Heartland Small Cap Value Strategy 2Q16 Portfolio Manager Commentary

 Talking Points

  • Stock selection was strong in Materials and Industrials, but Information Technology detracted and caused the Strategy to lag its benchmark, returning 1.55%† versus 4.31%.
  • Breadth improved with nearly 60% of names in the Russell 2000® Value Index breaking above their 200-day moving average.
  • Among the top contributors for the Strategy were companies with market caps less than $400 million.
  • After a long drought, patient investors should be well positioned to have their perseverance rewarded.

“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”
- Rudiger Dornbusch,
Economist and Professor

Second Quarter Market Discussion

Valuation focused investors received a double dose of good news this quarter: Market breadth expanded and small-cap value outpaced growth.
 
A closer look at Russell 2000® Value Index performance shows size seems to be the difference between the winners and losers. Grouping the Index holdings into market capitalization deciles highlights the sharp contrast. Since January, as shown, the largest 30% of names were up twice as much as the smallest 30%. To us, the focus on such a narrow section of small-cap land means significant opportunities are being overlooked. Things have gotten better lately, but too many good companies aren’t getting their due. 
 
Largest Names in Russell 2000® Value Driving Results

Heartland Small Cap Value Strategy Portfolio Manager Commentary Return by Declines Chart

Source: FactSet Research Systems, Inc., Heartland Advisors, Inc., and Russell®, 1/4/2016 to 6/30/2016
Deciles are organized by market capitalization with 1 representing the largest and 10 representing the smallest.
Past performance does not guarantee future results.
 
Breadth should continue to improve as the market starts to slowly take notice of smaller names with strong fundamentals and opportunities to grow faster than the average company in the S&P 500. As you can see, nearly 60% of stocks in the Russell 2000® Value Index have broken above their 200-day moving average. Historically, this has been very good for small-cap value investors such as Heartland.
 
Broadening Strength in the Russell 2000® Value

Heartland Small Cap Value Strategy Portfolio Manager Commentary Russell 2000 Value Chart

Source: Bloomberg L.P. and Russell®, 3/20/2000 to 6/30/2016
Economic predictions are based on estimates and subject to change.
Past performance does not guarantee future results.
 

Portfolio Activity

Stock selection was strong with holdings in Materials and Industrials leading the way. Information Technology detracted and caused the Strategy to lag its benchmark. Although smaller names were weak performers for the Index, some of the Portfolio’s top contributors were microcaps with market caps less than $400 million.

Small tech, big potential

Recent addition RadiSys Corporation (RSYS) is an example of a small company that should receive increased investor interest. The Oregon-based company makes software and embedded servers that help manage internet and telecom traffic as well as allow industrial machines to receive information remotely.

Continued growth in its higher margin software products and the introduction of a new hardware product are being embraced by clients. Verizon chose RadiSys’ products over much larger global players and placed a $50 million order, which should boost annual revenues by 25%! The purchase may be the first of many as competitors take notice of the new product offerings.

Trading at .9x estimated 2017 enterprise value-to-sales versus a peer group average of 2x and cash on the balance sheet, the company still represents a significant value in our view.

Banking on the overlooked

As expectations of a rate hike have faded, banks have become a forgotten sector. In the near-term, credit quality of borrowers is unlikely to get better and lending spreads are expected to remain flat. However, we continue to find overlooked gems like TriState Capital Holdings, Inc. (TSC). 
 
The holding company of TriState Capital Bank offers commercial and private banking services to middle markets, and also has an investment management group with $10 billion in assets under management. 
 
The company has leveraged a branchless distribution model to grow its loan book in the mid to high teens annually. The success has led to it outpacing peers in organic growth. Additionally, its investment management line generates significant fees and helps offset some of the pressures on lending spreads due to low interest rates.
 
We initiated a stake in the $3.4 billion Pittsburg-based bank when it was trading near book value. Valuations were compelling and so was the management team led by Chief Executive Officer (CEO) James Getz. Before founding TriState, Mr. Getz was a President/CEO of Federated Bank and Trust and President/Sales Manager of Federated Securities Corp., helping build Federated into a $1.1 trillion financial services enterprise. 
 
Under his leadership, TriState, in less than five years, has almost doubled in size to $3.4 billion. The stock has a track record of producing organic growth, yet still trades at just 1.3x tangible book value a discount to the 1.6x peer group average of branchless banks. In our view, TriState is a growth bank available at value prices.
 

A play for the road ahead

We remain constructive on Sonic Automotive Inc. (SAH). The country’s third largest automotive retailer, despite its $755 million market cap, has 118 franchises in 13 states and $10 billion in sales. The business operates in two segments—traditional new and used car sales locations and its EchoPark segment that operates standalone used cars sales outlets. Management has implemented a “One Sonic, One Experience” strategy that utilizes set rate pricing and relies on so-called experience guides in place of traditional sales people. The strategy has taken hold in the company’s home territory of Charlotte, NC, and has helped boost market share. Its customer-centric outlets have received glowing reviews and should help the company draw millennial customers. 
 
Sonic is actively buying back shares and purchased 7% of those outstanding during the first quarter. Trading at an estimated 2016 price-to-earnings ratio of 7.65x, investors seem to be more focused on near-term sales volatility and overlooking an opportunity to own a franchise positioned to endure.
 

How we plan to capitalize in Small Cap Value

We have been finding compelling investments among small-caps of all sizes, but many recent opportunities we’ve uncovered have been in names over $1 billion. Businesses where catalysts have not played out or valuations are too rich are being trimmed to fund new purchases. 
 
During our decades of investment experience, there have been periods where markets have been more distorted, but we don’t recall a time when a disregard for valuations has remained in place for so long. The road has been rough, but signs that the worst may be over are appearing. The economy continues to move forward, wage inflation is picking up, and many small-cap names are trade at meaningful discounts to their historic averages. After a long drought, patient investors should be well positioned to have their perseverance rewarded.
 
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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Bill Nasgovitz

Bill Nasgovitz

Nasgovitz is Chairman and CIO, and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He also is President and Director of Heartland Funds. He has 48 years of industry experience, 34 at Heartland.

Heartland Advisors Value Investing Research Analyst Eric Miller

Eric Miller

Miller is Vice President and Portfolio Manager of the Heartland Value Fund and its corresponding separately managed account strategy. He has 23 years of industry experience, 13 at Heartland.

Composite Returns*

6/30/2016

Scroll over to view complete data

Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Small Cap Value Composite (Net of Advisory Fees)**11.451.31-2.30-0.81-14.27-5.021.55
Small Cap Value Composite (Net of Bundled Fees)9.640.25-3.20-1.68-14.83-5.161.48
Russell 2000® Value10.335.158.156.36-2.586.084.31

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 10/1/1988.
**Shown as supplemental information.

Past performance does not guarantee future results.

The Small Cap Value 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 6/30/2016, RadiSys Corporation, TriState Capital Holdings, Inc., and Sonic Automotive Inc. represented 1.0%, 3.9%, and 3.7% of the Small Cap Value Composite, respectively.

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

Statements regarding securities are not recommendations to buy or sell.

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.

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®.

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

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