Heartland Mid Cap Value Fund 4Q17 Portfolio Manager Commentary

Executive Summary

  • Stock selection was strong with holdings in Real Estate and Consumer Discretionary helping the Fund beat its benchmark, the Russell Midcap® Value Index returning 6.75% versus 5.50%.
  • A steady stream of positive economic news led investors to bid up equities and the major indices notched several new highs during the period.
  • Corporate debt is reaching levels not seen since the Great Recession, and the yield curve has begun to flatten.
  • We have upgraded the quality of names in areas such as Energy.

Fourth Quarter Market Discussion

Buoyed by a steady stream of positive economic news, investors poured money into equities and the major indices notched several new highs during the period. Bullish signs were widespread with 73% of companies in the S&P 500 beating consensus earnings estimates for the quarter. 
An improving energy market, progress on pro-growth tax legislation, and forecasts for a jump in business investment convinced many that the recent surge had staying power. Newfound optimism led to some bargain hunting as investors concluded that earnings growth may be easier in the quarters ahead, and so could be found in a broader list of companies trading at lower valuations. 
While the mood on Wall Street was upbeat, areas of concern remain. Corporate debt is reaching levels not seen since the Great Recession, and the yield curve, as shown, has begun to flatten.
Have Expectations Gone Flat?
U.S. Treasury Yield Curve
Heartland Advisors Value Investing Portfolio Manager Commentary U.S. Treasury Yield Curve
Source: U.S. Department of the Treasury
Past performance does not guarantee future results.
Attribution Analysis
Stock selection in several areas led the portfolio to beat its Russell Midcap® Value benchmark for the quarter. Real Estate stood out along with the Strategy’s Consumer Discretionary holdings. Allocation decisions contributed positively. The portfolio’s Financials names detracted mildly on a relative basis. 
Heartland Advisors Value Investing Portfolio Manager Commentary Real Estate Sector IconLeveraging expertise. Real Estate names as a whole continued the sideways trend they’ve followed for much of the year; however, the portfolio’s holdings were up and the group contained a key contributor. Jones Lang LaSalle Incorporated (JLL), a top global real estate consultant and brokerage, was up after posting better than expected earnings and an improving balance sheet.
We initiated a position in the business this spring on the belief that the market was too aggressively projecting earnings declines going forward. Additionally, commercial real estate is becoming more global and institutionally oriented, which should bode well for industry leaders such as JLL that can provide valuable expertise to insurance companies and other property investors. As earnings have improved and management streamlines the cost structure, shares have taken off and valuations have climbed. We’ve trimmed our exposure in response to mitigate risk, but the company remains a full position in the portfolio. 
Heartland Advisors Value Investing Portfolio Manager Commentary Consumer Discretionary Sector IconNavigating success. The portfolio’s Consumer Discretionary names were a point of strength on both an absolute and relative basis and included a solid contributor. Garmin Ltd. (GRMN), a manufacturer of navigation and communication equipment, was rewarded after reporting better than expected earnings. The business has consistently beat expectations over the past 18 months as the decline in its legacy personal navigation devices for cars has been slower than expected. Additionally, Garmin has been successful rolling out new products in its fitness, outdoor, marine, and aviation segments. 
We remain constructive on the company as it is starting to get traction in sales of in-dash GPS equipment. This represents a significant opportunity to solidify a foothold with automakers. Further, Garmin could benefit from a new federal mandate that requires all aircraft be updated to comply with new air traffic modernization standards.
An uptick in its automotive and aviation lines should boost margins, in our view, and as margins expand we think market multiples will also increase. 
Heartland Advisors Value Investing Portfolio Manager Commentary Energy Sector IconPriming the pump? Oil moved higher during the quarter and Energy stocks enjoyed a bounce. The portfolio’s holdings in the space were off modestly and contained a detractor. Shares of National Oilwell Varco, Inc. (NOV), a leading global oilfield services company, lagged as investors continue to wait for an uptick in orders before rewarding the stock.
We view NOV as a deep value opportunity that is trading near the trough of its business cycle. The company has a history of strengthening its business line during downturns and, in our opinion, has done so again. Shares are trading at just 0.9x book value—near all-time lows. The company has historically generated 10-20% return of equity over cycles, and can do so next time around at even lower levels of activity with its lower cost structure. 
As the Energy space begins to mend, we believe NOV’s products will make it an early beneficiary. In addition to providing rigs to the industry, the company’s Wellbore Technologies unit develops and sells various technologies and equipment that is critical to the cost-effective production of energy.
Heartland Advisors Value Investing Portfolio Manager Commentary Sector IconShaking off the rust. Our Materials holdings were up on an absolute basis and we continue to focus on companies that can drive improvements in earnings through self-help. For example, Cleveland-Cliffs Inc. (CLF), a Midwest-based iron ore producer, has refocused its strategy to leverage significant competitive advantages it holds in the Great Lakes region.
Shares initially fell after management issued debt to fund development of an ore processing plant that makes hot briquetted iron, which is easier to ship and can be more desirable for use by manufacturers. The project makes sense in our view, as it should allow Cleveland-Cliffs to serve additional clients that prefer briquette iron to produce steel. We’ve also been impressed with management’s ability to cut costs and exit less profitable markets. The result of these efforts is a company that generates 2x-3x the margins of some of its best competitors in the metals industry. 
With shares trading at just 7x earnings before interest, taxes, depreciation and amortization (EBITDA), we view the stock as having strong upside potential.

Portfolio Activity

The environment for price-sensitive investors has become more challenging in recent months, but there are still ample opportunities to find compelling investments away from some of the more speculative names in the market. Against this backdrop, we have trimmed some winners and added to existing investments and initiated new positions. 
The result of the activity is a portfolio that holds roughly two-thirds of its assets in more traditional value opportunities characterized by good companies experiencing a temporary overhang that has resulted in depressed valuations. The remaining third is held in less distinguished businesses trading at significant discounts. 
As always, each buy and sell decision is based on the underlying fundamentals of the company; this work has resulted in increased exposure in the Consumer Staples and Materials sectors. We have also been able to upgrade the quality of our names in areas such as Energy.

Outlook and Positioning

Heartland Mid Cap Value Fund Portfolio Manager Commentary Quote
Last quarter, we suggested that macro events would stop driving the market under the following scenarios: Data started to confirm the economy is strong enough to stand on its own; or valuations for momentum, growth, and defensive stocks became too bloated to ignore. The past three months appears to support our view. Data continues to point to widespread economic strength, and investors are once again focusing on stock prices. 
It is too early to determine whether the change has staying power; however, we believe there are a few areas that will provide greater clarity: 
  • Will the upbeat outlook for business investment translate to a surge in capital expenditures?
  • Will the yield curve continue to flatten or possibly invert—forecasting a weakening economy?
  • What do corporations do with the windfall from recently approved tax cuts? 
While we are monitoring these developments, the results will not change our philosophy or process. The team continues to seek attractively valued companies across all sectors. We remain focused on balance sheet strength, and on identifying catalysts that can result in a change in perception by investors.
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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Colin McWey

Colin McWey

McWey, CFA, is Vice President and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He has 16 years of industry experience, 9 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 18 years of industry experience, 14 at Heartland.

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In the prospectus (pdf) dated 5/1/2018, the Net Fund Operating Expenses for the investor and institutional classes of the Mid Cap Value Fund are 1.25% and 0.99%, respectively. The Advisor has contractually agreed to waive its management fees and/or reimburse expenses of the Fund to ensure that Net Fund Operating Expenses for the Fund do not exceed 1.25% of the Fund’s average net assets for the investor class shares and 0.99% for the institutional class shares, through at least 5/1/2019, and subject thereafter to annual reapproval of the agreement by the Board of Directors. Without such waiver and/or reimbursements, the Gross Fund Operating Expenses would be 2.50% for the investor class shares and 2.45% for the institutional class shares.

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As of 12/31/2017, Cleveland-Cliffs Inc., Garmin Ltd., Jones Lang LaSalle Incorporated, and National Oilwell Varco, Inc. represented 1.12%, 1.42%, 2.54%, and 2.73% of the Mid Cap Value Fund’s net assets, respectively.

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The Mid Cap Value Fund invests in a smaller number of stocks (generally 30 to 60) than the average mutual fund. The performance of these holdings generally will increase the volatility of the Fund’s returns. The Fund also invests in mid–sized companies on a value basis. Mid-sized securities generally are more volatile and less liquid than those of larger companies. There can be no assurance that the Fund will grow to or maintain an economically viable size, in which case the Board of Directors may determine to liquidate the Fund.

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