Heartland Opportunistic Value Equity Strategy 2Q16 Portfolio Manager Commentary

Talking Points

  • Strong stock selection in Financials and Utilities led the Strategy to outperform its benchmark, the Russell 3000® Value Index, returning 5.03%† versus 4.57%.
  • Against the unsettled macro outlook, bargain hunting was a point of emphasis and groups that had previously been under pressure fared well.
  • We continue to focus on names with strong balance sheets and consistent revenue.
  • As dollar strength ebbs, large companies with strong brands and product lines should outperform.

Second Quarter Market Discussion

The relief rally that started in mid-February continued pushing the major indices higher. However, mixed economic data and uncertainty about if, or when, the Fed will raise rates left investors in limbo.

This quarter reflected a measured approach that led to broad strength. Against the unsettled macro outlook, bargain hunting was a point of emphasis and groups that had previously been under pressure fared well. Cyclical areas were the primary beneficiaries. Rising oil prices provided an additional lift to Energy names.

A greater premium was placed on valuations as recession fears faded. Smaller companies, which were among the hardest hit earlier this year, also bounced back as investors looked to capitalize on previously oversold conditions.

Attribution Analysis

Positive security selection was the main source of outperformance relative to the Russell 3000® Value Index, with holdings in Financials and Utilities providing much of the strength. Additionally, our Health Care names were up on an absolute basis, yet lagged the benchmark.

A Utility player. While Utilities have been a beneficiary of the Fed’s low rate policies and the scramble for yield, we believe many regulated power companies are generally expensive with weak prospects for increased revenue. Our research has led us to compelling opportunities among partially or unregulated players. MDU Resources Inc. (MDU), a Utility with construction, pipeline and energy services business lines, fits the mold. The company reported solid earnings helped by recently approved rate increases. Backlogs for its construction services and materials units also grew considerably and we expect the aggregates business could see improved margins in the quarters ahead. Trading at a 20% discount to our sum-of-the-parts analysis, we believe MDU’s diversified business provides multiple avenues to continue to grow.

The Strategy’s Information Technology (IT) holdings performed in line with the benchmark, and contained a top performer.

Broadband beneficiary. Fabrinet (FN), a maker of optical components, was up after posting better than expected results and raising guidance. The company has surpassed Wall Street estimates for several consecutive quarters, and we believe it will continue to benefit from demand for broadband services. The stock has garnered investor attention recently due to its positive earnings history, clean balance sheet, and healthy cash position, but is still trading at a reasonable 12.7x estimated 2016 earnings. We’ve been cognizant of position size, and trimmed our share count to maintain a consistent level of exposure.

Not in the shopping mood. The Portfolio’s Consumer Discretionary names performed well but the group contained a key detractor. National department store Kohl’s Corp. (KSS) was down after reporting declining year-over-year sales, which management attributed to poor weather. The company also acknowledged that efforts to enhance online marketing ate too deeply into its conventional marketing budget. We were disappointed in the results, but are encouraged by the arrival of new Chief Operating Officer Sona Chawla as well as a renewed sense of urgency and accountability among management. The company is focused on improving store-wide inventory to capitalize on local preferences and online demand. It’s undertaking an initiative for faster product development that could result in up to 50% of new products going from design to production in 18 weeks or less—currently, just 27% of goods are produced that quickly. Kohl’s also maintained its guidance for the full year.

We believe Kohl’s faces pressure—like many retailers—from the dominance of Amazon. However, the company is trading at its lowest level in a decade as measured by price-to-book; enterprise value-to-earnings before interest, taxes, depreciation and amortization; and price-to-earnings. At these significantly depressed levels, even modest improvements in sales should result in a sizeable move for the stock.

Portfolio Activity

Our focus remains on names with strong balance sheets and those with consistent revenue.  Our analysis has led to the addition of two names during the past three months. Given that the economy is still in flux, we believe volatile stocks present greater downside risk and have sought to mitigate that factor by holding higher market cap stocks with superior franchises.

Recent addition American Express (AXP) is an example of a larger name with an exceptional brand that should provide stability yet also participate on the upside. The diversified financial services company operates as a credit card lender and offers merchant services to process purchases made with its cards. The company faced challenges ranging from expenses related to the termination of two cobranding relationships to currency exchanges into stronger dollars and a slowdown in commercial spending by its clients. These headwinds should be temporary.

We are encouraged by an 11% increase in 2015 of the number of merchants accepting its cards and anticipate the company will return to its historical range of 12% to 15% annual earnings growth. American Express had been on our watch list for more than a year, and, after the setbacks in 2015 led to a selloff, the company became available at a significant discount to its 20 year historical average of 17x forward estimated earnings.

Outlook and Positioning

For the past few quarters, as investors crowded into a small sliver of the market, valuations have become distorted. Investors have been crowding into defensive areas at the expense of cyclical names. As you can see, the least crowded areas have taken the brunt of the pain and their multiples have shrunk in response to macro uncertainty. Recent data suggests that while we may not be on the verge of an economic boom, things have begun to stabilize. We are taking advantage of the depressed valuations by seeking out late-stage cyclical areas. Our exposure to Energy has increased while our allocation to Consumer Discretionary and Financials has declined.

Value Among the Unloved
Median Price/Book Ratio of North American Stocks

Heartland Opportunistic Value Equity Strategy Portfolio Manager Commentary Price-to-Book Chart

Source: FactSet Research Systems, Inc., Bernstein U.S. Quant Team, and Heartland Advisors, Inc., 9/28/2007 to 6/27/2016, Crowded designations as of 6/27/2016
Past performance does not guarantee future results.

Energy will likely continue to have a significant impact on the economy and markets in the near-term; however, we are encouraged by a growing sense of clarity in the sector. We continue to balance the Portfolio’s exposure in the space by holding a combination of names that are highly correlated with the price of crude as well as some countercyclical companies that should thrive in a low commodity price environment.

The resiliency of the consumer will likely face greater tests in the coming months as companies try to pass along higher input costs and gas prices and as interest rates begin to take hold. As a result, we have reduced our exposure among consumer-oriented names.

As dollar strength ebbs, we believe large companies with strong brands and product lines should outperform as their entrenched position allows them to withstand periods of economic uncertainty. However, we continue to find and hold high conviction ideas among smaller companies such as Fabrinet and MDU with unique niches and competitive advantages.

While a move into late cyclical businesses is prudent in our opinion, we continue to monitor allocation risk and have structured the portfolio to benefit from stable companies with idiosyncratic factors identified through bottom-up analysis.

Thank you for the opportunity to manage your capital.

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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager David Fondrie

David Fondrie

Fondrie, CPA, is Senior Vice President and Portfolio Manager of the Select Value Fund and its corresponding separately managed account strategy. He has 22 years of industry experience, all at Heartland.

Heartland Advisors Value Investing Portfolio Manager Colin McWey

Colin McWey

McWey, CFA, is Vice President and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He has 14 years of industry experience, 7 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 16 years of industry experience, 13 at Heartland.

Composite Returns*

6/30/2016

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Opportunistic Value Equity Composite (Net of Advisory Fees)**9.776.236.936.62-1.854.355.03
Opportunistic Value Equity Composite (Net of Bundled Fees)7.684.184.844.53-3.793.314.52
Russell 3000® Value6.576.0511.099.582.426.294.57

Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.

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†Composite return is net of advisory fees.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 9/30/1999.
**Provided as supplemental information.

Past performance does not guarantee future results.

In addition to stocks of large companies, the Opportunistic Value Equity Strategy invests in stocks of small- and mid-cap companies that are generally less liquid than large companies. The performance of these holdings generally will increase the volatility of the strategy’s returns.

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

Heartland Advisors, Inc. (the "Firm") claims compliance with the Global Investment Performance Standards (GIPS®). The Firm is a wholly owned subsidiary of Heartland Holdings, Inc., and is registered with the Securities and Exchange Commission. For a complete list and description of Heartland Advisors composites and/or a presentation that adheres to the GIPS® standards, contact the Institutional Sales Team at Heartland Advisors.

The U.S. dollar is the currency used to express performance.

As of 6/30/2016, MDU Resources Inc., Fabrinet, Kohl’s Corp., Amazon.com, Inc., and American Express represented 2.6%, 2.1%, 0.7%, 00.0%, and 2.0% of the Opportunistic Value Equity Composite, respectively.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

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.

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

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®.

Crowded stocks are defined by Bernstein Analysis using a proprietary model that measures crowding based on institutional ownership (through active bets and trade persistence metrics), sentiment (price momentum and sellside analysts' ratings), and expectations (earnings forecasts and valuation).

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