Heartland Small Cap Value Plus Strategy 1Q16 Portfolio Manager Commentary

 Executive Summary

  • Strong stock selection in Financials and Consumer Discretionary couldn’t overcome weakness in Energy and Materials. The Strategy returned -0.36%† and lagged the 1.70% of the Russell 2000® Value Index.
  • Widespread pessimism to start the quarter gave way to a constructive tone that benefited cyclical areas the most.
  • Recent volatility may point to a change in leadership, with momentum stocks no longer leading the markets.
  • Our analysis has led us to names levered to economic growth with less debt and idiosyncratic catalysts for improvement.

First Quarter Market Discussion

Modest returns in the major indices masked a volatile quarter caused by investors grappling for direction against a mixed economic backdrop.

The defensive mindset that took root in late 2015 dominated the first six weeks of the quarter as oil hit new lows and global economic prospects appeared weak. Widespread pessimism led to heavy selling, with nine of ten sectors in the Russell 2000® Value Index down. In response to concerns about tighter credit markets, balance sheets remained an area of focus and highly leveraged companies were hardest hit.  

The trend abruptly reversed in mid-February, as shown, after a string of data came out that contradicted the negative outlook priced into equities. The more constructive tone benefited cyclical areas the most and was amplified by short sellers scrambling to cover positions in some of the hardest hit sectors.

A Tale of Two Halves

Heartland Small Cap Value Plus Strategy Portfolio Manager Commentary Sector Chart

Source: FactSet Research Systems Inc., 1/4/2016 to 3/31/2016
Past performance does not guarantee future results.

Attribution Analysis

Security selection in Financials and Consumer Discretionary was strong. Holdings in Industrials underperformed on a relative basis, but the group held a top contributor. Materials was a detractor on a relative and absolute basis. Allocation decisions were mixed: an overweight to Consumer Staples and underweight to Financials boosted performance. Limited exposure to Utilities detracted.

Energy swings. Energy holding Carbo Ceramics Inc. (CRR), a detractor, exemplifies the volatility that defined the quarter. After selling off in sympathy with the sector in January, the manufacturer of materials used in fracking rebounded sharply after reporting better than expected earnings. Shares got an additional boost as oil bounced and the company reported a significant customer had generated better results in the Utica shale using one of its new proppants.  The strength faltered after a short seller published a note highlighting debt covenants that may need to be renegotiated. The stock was down on the report. However, the information included in the piece was already publicly known. We viewed the setback as an overreaction and purchased more shares on the dip.

We believe Carbo’s technology is superior and its products will be increasingly important when the sector recovers and drillers discover ways to maximize well pumping, thereby spreading fixed costs over a broader product offering. 

Our Industrials holdings as a whole detracted from relative performance, but the group contained a key contributor.

Labeled a winner. Brady Corp. (BRC) boosted results after reporting better than expected earnings on higher margins and improved guidance. The maker of safety labels and security products benefited from cost cutting measures instituted in 2015 and has been using free cash flow to pay down debt.

Although management raised full-year guidance, there appears to be additional room for improvement. The consolidation and cost cutting undertaken last year should help the company continue to grow earnings even if sales are flat or slightly soft. Given its 3% dividend yield, 4% free cash flow yield, and that it is trading at 9x estimated 2017 earnings before interest, taxes, depreciation, and amortization (EBITDA), Brady is attractively valued, in our view. We believe it should continue to perform even if the economy softens.

Health check. The Portfolio’s Health Care holdings moderately lagged those in the Russell 2000® Value benchmark, and the group contained a key detractor. Invacare Corp. (IVC), a maker of health care products for home use, reported continued progress on its operational turnaround, which drove the stock higher post earnings. However, the company subsequently issued a dilutive convertible debt offering in order to support new growth initiatives. The move was unanticipated by investors and resulted in selling pressure.

We continue to find the company attractive due to strong secular demand for home health care products. Invacare’s free cash flow should continue and its low debt levels are likely to help it withstand any unforeseen challenges.

Portfolio Activity 

We have taken volatility as an opportunity to upgrade quality in the Portfolio by buying businesses that have idiosyncratic catalysts. Equity Commonwealth (EQC) is an example of a company we found attractive because of its unique positioning.

Traditionally, rich valuations and lackluster growth prospects have made it difficult for us to find compelling opportunities in the real estate investment trusts (REITs) space. Equity Commonwealth is an exception due to its value-oriented approach. The company owns primarily office space in Chicago, Philadelphia, Indianapolis, and Austin. The Trust has been selling low performing properties into what it considers an over-valued real estate market. The upshot is the company has been able to pay down debt and accumulate a large cash balance that can be used to payout dividends or buy properties later when real estate valuations recede from their current levels. We believe the company is a rare value in the REIT industry, trading at a 15% to25% discount to our estimate of its intrinsic value.

Following where the research leads. Our search for steady, financially sound companies with solid growth prospects has led us to larger names. New additions this quarter had an average market cap of $2.8 billion versus the holdings we sold, which averaged $1.8 billion.

Outlook and Positioning

Given a muddled global economic picture, it’s conceivable volatility could persist for the next several months. While the push and pull of conflicting data may result in a stalemate for the direction of the indices, we believe it is part of the process of ushering in new market leadership. Some of the change may be starting to take shape as momentum stocks that enjoyed a strong run in 2014 and 2015 have lost steam and are now being outpaced by cyclically exposed areas of the market.

Against this backdrop, we remain committed to valuations and balance sheets. This dedication has resulted in a portfolio of names that have less debt, are larger and more liquid, and are modestly more cyclical than in recent quarters. These names should perform well against various macro trends and will benefit from strong idiosyncratic, company specific catalysts.

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 20 years of industry experience, 17 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.

Composite Returns*

3/31/2016

Scroll over to view complete data

Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Small Cap Value Plus Composite (Net of Advisory Fees)**4.84-1.83-0.59-14.37-0.36-0.36
Small Cap Value Plus Composite (Net of Bundled Fees)3.80-0.95-1.09-14.83-0.48-0.48
Russell 2000® Value5.46-6.675.73-7.721.701.70

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 11/30/2007.
**Shown as supplemental information.

Past performance does not guarantee future results. Performance represents past performance, and current returns may differ.

The Small Cap Value Plus Strategy 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.

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 3/31/2016, Brady Corp., Carbo Ceramics Inc., Equity Commonwealth, and Invacare Corp represented 2.1%, 2.4%, 2.5%, and 2.9% of the Small Cap Value Plus 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.

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.

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

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

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

CFA® is a registered trademark owned by the CFA Institute.

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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