Heartland Value Plus Fund 2Q16 Portfolio Manager Commentary

Talking Points

  • Strong stock selection in Energy and Information Technology (IT) couldn’t overcome weakness in Industrials and Materials, and the Fund lagged its benchmark, the Russell 2000® Value Index, returning 1.33% versus 4.31%.
  • Mixed economic news eased concerns of a near-term rate hike, benefiting leveraged companies.
  • Our focus remains on balance sheet strength and margin expansion opportunities.
  • The economic picture remains muddled and volatility could persist. 

Second Quarter Market Discussion

The quarter offered more of the same for those trying to get a read on the economy. Much welcomed strength in oil and commodities was offset by continued slowing growth and lowered earnings estimates.

The tone left investors restless and the markets volatile. Mixed economic data eased concerns of a near-term rate hike, benefiting highly leveraged companies.

The subdued mood of management teams, as shown, reflects the sentiment on Wall Street. Many executives of the businesses we own say they are cautious and bracing for continued slow economic growth. The tepid growth of the past several quarters began to take a toll on smaller companies and earnings reflected sluggish sales. Cost cutting and boosting efficiency were widespread themes.

Small Business Optimism Fading

Heartland Value Plus Fund Portfolio Manager Commentary Small Business Chart

Source: Bloomberg L.P., 5/31/2015 to 5/31/2016
National Federation of Independent Business (NFIB) U.S. Small Business Optimism Index

Attribution Analysis

The Fund lagged the Russell 2000® Value Index. Stock selection in Materials detracted, and an overweight to the sector couldn’t offset the weakness. Security selection in Energy and Information Technology (IT) was strong. Holdings in Financials outperformed on a relative basis, and the group held a top contributor. Allocation decisions were mixed: While an overweight to Energy contributed to performance an overweight to Consumer Discretionary detracted.

Energized. As crude prices recovered, drillers and industrial companies tied to the sector were rewarded. Recent addition Now, Inc. (DNOW), a distributor of drilling equipment, pipes, tubes, and safety products used by exploration and production companies, was a beneficiary. The company fits with our goal of finding businesses that can improve bottom line results through internally focused efforts.

Management has created significant cost savings over the past 18 months and has shuttered 46 branches. Its robust balance sheet is helping to advance its market share as weaker players are being shunned due to bankruptcy concerns. Improved margins from increased efficiencies, cost reductions, and a pristine balance sheet should allow the business to succeed at current energy prices. When oil and gas gain additional strength, these attributes could lead to greater upside versus the sector as a whole.

Now was one of several self-help stories that contributed to performance.

Much deserved credit. Union Bankshares Corp. (UBSH) was a contributor after it reported solid first quarter results and improved loan growth. We have found the business attractive due to cost cutting opportunities from a large merger and the Virginia-based bank’s high quality loan portfolio. Both attributes were rewarded this quarter and leadership is committed to further overhead reductions. With its strong franchise and trading at 1.2x stated book value, the company could be an enticing takeout target.

In addition to traditional banks like Union, unique opportunities exist in other industries within Financials.

Breaking out of confinement. Corrections Corporation of America (CXW), a private prison owner/operator in the real estate investment trust (REITs) space, was up after posting better than expected earnings and a solid outlook. The stock had been under pressure as investors have grown concerned about the impact of sentencing reforms and presidential campaign anti-private-prison rhetoric. These fears are overstated in our view.

At 11x estimated 2017 funds from operations versus a peer average of 14x, the full story is seemingly being overlooked. In addition to offering a 6% dividend yield, the company could see margin expansion and increased revenue from renting out existing mothballed facilities. Additionally, Corrections Corp.’s residential rehabilitation franchise that contributes $20 million in earnings before interest, taxes, depreciation and amortization (EBITDA) is a growth catalyst that we believe isn’t being fully recognized by the market.

Portfolio Activity 

Faced with a murky view of near-term economic prospects, our focus remains on businesses that can: 1) generate margin expansion through self-help, 2) are prudent allocators of capital, and 3) have low debt. Companies with strong balance sheets should be better positioned to withstand unforeseen slowdowns as well as act opportunistically to upgrade operations or to take strategic actions.

Some of the portfolio’s largest positions have been trimmed to fund new opportunities. In light of recent heightened volatility, we have initiated small positions and added opportunistically as prices warrant. Capital starved industries remain fertile hunting grounds. The lack of investment translates to an erosion of capacity and sets the stage for outsized returns for strong players when demand resumes.

A cautious approach. Werner Enterprises, Inc. (WERN) is an example of a company that we believe will benefit from upgrading its equipment when prices are depressed. The Nebraska-based trucking company has used its robust cash flows to upgrade its fleet of tractors. The company aims to reduce the average age of its tractors to 1.5 years, which should improve reliability and serve as a valuable recruiting tool for attracting experienced drivers.

New rules are set to take effect in 2017 that will make it easier for regulators to track the hours a driver is on the road. Stringent monitoring should lead to operators logging fewer miles and could provide pricing power for large industry players as capacity is reduced. As these changes take hold, we expect Werner will be well positioned to take market share and increase margins.

Heartland Value Plus Fund Portfolio Manager Commentary quoteOutlook and Positioning

The global economic picture remains muddled as the aftermath of the United Kingdom’s decision to leave the European Union continues to be sorted out and heightened volatility could persist for the next several months. Inflation is starting to creep up and energy prices have had a healthy recovery. These factors could spur an acceleration of growth or lead to stagflation. Instead of making a call on how the macro environment will unfold, we are focusing on owning businesses with strong management that can improve results and increase margins by pulling multiple levers, including options such as:

  • Facility consolidation,
  • Cutting redundancies,
  • Reducing overhead expenses,
  • Divesting or discontinuing less profitable product lines, and
  • Capitalizing on pricing power.

Additionally, we want to own businesses that have strong balance sheets and that will employ solid capital allocation strategies. Companies that can drive operational improvements regardless of the macro backdrop should be well positioned to produce solid results and be recognized by the markets.

Thank you for the opportunity to manage your capital.

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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Bradford A. Evans

Bradford A. Evans

Evans, CFA, is Senior Vice President and Portfolio Manager of the Value Plus Fund and its corresponding separately managed account strategy. He has 21 years of industry experience, 18 at Heartland.

Heartland Advisors Value Investing Research Analyst Andrew Fleming

Andrew J. Fleming

Fleming, CFA, is Vice President and Portfolio Manager of the Value Plus Fund and its corresponding separately managed account strategy. He has 7 years of industry experience, 4 at Heartland.

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In the prospectus (pdf) dated 5/1/2016, the gross expense ratios for the investor and institutional class of the Value Plus Fund are 1.16% and 0.90%, 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.

As of 6/30/2016, Corrections Corporation of America, Now, Inc., Union Bankshares Corporation, and Werner Enterprises, Inc. represented 3.01%, 2.63%, 3.36%, and 1.66% of the Value Plus 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®.

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

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

The Value Plus Fund invests in small companies that are generally less liquid and more volatile than large companies. The Fund also invests in a smaller number of stocks (generally 40 to 70) than the average mutual fund. The performance of these holdings generally will increase the volatility of the Fund’s returns.

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

The Value Plus Fund seeks long–term capital appreciation and modest current income.

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

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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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