First Quarter Market Discussion
Consumer and business confidence continued to surge but the major indexes took a more measured tone. Following a year-end rally for attractively valued businesses, investors hedged their optimism by focusing on growth-oriented names, defensive areas, and larger businesses.
The renewed emphasis on top-line expansion, we believe, reflects a growing debate over whether the economy has peaked or has room to grow. While we are not making an economic call, we expect the move toward growth names will be short-lived and value stocks will return to closing the performance gap versus their growth counterparts.
The Federal Reserve Board’s mid-March interest hike was widely expected and viewed as another step on the road to normalized rates. Commentary by the board was interpreted the Fed’s willingness to take a slow and steady approach to tightening.
Security selection was positive in several sectors but weakness in the portfolio’s Health Care and Energy names caused the Fund to lag its benchmark, the Russell 3000® Value Index. Industrial holdings led on the upside followed by Financials and Consumer Discretionary companies. Allocation decisions boosted performance modestly.
No place like home. PulteGroup Inc. (PHM), a national, diversified homebuilder, drove performance in Consumer Discretionary. The company reported better than expected results on improved sales. New home orders were also up 15% on a year-over-year basis.
The housing industry has benefited from consumer confidence, and single-family new home permits have surged. Our outlook on Pulte remains positive and we have been impressed with the progress management has made on improving returns on invested capital. However, we have trimmed our exposure to the company and our other strong-performing building supply name to mitigate risk.
Small size—big impact. Following several months of firming prices, oil fell based on investor concerns about excess reserves being brought to market as well as questions about whether an agreement among members of the Organization of the Petroleum Exporting Countries to cut production would be renewed.
Companies ranging from producers to equipment manufacturers shared in the pain. Small businesses were particularly hard hit as investors seemed to look to larger names in hopes that size would offset volatility. Some of our smaller names in the space were no exception, and held back results.
Despite the setback, we remain constructive on holdings like Oil States International Inc. (OIS). The $1.7 billion energy equipment and services company generates most of its revenue from offshore related products for floating drilling platforms. With capital expenditures for deep-sea producers still soft, shares of OIS have struggled. We believe the market is overlooking the company’s superior technology and future revenue tied to completion business of land-based wells. If, as expected, the offshore market rebounds later this year, we believe the company will be well positioned to capitalize on the improvement.
Strength through industry. The portfolio’s Industrial names were top performers on an absolute and relative basis. Kennametal Inc. (KMT), a name we bought last fall, continued its winning ways. The company is the third-largest maker of tools used in the metal working industry. Management continues to make progress on cost-cutting measures including closing underutilized facilities and reducing overhead by slashing its bloated marketing program. The strides resulted in higher than expected margins reported in Kennametal’s most recent earnings release. The stock also benefited from a continued uptick in industrial demand following several quarters of contraction.
We remain confident in the new CEO’s plan to reduce costs and reorganize the sales approach but have trimmed exposure to the company as valuations have climbed.
Against a backdrop of political battles in Washington and elevated multiples in the major indexes, we remain focused on finding names trading at multiples that adequately compensate investors for risk. The surge to close out 2016 led to widespread valuation expansion and has resulted in average companies trading at levels that are in line with high-quality counterparts.
Our response has been to trim winners as valuations warrant and redeploy gains into higher-quality names with robust balance sheets and enduring franchises.
For example, we have sold some of our smaller banks and added to positions among larger financials. Small banks have had a strong run as investors anticipate a more normalized rate environment. The move has left valuations stretched, as shown, and we have moved into larger institutions with revenue generation opportunities beyond improved net interest margins.
A Pricey Play on Rates?
Source: FactSet Research Systems Inc., 1/2/1995 to 3/31/2017
Small-cap banks are represented by securities in the S&P SmallCap 600® Index with the Bank industry classification, and Large-cap banks are represented by the same classification of securities within the S&P 500 Index.
Past performance does not guarantee future results.
Outlook and Positioning
The economic outlook remains sound, yet strong stock performance late last year has made valuations less compelling. Companies that have had strong runs over the past few months may face reduced upside until evidence of continuing business cycle strength emerges.
As such, we continue to comb through all sectors and industries looking for opportunities where we believe risk is mispriced. Our efforts have resulted in more early cyclical names on our watch list as well as some defensive names with idiosyncratic challenges weighing on valuations.
As investors continue to act on improved expectations, we are focused on striking a balance between maximizing upside potential by buying attractively valued businesses and mitigating downside risk by finding sound companies that are less volatile than their peers.
Effective April 30, Portfolio Manager and Heartland veteran David Fondrie will retire. This will mark the end of a multi-year transition for Dave into retirement. Dave began discussing his decision with leadership five years ago to ensure a seamless transition. Dave has been a valued member of the firm and an outstanding mentor to analysts and Portfolio Managers alike during his 20+ years with Heartland.
Following Dave’s retirement, the Select Value Fund will continue to be managed by Will Nasgovitz and Colin McWey, CFA. Will has served as a Portfolio Manager of the Fund since May 2006, including serving as the Lead PM since May 2014. Colin was named co-PM in February 2015. The team is also supported by Analyst Troy McGlone, CFA.
Thank you for the opportunity to manage your capital.