Heartland Small Cap Value Strategy 3Q17 Portfolio Manager Commentary

 Executive Summary

  • Stock performance was positive and the portfolio remains up year-to-date.
  • Investors reacted to new challenges by sticking with their love affair of momentum and big-cap growth stocks.
  • Speculators tried to guess the next move for Bitcoin, but we stayed with an old-fashioned focus on valuations.
  • An index mania is setting up distortions, including mispricing of businesses, which we hope to capitalize on.
  • Your small-cap portfolio avoids the herd by having 53% of its assets in stocks not held by the benchmark.
“Risk comes from not knowing what you’re doing.”
— Warren Buffett
Third Quarter Market Discussion
Investors reacted to the latest macro challenges by clinging to the same old approach many have followed for almost a decade—ignore valuations and pay up for market darlings. The trend has been going on for so long it seems automatic. Whether it’s a new flare-up in North Korea or gyrations in the price of oil, money continues to flock into momentum stocks. As the chart below shows, the results are particularly striking when looking at the high-flying NASDAQ versus our benchmark of small-cap stocks.
 
Gorging on Growth

Heartland Opportunistic Value Equity Strategy Portfolio Manager Commentary NASDAQ Chart

Source: Bloomberg L.P. and Russell®, 12/30/2016 to 9/29/2017
All indices are unmanaged. It is not possible to invest directly in an index. 
Past performance does not guarantee future results.

With the major indices at historically high multiples, we believe chasing returns leads to overpaying and taking on unnecessary risk. Our approach attempts to mitigate risk by focusing on traditional valuation metrics such as price/earnings (P/E), price/sales (P/S) and buying small, overlooked companies at a discount to our estimates of their intrinsic value. Put simply, valuation does matter.
 

Portfolio Activity

Stock selection was strong in a number of areas with Materials and Energy holdings leading on the upside. Consumer Discretionary and Health Care names detracted from performance, and the Strategy lagged its benchmark.
 
A glittering example of value
While speculators tried to guess the next move of so-called cryptocurrencies like Bitcoin, we trusted our disciplined approach of focusing on valuations. Our work led us to an asset—Gold—that has been out of favor, has a history of being the investment of choice for many in turbulent times, and could benefit from central bankers efforts to fan the flames of inflation.
 
A standout performer for the portfolio during the quarter and year-to-date has been Centerra Gold Inc. (CG CN). Last summer we began accumulating shares of the low-cost, international gold producer because of its history of success:
 
  • Diversified asset base with two cornerstone mines in Canada and Eastern Europe
  • Growing gold and copper reserves
  • Record production—since 2007, Centerra has doubled sales to over $1 billion
  • Low-cost, long-life mines that generate free cash flow
  • A conservative balance sheet with a healthy cash position
  • Solid development program with potential new mines in Canada and Turkey
Due to a protracted dispute with the Government of the Kyrgyz Republic in 2016 the stock was under selling pressure, essentially “wall flowered” while gold and mining shares rallied smartly.  Since the Kyrgyz Government needs royalty mining income & employment, and remarkably owns 26% of Centerra, we believed both parties had a vested interest in reaching a reasonable settlement. It took longer than expected but during the quarter a deal was inked.
 
As seen by the chart below Centerra shares have rebounded from the low and broken out to the upside. We are encouraged that investors have rediscovered the stock and are sitting tight believing the company is worth more than current valuation: only 7X earnings per share (EPS), 4.5X cash flow, and well below our estimate of net asset value.
 
A Golden Opportunity?

Heartland Opportunistic Value Equity Strategy Portfolio Manager Commentary Gold Chart

Source: FactSet Research Systems Inc., 9/28/2007 to 9/29/2017
Past performance does not guarantee future results.

Our holdings in Industrials outpaced the market and the group contained a top contributor.
 
Conviction rewarded
SRC Energy Inc. (SRCI), a name we wrote about last quarter, was up sharply. The company, specializes in oil and natural gas exploration and production using unconventional horizontal drilling in the United States. Shares had a strong run in the second half of 2016 but pulled back in the first half of 2017 despite the business reporting solid earnings results and carrying a pristine balance sheet. Investors grew concerned that proposed local restrictions could hamper production. However, the drilling regulations are unlikely to impact SRC, in our view, because the restrictions focus on curtailing vertical wells, which accounts for just 2% of the company’s production. 
 
Our conviction that these fears were overblown was well rewarded in Q3 2017 as the stock soared nearly 44% in the quarter, far outpacing the average Energy stock in the benchmark. Driving the upside was upward revisions to production guidance for both 2017 and 2018 as well as the maintenance of a strong balance sheet.  
 
SRCI use of horizontal drilling technology increases efficiency and reduces costs. At current prices, shares are trading at a 20% discount to our estimates of net asset value.
 
Home of opportunity
LGI Homes, Inc. (LGIH), a name we’ve highlighted in the past, continued its strong run and was a top contributor for your portfolio. The company is one of the nation’s fastest-growing homebuilders and operates in 10 states in the south and western U.S. It focuses on the entry-level market with an average selling price of just over $200,000. To keep costs down and margins up, LGIH builds standardized homes and uses an aggressive sales and marketing program to target the apartment rental market. 
 
The no-frills approach has helped the company grow from a startup in 2003 to an estimated $1 billion in sales this year. LGIH has made a profit every year since opening and boasts a gross margin the envy of the industry. 
 
Recent home-buying figures point to an uptick in sales to millennials. If this trend takes hold, it should be a boon for LGI due to its focus on first-time homebuyers. Despite growth projections of roughly 20% for the next two years, its shares are trading at less than 11x this year’s estimated EPS. As shares have appreciated, we’ve trimmed some exposure to the real estate market. 
 

Avoiding a False Choice

For the past few years, many investors have chosen one of two paths: Chase the promise of top-line growth or pay a premium in hopes that so-called defensive areas won’t sell off when interest rates rise or the economy cools. As disciplined value investors, these seem to be flawed choices. Buying companies that can produce earnings growth shouldn’t mean having to pay an exorbitant price. And being defensive, in our view, has less to do with which sector a business is in than it does with the cost of buying the company.
 
Leveraging hard work and the knowledge gained through Heartland’s more than 280 years of investment experience, the team believes market inefficiencies have created dramatic opportunities, particularly among small businesses that are not part of an index.
 
Although the NASDAQ may be trading at vertigo-inducing 23.6x P/E***, we are still finding well run, growing businesses providing double-digit earnings yields. Unearthing these opportunities demands digging into balance sheets, understanding management teams, and examining valuations. Put simply, it requires knowing what you are doing in a way that a passive index portfolio or momentum investors could never match. And as Mr. Buffett noted Ignorance is risk.
 
Your Heartland Value Team
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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 49 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, 14 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 Composite (Net of Advisory Fees)**11.662.952.480.837.393.043.33
Small Cap Value Composite (Net of Bundled Fees)9.912.051.710.247.072.803.25
Russell 2000® Value10.907.1413.2712.1220.555.685.11

Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.

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*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 10/1/1988.
**Shown as supplemental information.
***NASDAQ Composite Index P/E (trailing 12 months) as of 9/29/2017.

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 9/30/2017, Centerra Gold Inc., LGI Homes, Inc., and SRC Energy Inc. represented 5.13%, 1.95%, and 4.18% of the Small Cap Value 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.

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.

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

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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