Heartland Small Cap Value Plus Strategy 1Q17 Portfolio Manager Commentary

 Executive Summary

  • Stock selection was strong in Financials and Real Estate but the Strategy modestly lagged its benchmark, the Russell 2000® Value Index, returning -0.89%† versus -0.13%.
  • Investors remained constructive on equities but hedged some of their bullishness by favoring larger companies and less volatile names.
  • Companies that rely on commodities in production could face margin pressure in the quarters ahead.
  • A renewed interest on valuations, we believe, will be closely tied to improved clarity on economic prospects.

First Quarter Market Discussion

Optimism that drove the market toward the end of 2016 continued, but enthusiasm tempered as the quarter wore on. Positive economic data and stronger than expected job growth were balanced against political discord in Washington and elevated valuations for the major indexes.

Investors remained constructive on equities but hedged some of their bullishness by favoring larger companies and less volatile names. The Federal Reserve Board’s mid-March interest hike was widely expected and viewed as another step on the road to normalized rates. Following the tightening, investors turned their focus back toward the underlying strength of the economy and prospects for earnings growth going forward.

Despite the rate increase, Fed commentary was interpreted as a willingness by the Board to move slowly and accept elevated inflation as a trade-off for allowing the economy to grow faster.

Attribution Analysis

Security selection was positive with Financials, Energy, and Real Estate holdings leading the way on the upside. Our stocks in Utilities and Health Care lagged on a relative basis and the Strategy trailed its benchmark, the Russell 2000® Value Index. An underweight to Financials also boosted results. Our holdings in Materials detracted but an overweight to the group offset some off the weakness.

Heartland Advisors financials iconA boost from rising rates. MGIC Investment Corp. (MTG), one of the largest private mortgage insurers in the U.S., experienced a surge in new mortgages as home buyers rushed to lock in loans before rates rise. 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 is beginning to benefit from excellent performance of its current pool of policies. Delinquencies are down and insurance in force continues to grow.

MGIC has been generating solid cash flow and reducing debt. With the company trading at 10.5x estimated 2017 earnings (P/E) and only 1.3x tangible book value, we view the company as an undervalued leader in an industry vital to the domestic economy.

Heartland Advisors materials iconDone in by the dollar. Our Materials names lagged, with the majority of weakness coming from the Metals and Mining industry. Schnitzer Steel Industries, Inc. (SCHN), was a key detractor for the portfolio. Shares of the industry-leading scrap and finished metal producer were off after the company reported weaker than expected results for the quarter. A strong dollar and lower scrap metal prices weighed on results.

Steel prices have begun to inflect, and we expect them to continue higher going forward. Schnitzer’s technological advantages over competitors—which allow the company to produce more cost-effectively—should result in greater benefits from an incremental gain in pricing. Additionally, the company has already reduced costs and is well positioned to benefit from future pricing strength in a consolidating industry.

With the stock trading at 6.7x enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA), we believe the market isn’t fully valuing the company’s operating leverage and is too pessimistic on steel prices.

Heartland Advisors information technology iconChipping in. The Strategy’s Information Technology names were up moderately on an absolute basis but lagged the benchmark. Our bottom-up research continues to uncover attractive opportunities in the space. For example, we initiated a position in a California-based chip maker.

The company has been actively reducing supply chain costs and has shifted its product mix to higher margin offerings. We also were attracted to its pipeline of new products that should boost top-line growth in the coming quarters. Weeks after we started accumulating shares, the company announced it had agreed to be acquired by a competitor at a significant premium. We exited our position on the news.

Portfolio Activity  

While we anticipate regulatory relief and Washington’s focus on improving the domestic business climate will be a tailwind for the economy, we are avoiding companies that could be adversely impacted by rising inflation. Instead, we are focused on beneficiaries of rising raw material prices. Inflation has been building for the past several months and, as illustrated in the chart, began to outpace market expectations in December. Companies that lack pricing power or which rely on commodities in production of goods could face margin pressure in the quarters ahead.

Cost Increases Outpacing Expectations
Citi Global Inflation Surprise Index

Heartland Value Plus Fund Portfolio Manager Commentary Inflation Surprise Index Chart

Source: Bloomberg L.P., 1/31/2004 to 3/31/2017

Businesses with opportunities to reduce costs and improve margins through internally focused efforts should be able to capitalize on operating leverage in an expanding economy or modestly grow earnings should sales remain flat.

We’ve trimmed some holdings on recent strength and redeployed assets into more attractively valued businesses in various industries. The result is a compact portfolio of approximately 50 names with more than one-quarter of assets held in the 10 largest positions.

Outlook and Positioning

We believe a renewed interest on valuations and earnings prospects will be closely tied to improved clarity for the economy and the geopolitical backdrop. If the administration in Washington is able to deliver on expected regulatory relief, a second leg up for the business climate should materialize.

The strong run for equities and the length of the bull market has led some investors to question whether valuations have gotten ahead of themselves. The market as a whole appears fully valued; however, as bottom-up investors we are focused on the valuations and business prospects of individual names we hold as opposed to the P/E of a broad index.

Additionally, we want to invest in businesses that have strong balance sheets and that employ solid capital allocation strategies. Companies that can drive operational improvements regardless of the macro backdrop should produce solid results in multiple environments and be recognized by the markets as catalysts occur.

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 8 years of industry experience, 5 at Heartland.

Composite Returns*

3/31/2017

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Small Cap Value Plus Composite (Net of Advisory Fees)**6.95-7.08-0.2926.09-0.89-0.89
Small Cap Value Plus Composite (Net of Bundled Fees)5.94-6.39-0.7925.45-1.01-1.01
Russell 2000® Value7.79-12.547.6229.37-0.13-0.13

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.

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 3/31/2017, MGIC Investment Corporation and Schnitzer Steel Industries, Inc. represented 1.6% and 1.9% 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, 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®.

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

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

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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