Heartland Value Fund 3Q16 Portfolio Manager Commentary

Executive Summary

  • Stock selection was strong in several sectors. Industrials, Real Estate and Consumer Discretionary led the way and the Fund outperformed its benchmark, returning 11.48% versus 8.87%.
  • Smaller names in the Index performed well and could point to staying power for value stocks.
  • Our watch list is robust and we continue to find compelling value opportunities.

“The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.”
Seth Klarman, Investor

Third Quarter Market Discussion

Attractively valued companies held their own against growth/glamor stocks for a second straight quarter. Market strength was broad and smaller names were among the top performers. Boosted by strong results among our smallest holdings, the Value Fund outperformed its benchmark.

For the period, the smallest 30% by market cap in the Russell 2000® Value were up an average of 11.90% compared to 8.51% for the largest 30%.  The willingness by investors to go further down the market–cap range points to continued broadening of the market and a willingness to dig deeper for compelling opportunities.

Strength in Small

Heartland Value Fund Portfolio Manager Commentary Return by Deciles Chart

Source: FactSet Research Systems, Inc., Heartland Advisors, Inc., and Russell®, 6/30/2016 to 9/30/2016
Deciles are represented by the Russell 2000® Value Index and organized by market capitalization with 1 representing the largest and 10 representing the smallest.
Past performance does not guarantee future results.

As investors continue to hunt for companies that outperform in a flat economy, we believe they will look to niche businesses with strong sales and earnings prospects—the kinds of names that have gone unloved for too long in the small–cap space.

Portfolio Activity

Stock selection was positive with holdings in many sectors outperforming. Industrials, Real Estate, and Consumer Discretionary led the way. The portfolio’s Energy names lagged. Performance was solid regardless of market cap with larger small–caps and micro–caps each contributing.

Programming performance

TiVo Corp. (TIVO) fits our strategy of owning businesses with a competitive advantage that should allow them to grow faster than the economy. With over 5,000 patents and serving 500 pay TV providers in 70 countries, the company is a dominant player in providing interactive programming guides to the cable/satellite industry and offers predictive analytics to advertisers.

We initially purchased Rovi Corp. (TIVO), which acquired TiVo because of its superior technology and position as a provider of a must–have product. The recently completed merger between the organizations furthers the combined company’s intellectual property dominance, expands its customer base, and provides opportunity for $100 million or more in cost cuts (equal to $1 per share). Additionally, the company has had contract wins with larger clients at favorable pricing, which should result in growth in the years ahead.

Sharp intellect

Intellectual property holding Acacia Research Corporation (ACTG) is reaping rewards from its book of patents while planting seeds for future revenue. The company, which partners with third–party firms to license and enforce patents on technology, was a top contributor. It recently won a lawsuit against Apple Inc. (APPL) revolving around the computer giant’s use of Acacia’s patented cell phone technology. The jury determined Apple must pay the company more than $22 million in damages. CEO Marvin Key has focused on quick, profitable resolutions with patent infringers, reducing legal costs, and restructuring staff compensation.

The results since Mr. Key took the reins in late 2015 have been impressive. Overhead has been slashed more than 50%, and cash settlements have increased leading to an additional $1 per share in cash generation.

The company has also actively invested for the future. Through a funding deal with a cloud–based, artificial intelligence (AI) business, Acacia could gain a foothold into the untapped business of cataloging data to make it more accessible. The market potential in our opinion is exceptional and has yet to be fully appreciated by analysts. With no debt and $3 per share on the balance sheet, we are happy to hold shares alongside insiders who have been piling in!

Getting its magic back

MGIC Investment Corporation (MTG), one of the largest private mortgage insurers in the U.S., has benefited from improved loss ratios and firmer pricing in the industry. The company, along with its competitors, was hit hard with loss payouts stemming from the real estate implosion of 2007–08. With the majority of bad loans from the pre–financial crash behind it, the Milwaukee–based company has begun to benefit from excellent performance by its current pool of policies. Delinquencies are down and insurance in force continued to grow.

It has been generating solid cash flow and buying back some of its convertible debt, which lessens the threat of future dilution of shares. Trading at 8x estimated 2017 earnings and only 1.1x tangible book value, we view the company as an undervalued leader in an industry vital to the domestic economy.

The private mortgage insurance market should continue to recover and we’ve been encouraged by pricing strength. There was heavy insider buying in early 2016 that we viewed as validation of our fundamental research.

Heartland Value Fund Portfolio Manager Commentary QuoteA bright future for value?

The clouded earnings picture has heightened the risk of holding turnaround stories. Instead, we are focusing on companies serving unique niches, with exceptional balance sheets that can generate strong free cash flow. As Seth Klarman noted, the market is a story of cycles and after a long wait for the cycle of macro–driven, index mania to unwind, patient value investors, such as yourself, should be well positioned to have their perseverance rewarded.

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, 13 at Heartland.

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In the prospectus (pdf) dated 5/1/2016, the gross expense ratios for the investor and institutional classes of the Value Fund are 1.06% and 0.91%, 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 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.

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 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.

Small-cap and large-cap investment strategies each have their own unique risks and potential for rewards and may not be suitable for all investors. Small-cap investment strategies emphasize the significant growth potential of small companies, however, small-cap securities, are generally more volatile and less liquid than those of larger companies. Large-cap investment strategies emphasize the stability of large companies, however, large-cap securities are more susceptible to momentum investments and may quickly become overpriced or suffer losses.

As of 9/30/2016, Acacia Research Corporation, Apple Inc., MGIC Investment Corporation, and TiVo Corp. represented 3.82%, 0.00%, 1.27%, and 3.29% of the 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.

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 guarantee that a particular investment strategy will be successful.

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.

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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