Heartland Small Cap Value Plus Strategy 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 Strategy lagged its benchmark, the Russell 2000® Value Index, returning 3.08%† 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 Small Cap Value Plus Strategy Portfolio Manager Commentary Small Business Chart

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

Attribution Analysis

The Strategy 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 mostly constructive: While an overweight to Energy and Materials contributed, an overweight to Consumer Staples 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 and 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 than the sector as a whole.
Now was one of several self-help stories that contributed to performance. 
Much deserved credit. Union Bankshares Corporation (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.
Along with traditional banks like Union, unique opportunities exist among 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 Strategy’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 serves 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.

Outlook 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 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 8 years of industry experience, 5 at Heartland.

Composite Returns*


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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)**5.08-2.700.72-9.712.713.08
Small Cap Value Plus Composite (Net of Bundled Fees)4.06-1.890.22-10.172.462.95
Russell 2000® Value5.81-8.156.36-2.586.084.31

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 6/30/2016, Corrections Corporation of America, Now, Inc., Union Bankshares Corporation, and Werner Enterprises, Inc. represented 3.7%, 3.1%, 2.0%, and 1.8% 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.

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

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