Heartland Value Fund 2Q17 Portfolio Manager Commentary

Executive Summary

  • Investors doubled down on their love affair with momentum and big cap growth stocks. 
  • Massive flows into Index funds, which focus on size, not valuation, pushed major indices to all-time highs.
  • Despite the headwinds, the Value Fund outperformed its benchmark the Russell 2000® Value Index, returning 3.81% versus 0.67%.
  • On an EV/EBITDA basis, the Value portfolio trades at a 30% discount to its benchmark.
  • The current Indexation Mania is setting up distortions, including mispricing of businesses, which we hope to capitalize on.
“The secret of success is constancy of purpose.” 
— Benjamin Disraeli, 19th century British Prime Minister 

Second Quarter Market Discussion

Many Investors spent the quarter balancing a mixed economic outlook against fears of being left behind from the ongoing equity market surge. Their response was to bid up what has worked the past few years—momentum and growth stocks. Despite the trend, the Value Fund substantially outperformed its benchmark.

The effect of chasing what has worked was magnified by a continued rush into passive funds and exchange traded funds (ETFs) that don’t look at valuations—just size. History has shown us how this can end and, in June, we may have gotten a preview of things to come as the largest market darlings hit the skids. 

The value of being active

The economic uncertainty shadowing today’s markets is nothing new. Conflicting views are essential to every buy and sell trade. What is unprecedented, however, is the level of indifference investors are showing toward valuations. The infatuation with growth at any price has reached an historic extreme, as shown, and sets up for a reversion to the mean, which should be meaningful for value investors.

Historic Outperformance of Growth vs. Value
Russell 2000® Value Index Less Russell 2000® Growth Index

Heartland Value Fund Portfolio Manager Commentary Growth vs Value Chart

Source: Furey Research Partners, LLC and Russell®, 12/31/1978 to 6/30/2017, annualized return over rolling 10-year periods
Additional information for indexes shown at end of commentary. All indexes are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

We view our purpose as the opposite of this approach. Instead of bidding up companies based on market cap, we continue to be price sensitive, seeking businesses addressing unique needs, producing top-line growth, with exceptional balance sheets, and that are capable of generating strong free cash flow. 

In recent months we’ve trimmed back some winners as valuations became stretched and reinvested in opportunities that were priced at a discount to estimated intrinsic value. These efforts have resulted in a portfolio far different than that of an index or ETF. The Fund has approximately 54% of its assets invested in companies that are included in the Russell 2000 Index and just 17% that are included in the S&P SmallCap 600. Our deliberate approach is reflected in valuation metrics. The Fund trades at an almost 38% discount to the Russell 2000® Value Index on a price/sales basis. On a weighted average enterprise value/ earnings before interest, taxes, depreciation, and amortization (EBITDA) measure, the portfolio is more than 30% cheaper.

In today’s era of pervasive passivity, we believe this is the best approach to producing above average performance over the long run.

Portfolio Activity

Stock selection was strong with holdings in a majority of sectors outperforming on a relative basis—positions in Consumer Discretionary and Industrials boosted returns. Allocation decisions also contributed on the upside but performance of Health Care names detracted. Overall, the Fund was up on an absolute and relative basis.

Smart shopping

The rapid rise of online sales and an oversupply of brick-and-mortar stores has made investing in consumer-oriented businesses a challenge. Despite the difficulties, the Fund’s Consumer Discretionary names were up sharply on an absolute basis and outperformed the benchmark.

Our research has led us away from hard-hit mall retailers and into areas such as select homebuilders and for-profit education. Both industries should receive a boost from maturing Millennials. We’ve also been encouraged by a new tone out of Washington toward private education companies that can provide a vital service in closing the skills gap for many workers.

RetailMeNot, Inc. (SALE), a leading provider of digital coupons, was up significantly after it announced it was being taken private by a digital payment and marketing company. We were constructive on SALE due to its strong balance sheet, position as an industry leader, and attractive valuation. We sold out of the name following the announcement.

Golden years

Long-time holding Care Trust REIT Inc. (CTRE) continued its impressive showing for the year. The real estate investment company specializes in managing and acquiring skilled nursing, assisted living, and independent senior housing. The company’s focus on regional, mid-market locations along with its seasoned management team makes it a differentiated player in the industry.

With 165 properties and nearly $1.2 billion in assets, we estimate the company’s pro forma debt/capitalization stands at a conservative 23% and its interest coverage ratio at a robust 4.9x. The company has been able to stand out in a strong performing sector by bolstering its balance sheet, which will provide it with dry powder to use to opportunistically acquire additional properties. Care Trust’s accomplished management team has been able to generate an impressive 9% yield on its properties in 2017. With a payout ratio estimated at only 60% of funds from operations, the company has ample opportunity to grow its 3.9% dividend yield. We believe factors such as aging population, industry supply constraints, and increased cost of treatment alternatives will bode well for this well-run operator. 


Portfolio Manager Eric Miller provides additional insight on the Fund's approach in Real Estate:

Play audio (1:34)


Energy sapped

Oil prices retreated as the outlook for economic growth grew less certain. Energy was the weakest-performing group for the broad index, but the Fund’s names outperformed on a relative basis. While we are disappointed by absolute returns for the group, we believe our holdings are well positioned for an uptick in the price of crude.

Willbros Group, Inc. (WG), a specialty energy pipeline contractor and utility transmission provider, was down for the quarter but we view the company as a compelling opportunity. The business faced significant financial pressure during the plunge in oil prices in late 2014. Impressed with a new management team brought in to navigate the rocky energy market we maintained our position in the company.

Re-Energized?

Heartland Value Fund Portfolio Manager Commentary Energy Chart

Source: FactSet Research Systems Inc., 6/29/2012 to 6/30/2017
Closing prices charted on a weekly frequency. Management purchases include only open-market transactions.
Statements regarding securities are not recommendations to buy or sell.
Past performance does not guarantee future results.


Well down from its high, WG has been building a long-term base.

 

Although shares remain under pressure as the price of crude struggles, we are encouraged by a 25% spike in Willbros’ order backlog to a new recovery high of $840 million and recent wins of new pipeline construction bids in the Marcellus region. The company recently netted $50 million in new construction contracts for power boosting stations in the Midwest. The utility transmission and distribution (UTD) business is solid. In 2016, UTD accounted for half of the firm’s revenues and is the fastest growing segment—first quarter of 2017 revenues were up 19% year-over-year.

Despite the progress, shares are trading at just 1.2x book value versus 1.9x for the peer group average and 4.1x for the S&P 500 Index.

SRC Energy Inc. (SRCI) specializes in oil and natural gas exploration and production using unconventional horizontal drilling in the United States. The company has a total of about 60,000 acres in the Greater Wattenberg Area of Colorado. Shares had a strong run in the second half of 2016 but have since pulled back despite the business reporting solid earnings results and carrying a pristine balance sheet.

Investors have grown concerned that proposed local restrictions could hamper production. The drilling regulations are unlikely to impact SRC, in our view, because the restrictions focus on curtailing vertical wells, which accounts for just 2% of the company’s production. We believe regardless of the anticipated rule changes the company is on track to double its output in 2017.

SRC’s use of horizontal drilling technology increases efficiency and reduces costs. At current prices, shares are trading at a more than 40% discount to our estimates of net asset value.

Committed to our process

The enormous pressure to throw in the towel and join the herd has worn down some of our long-time peers. We’ve recently seen traditional value managers join the FAANG* chase in hopes of keeping up in the near term.

We continue to follow different path and remain true to our Principles™ by refusing to pay up for momentum or the promise of top-line increases. Instead, we focus on valuations and dig into balance sheets, seeking businesses that can exploit unique niches to grow in today’s business climate.

Thank you for the opportunity to manage your capital.

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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Bill Nasgovitz

Bill Nasgovitz

Nasgovitz is Chairman and CIO, and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He also is President and Director of Heartland Funds. He has 48 years of industry experience, 34 at Heartland.

Heartland Advisors Value Investing Research Analyst Eric Miller

Eric Miller

Miller is Vice President and Portfolio Manager of the Heartland Value Fund and its corresponding separately managed account strategy. He has 23 years of industry experience, 14 at Heartland.

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*FAANG stands for Facebook, Inc., Apple Inc., Amazon.com, Inc., Netflix, Inc., and Google (Alphabet Inc.)

In the prospectus (pdf) dated 5/1/2017, the gross expense ratios for the investor and institutional classes of the Value Fund are 1.09% and 0.92%, 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 “Net Annual Operating Expenses” at a ratio not to exceed 0.99% of average daily net assets. This voluntary waiver/ reimbursement may be discontinued at any time. Without such waivers and/or reimbursements, total returns may have been lower.

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.

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.

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.

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

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

As of 6/30/2017, RetailMeNot, Inc., CareTrust REIT, Inc., Willbros Group, Inc., SRC Energy Inc., Facebook, Inc., Amazon.com, Inc., Apple Inc., Netflix, Inc., and Alphabet Inc. represented 0.00%, 2.54%, 1.08%, 1.26%, 0.00%, 0.00%, 0.00%, 0.00%, and 0.00%, of the Value Fund’s 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.

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®.

Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued.

The Value Fund primarily invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

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

The above individuals are registered representatives of ALPS Distributors, Inc.

Additional Information for Indexes in Chart (calendar year returns %):

    1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 YTD 2017*
Russell 2000® Growth Index   20.37 20.17 -17.41 51.19 7.77 13.37 -2.43 31.04 11.26 12.95 1.23 43.09 -22.43 -9.23 -30.26 48.54 14.31 4.15 13.35 7.05 -38.54 34.47 29.09 -2.91 14.59 43.29 5.62 -1.38 11.32 9.97
Russell 2000® Value Index   29.47 12.43 -21.77 41.70 29.14 23.77 -1.54 25.75 21.37 31.78 -6.45 -1.49 22.83 14.02 -11.43 46.03 22.25 4.71 23.48 -9.78 -28.92 20.58 24.50 -5.50 18.05 34.50 4.22 -7.47 31.74 0.54

*Not annualized as of 6/30/2017
Source: FactSet Research Systems Inc. and Russell®

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

The Heartland Funds are distributed by ALPS Distributors, Inc.

Separately managed accounts and related investment advisory services are provided by Heartland Advisors, Inc., a federally registered investment advisor. ALPS Distributors, Inc., is not affiliated with Heartland Advisors, Inc.

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