Heartland Value Fund 4Q16 Portfolio Manager Commentary

Executive Summary

  • The portfolio’s holdings were up on an absolute basis but the Fund lagged its benchmark, the Russell 2000® Value Index.
  • Valuations point to much of the easy money having already been made.
  • We continue to focus on companies serving unique niches, with exceptional balance sheets, and that are capable of generating strong free cash flow.

“It is impossible to produce superior performance unless you do something different from the majority." 
—Sir John Templeton

Fourth Quarter Market Discussion

A surprise outcome in the presidential election unleashed a wave of optimism that pushed markets to new highs. Many investors cheered the incoming administration believing it would usher in tax reform, fewer regulations, and relief from the Affordable Care Act. The reaction was swift and powerful. 

Less government influence in the economy was viewed as a catalyst for growth and, as shown below, cyclical areas benefited most. The December rate hike, and expectations of more to follow, boosted Banks as investors bet on a rise in interest income. 

Reversal of Fortunes  

Heartland Value Fund Portfolio Manager Commentary Return Chart

Source: FactSet Research Systems, Inc., Heartland Advisors, Inc., and Russell®
Holdings data as of 10/3/2016 to 11/7/2016 and 11/9/2016 to 12/30/2016
Past performance does not guarantee future results.

The new administration should breathe life into an underperforming economy. However, valuations appear stretched. Against this backdrop, we believe finding compelling opportunities will require fundamental research—and not a passive approach.  

Portfolio Activity

The Fund’s holdings were up on an absolute basis but mixed relative to the benchmark, the Russell 2000® Value Index. Stock selection in Financials, Energy, and Utilities boosted performance. Health Care names detracted due to a company specific issue with one of our companies.

Misdiagnosed

Heartland Value Fund portfolio manager commentary Health Care iconTrinity Biotech PLC (TRIB), a developer and manufacturer of diagnostic products, fits our strategy of holding businesses with competitive advantages that should allow them to grow faster than peers. The stock was down sharply after it announced it was pulling its bid for Federal Drug Administration (FDA) approval of a test used for rapid detection of heart attacks in emergency room settings. The test showed promising results, but the company rescinded its application based on an FDA recommendation.

The decision was a disappointment, but the market’s reaction, in our view, is overblown. Trinity remains a premier player in diabetes testing. It also dominates the HIV diagnostic market in Africa and controls a third of the segment in the U.S. The company’s infectious disease line generates $43 million in annual sales—half our estimate of the Dublin-based business’ intrinsic value.

Trinity’s position as a global leader in diagnostics should help it quickly establish itself in new markets such as Brazil. Looking solely at the company’s earnings power from its diabetes line, we believe the stock is trading at a 50% discount of its worth using peer-average multiples.

Cashing in on the cloud

Heartland Value Fund portfolio manager commentary Information Technology iconInformation Technology holding RadiSys Corp (RSYS) lagged despite seeing an inflection in earnings this year. The developer of high-performance software and integrated systems for the telecommunications space has undergone a transformation over the past five years.

As the wireless industry began to transition away from integrated hardware to widespread use of software, the company adapted to keep pace. During the period sales and earnings declined while RadiSys built up its software line. However, 2016 marked an inflection point. Aided by a multi-year contract for upgrading a Verizon data center, the company finished the year on pace for a 16% jump in revenue.

In the coming years, traffic on mobile, fixed-line, and cable networks is expected to explode. The increased volume should help the company consistently grow sales in the mid-teens compounded annually. Additionally, the business’ software sales are gaining traction. The company has already landed two critical clients in the space and several more are expected to come aboard in 2017. Based on our price to sales analysis, the stock is trading at a discount of approximately 35%.

Looking past the banks

Heartland Value Fund portfolio manager commentary Financials iconStock selection in Financials was strong but the group detracted due to a material underweight to the area. The sector makes up almost one-third of the benchmark. We believe an allocation that size would create undue risk for investors and we remain underweight to the area.

The rapid rise in bank stocks has led to fewer compelling values in the space; however, we continue to find opportunities in other industries in the Financials sector. Radian Group Inc. (RDN), a private mortgage insurance (PMI) company, is a good example.

We have been impressed with its growing book of insurance in force and believe prospects for an uptick in new insurance written are strong. Additionally, a rise in interest rates should help PMI companies as homeowners will be less likely to refinance mortgages. A slowdown in refinancings should lead to insurance policies on existing loans remaining in force for longer.

Radian announced earnings that were better than Wall Street analysts had projected, and the stock was rewarded. We view its current valuation of 9x estimated 2017 earnings as a bargain for a name that has produced a 14% rise in book value per share over the past 12 months. Management has been buying back shares, and the combination of a growing pool of insurance in force and fewer shares in the market could result in strong earning per share growth in the coming quarters.

An Improved Outlook?

The economic picture has brightened and investors of all stripes have benefited. However, valuations point to the easy money having already been made. Going forward, we believe fundamental analysis is required to uncover businesses serving unique niches, producing top-line growth, with exceptional balance sheets, and that are capable of generating strong free cash flow. In an index-oriented investment world, we believe this is the best approach to producing superior performance over the long run.

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 49 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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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.

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

As of 12/31/2016, Trinity Biotech plc, RadiSys Corporation, Verizon Communications Inc., and Radian Group Inc. represented 0.83%, 1.17%, 0.00%, and 1.82% 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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