is spread across more units produced.

With the stock trading at less than 13x estimated 2017 earnings and with a 5% dividend yield, we believe the market is focusing too heavily on a temporary shortfall and that investors could be rewarded over the long term.

Portfolio Activity

As the Yen has appreciated in recent months, skepticism about the strength of the Japanese economy has increased. We believe fears are overblown and have created opportunities to own solid businesses trading at compelling valuations. Industrials is an area where we have found some attractive investments, including recent addition Okuma Corp. (6103 JP).

The company manufactures complex machine tools used in industries such as Aerospace and Automotive. Shares have fallen more than 50% over the past two years as demand for the types of products it sells has slumped. The selloff has resulted in shares trading at just 1x book value.

Orders for the last two quarters have exceeded sales, and a backlog is growing. Further, the company is completing a capital investment cycle and we expect free cash flow will improve as spending subsides. We believe these factors make for an attractive risk-reward profile for the company.

Outlook and Positioning

Global markets benefited from a break in macro events, but we expect the lull will prove temporary. Fallout from the Brexit vote remains on the horizon as do the implications of central banks’ increasingly ineffective efforts to drive economic growth.

Heartland International Value Fund Portfolio Manager Commentary Quote

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. Despite macro challenges, Japan continues to boast strong average earnings growth rates, and more companies are utilizing their excess cash to reward shareholders by boosting dividends and buying back shares. We are also becoming increasingly interested in names in the UK for the portfolio.

We are comfortable with our Emerging Market holdings, but are cognizant of 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 Management Team

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 14 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, 4 at Heartland.

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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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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 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, 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.

As of 9/30/2016, Far East Consortium, Keck Seng Investments, Semperit AG Holding, and Okuma Corp represented 2.87%, 3.83%, 2.01%, and 2.05% of the International Value Fund’s adjusted net assets, respectively.

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

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®.

There is no assurance that dividend-paying stocks will mitigate volatility.

Heartland’s investing glossary provides definitions for several terms used on this page.

There is no guarantee that a particular investment strategy will be successful.

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.

The European Comission Consumer Confidence Indicator - Eurozone is a monthly survey of 23,000 households in the European Area. The responses are aggregated to find the arithmetic average of the difference between positive and negative answering options (balances), measured as percentage points of total answers to questions on the financial situation of households, the general economic situation, unemployment expectations, and savings, all over the next 12 months. Balance values can range from -100 (very negative) to 100 (very positive). Balances are seasonally adjusted.

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