Heartland Select Value Fund 1Q18 Portfolio Manager Commentary

Executive Summary

  • Security selection in Industrials and Materials boosted relative performance and helped the Strategy outperform its benchmark, the Russell 3000® Value Index, returning -1.92% versus -2.82%.
  • Investors rang in the New Year celebrating the passage of tax cuts but then quickly turned their attention to the future.
  • The economy is hitting on all cylinders, but valuations for many companies are near peak levels—and year-over-year sales growth could be difficult to achieve.
  • We continue to seek companies where Street earnings expectations have failed to keep pace with improving sales and earnings trends.
  • Our efforts have resulted in a portfolio that is less economically sensitive and a watch list that contains more small-cap companies than in the recent quarters.

First Quarter Market Discussion

Investors rang in the New Year celebrating the passage of tax cuts but then quickly turned their attention to the future, searching for either catalysts for continued growth and market advances—or overlooked headwinds that could end the long-lived rally.  
On the one hand, employment figures, corporate earnings, and manufacturing data underscored the strength of the business climate. Yet, concerns emerged due to uncertainty related to the new chairman of the Federal Reserve, rising interest rates, and budding inflation. Together, these points of caution countered the euphoria that has driven equities higher in the recent past. 
All told, sentiment remained upbeat—but conviction softened and volatility staged a comeback.

Attribution Analysis

Security selection was positive and the portfolio’s Industrials names propelled the Strategy to outperform its benchmark, the Russell 3000® Value Index. Materials names also boosted results and were up on an absolute and relative basis. The price of crude held steady, but the Energy sector lagged the broader market. The Strategy’s holdings in the sector were also down and lagged those in the benchmark. An underweight to Real Estate boosted results. 
The consensus that rates will continue to climb has stoked selling pressure in bond proxies such as Real Estate and Utilities. Both groups have traditionally been viewed as defensive, but as the chart shows, profitability of Real Estate Investment Trusts have been more cyclical and may be softening once again. Utilities, however could be in the early stages of experiencing earnings growth.
Weak on Defense?
Heartland Advisors Historical Forward Chart
Source: KeyBanc Capital Markets, Thomson Reuters, and FactSet Research Systems Inc., 2/29/2004 to 2/28/2018
Real Estate Investment Trusts (REIT), Next Twelve Months (NTM), Funds From Operations (FFO), Earnings Per Share (EPS).
REIT data is based on all REITs included in KeyBanc Capital's database of coverage.
Past performance does not guarantee future results.
Heartland Advisors Information Technology Sector IconAdvanced technology. Selling pressure was widespread across the benchmark, with the majority of sectors down for the period. Technology was an exception as the space remained a source of strength for the index. This solid performance continued a trend that has persisted for the past few quarters and, we believe, reflects the positive impact tax cuts will have on the cash-rich industry. The portfolio’s names in the space were up and the group contained a top contributor. 
Cisco Systems. Inc. (CSCO), the world’s leading computer networking provider, extended the strong run it started in mid-2017. The company continues to experience growth in its recurring revenue businesses as it deemphasizes its price sensitive hardware line. Booming sales has produced a surge in Cisco’s free cash flow, which reached $13.5 billion during the trailing 12 months.
We believe the strong financial performance should continue as a new sales cycle for the company’s products appears to be in the early stages. Despite a strong run, shares are trading at 10x enterprise value/earnings before interest, taxes, depreciation and amortization (EV/EBITDA), which is at the low end of the range for its peer group. 
Heartland Advisors Industrials Sector IconIndustrial complex. Investors seemed to view higher interest rates and rising raw material prices as potential threats to further economic growth. Those concerns created a drag on many Industrial names and the sector was down in the broader benchmark. The portfolio’s holdings, however, fared better and the group contained a top performer.
Kirby Corporation (KEX), a Texas-based tank barge operator, was up after announcing it was acquiring a competitor in the inland barge business. The deal is expected to add to Kirby’s already dominant position in the space. Management has shown a knack for making shrewd acquisitions in the face of industry weakness and we view the latest deal as a continuation of the approach.
Additionally, the company has seen strong sales growth in its engine repair business, which helped it report better than expected earnings in the most recent quarter.
As Kirby’s engine repair orders and inland river barge business inflect higher, we believe the company’s earnings should continue to expand. Despite the positive developments, shares trade at 2.3x tangible book value, which is at the low end of its historical range.    
Tariff-ied by trade talk? While many of the portfolio’s Industrials holdings were up, others like WESCO International, Inc. (WCC) fell victim to macro-based concerns. Shares of the electrical equipment distributor were down despite reporting better-than-expected earnings and revenue growth. Investors looked past the results and focused instead on the company’s lower margins and fears that trade wars prompted by the enactment of tariffs by the U.S. would impact sales to Canada—the company derives just under 20% of sales from the country.
Concerns about the impact of tariffs are overstated, in our view, as we do not believe trade between the United States and Canada is a material driver of WESCO’s Canadian operation. However, a trade war could indirectly curtail local demand. We also view an uptick in inflation as constructive for the business because as a distributor, the company is positioned to pass along higher costs to clients.

Portfolio Activity

We’ve tuned out recent volatility and instead continue to stick to our discipline of seeking opportunities where the risk-reward profile appears to be mispriced. 
We’ve taken strength in some of our holdings in the Materials space as an opportunity to harvest gains and redeploy assets elsewhere. As part of this approach, we continue to seek businesses that are leaders in their fields where share price has deteriorated while earnings are moving higher. An area we continue to believe holds compelling opportunities is the retail industry. 
Ingredients for success? Recent addition Williams-Sonoma, Inc. (WSM) is an example of a well-known brand we’ve been able to purchase due to pressure in mall-based retail. The company sells home furniture and accessories under the Pottery Barn, Pottery Barn Kids, Pottery Barn Teen, West Elm, Williams Sonoma, Mark Graham, and Rejuvenation brands. Shares have languished due to lower same-store sales at its Pottery Barn locations as well as due to increased competition from online home goods sellers.
We believe the uptick in household formations and elevated consumer confidence should spark a rebound in sales. Additionally, as the chart shows, the deterioration in share price may be overdone and even modest increases sales could result in a solid rebound for shares.
Overlooked Progress
Williams-Sonoma, Inc.
Heartland Advisors Price vs. EPS Chart
Source: FactSet Research Systems Inc., 1/1/2013 to 3/29/2018
Next Twelve Months (NTM)
Past performance does not guarantee future results.
These moves, we believe, have resulted in a portfolio that should be well positioned whether the economy continues to climb, or begins to plateau.

Outlook and Positioning

Heartland Select Value Fund Portfolio Manager Commentary Quote
The economy is hitting on all cylinders, but valuations for many companies are near peak levels—and year-over-year sales growth could be difficult to achieve. If, as expected, interest rates continue to move higher, debt servicing costs will start to impact earnings. Throw in the potential for inflation to heat up and a case can be made for a market where companies will need to rely on more than a rising tide to lift share prices. 
In response, we continue to comb through all sectors and industries in search of businesses facing broad negative sentiment or where Street earnings expectations have failed to keep pace with improving sales and earnings trends. In particular, we are seeking businesses that have already endured a bear market and those that have strong balance sheets that will provide a cushion should the strength of the economy soften. Our efforts have resulted in a portfolio that is less economically sensitive and a watch list that contains more small-cap companies than in the recent quarters. 
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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, Mid Cap Value, and Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 18 years of industry experience, 15 at Heartland.

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In the prospectus (pdf) dated 5/1/2019, the Gross Fund Operating Expenses for the investor and institutional classes of the Select Value Fund are 1.20% and 0.98%, respectively. The Advisor has voluntarily agreed to waive fees and/or reimburse expenses with respect to the institutional class, to the extent necessary to maintain the institutional class’ “Net Annual Operating Expenses” at a ratio not to exceed 0.99% of average daily net assets. This voluntary waiver/reimbursement may be discontinued at any time. 

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As of 3/31/2018, Cisco Systems, Inc., Kirby Corporation, WESCO International, Inc., and Williams-Sonoma, Inc. represented 2.76%, 2.47%, 2.05%, and 0.85% of the Select Value Fund’s net assets, respectively.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

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In addition to stocks of large companies, the Select Value Fund invests in small- and mid-sized companies that are generally less liquid and more volatile than large companies. The Fund also invests in a smaller number of stocks (generally 40 to 60) than the average mutual fund. The performance of these holdings generally will increase the volatility of the Fund’s returns.

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