Heartland Small Cap Value Plus Strategy 3Q17 Portfolio Manager Commentary

 Executive Summary

  • Strong security selection in Financials and Industrials boosted results as the Strategy outperformed its benchmark, the Russell 2000® Value Index, returning 7.61%† versus 5.11%.
  • Positive economic data and improving Energy sector fundamentals were overshadowed by geopolitical tensions and the headlines of the day.
  • A focus on news headlines and geopolitical events may be causing investors to take on unseen risks.
  • We view softness in some areas of the market as an opportunity to buy solid businesses at compelling valuations.

Third Quarter Market Discussion

Positive economic data and improving oil inventory levels were overshadowed by geopolitical tensions and the headlines of the day. This fixation on current events left investors wary of future business prospects. Investors’ caution resulted in oil trading in a moderate range despite larger than expected drawdowns in stored crude. A look at the movement of the 10-year Treasury yield versus a basket of commodities used in manufacturing highlights how underlying economic strength is being overlooked. As illustrated in the chart, yields on the 10-year Treasury are forecasting slowing growth even though raw material prices are up for the quarter, suggesting a pickup in demand.

Conflicting Signals
Heartland Value Plus Fund Portfolio Manager Commentary CRB vs 10-Year Treasury Chart
Source: Bloomberg L.P., 9/30/2016 to 9/29/2017 10-Year Treasury, 9/30/2016 to 9/28/2017; CRB RIND
Commodity Research Bureau BLS Spot Raw Industrials Index (CRB RIND)
Past performance does not guarantee future results.


The cautious tone toward the economy led to so-called defensive areas like Utilities and Health Care rallying, while cyclical sectors were mostly down until a late quarter surge in mid-September.

Attribution Analysis

Strong security selection in Financials and Industrials boosted results, and the Strategy outperformed its benchmark, the Russell 2000® Value Index. Allocation decisions were positive, and an underweight to Real Estate helped relative results. An overweight to Health Care was additive but couldn’t overcome stock specific weakness in one of our names in the group.

Heartland Advisors value investing portfolio commentary materials sector icon

Coming up green. Our Materials holdings were up sharply and outpaced the Index. One of the top contributors was a manufacturer of chemicals and insecticides used in agriculture. Management provided an upbeat outlook for the second half of the year and noted that margins were improving as a result of increased sales of some of its more profitable products—including those tied to cotton crops. The outlook for the remainder of the year has been bolstered by increased global crop production and an expected increase in use of its mosquito-killing products as hurricane ravaged areas deal with a surge in insect population. 
 
The company has also been opportunistically buying assets from competitors forced to divest product lines as the industry consolidates. Because the divestitures are required for merger approval, the business has been able to acquire assets at significant discounts.    
 
We’ve been impressed with management’s ability to generate significant cash flow even in a soft sales environment. With an improving end market, we expect top line revenue will grow, providing management with opportunities to pay down debt and to make tactical acquisitions as opportunities arise. 
 
With shares trading at 2.1x stated book value (SBV) versus long-term average of 2.8x, we believe the market isn’t fully valuing the revenue and earnings boost that will be provided by organic growth and tuck-in acquisitions.
 
Heartland Advisors value investing portfolio commentary industrials sector iconA mixed bag. The portfolio’s Industrials holdings outpaced those in the Index and performance varied widely at the industry level. KBR, Inc. (KBR) was among the winners and a top contributor for the quarter.
 
The stock was up after posting strong sales and earnings that beat consensus expectations. The impressive results were driven by growth from its government services unit as well higher operating margins. Adding to the positive news was management’s bullish outlook for the remainder of the year and continued progress on reducing debt.
 
A new management team at KBR has shifted strategy to focus on stable, profitable growth. On the engineering and construction services side, the focus is on smaller, high-margin projects. Additionally, there is an emphasis on growing the government services business due to its above average margins and stable cash flows.
 
Inflection in sight? Powell Industries, Inc. (POWL) was hurt by weak sales and tepid demand from customers and concerns about Hurricane Harvey’s impact on the company’s Houston facilities. The manufacturer of complex power management systems was down after reporting a year-over-year decline in revenue on weak end-market demand. 
 
The Houston-based company has seen a drop off in sales from its customers tied to oil, gas, and petrochemical production. However, in the most recent quarter, management reported a 46% jump in new orders compared to year ago figures. The uptick in demand puts Powell’s book-to-bill ratio at 1x, this marks the first time in two years that new orders outpaced sales, suggesting that revenue may be on the verge of inflecting higher. 
 
Despite a downturn in recent sales, Powell continues to produce strong free cash flow and has $10 per share in net cash on the balance sheet, which should help the company weather any additional weakness in the Energy patch.
 

Portfolio Activity  

In board rooms and on Main Street, signs point to a growing economy. Wall Street takes a different view. Each headline seems to be greeted with a call that the next recession is just around the corner. We are trusting the data over emotion and view softness in some areas of the market as an opportunity to buy solid businesses at compelling valuations. 
 
The pace of improvement is uncertain, and so we are focused on owning businesses that: 
  • Have strong or improving balance sheets
  • Are well positioned to expand operating margins through self-help initiatives
  • Are undervalued. 
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.
 

Outlook and Positioning

Heartland Value Plus Fund Portfolio Manager Commentary Quote

As long-term investors, we believe a focus on news headlines and geopolitical events is causing investors to take on unseen risks. Instead of building diverse portfolios of stocks with unique catalysts for success, many continue to bid up yesterday’s winners—including low-volatility names and those with elevated dividend yields. This suggests the primary risks going forward are a downturn in the economy and continued low interest rates. A myopic approach could prove painful if current economic strength accelerates and rates rise.   
 
While we cannot predict how macro events may affect the business environment, our discussions with the management teams of our holdings suggests the outlook remains sound. As such, defensive areas of the market and momentum plays that have become increasingly expensive may face increasing headwinds going forward. 
 
In this environment, we continue to comb through all sectors and industries looking for opportunities where we believe risk is mispriced. 
 
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*

9/30/2017

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)**7.27-8.104.6822.605.587.61
Small Cap Value Plus Composite (Net of Bundled Fees)6.28-7.514.1521.985.177.48
Russell 2000® Value8.00-13.2712.1220.555.685.11

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.

As of 9/30/2017, KBR, Inc. and Powell Industries, Inc. represented 1.87% and 2.01% 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.

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

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.

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.

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.

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