Heartland Select Value Fund 1Q19 Portfolio Manager Commentary

Executive Summary

  • Security selection was mixed, and the portfolio’s Energy and Information Technology holdings boosted relative returns, but the Fund lagged its benchmark, the Russell 3000® Value Index, returning 10.63% versus 11.93%.
  • Investors responded to the Federal Reserve’s freeze on rate hikes and favorable signs from the credit market and equities were up sharply.
  • The sharp runup for stocks to start the year provided opportunities to harvest gains and redeploy assets.

First Quarter Market Discussion

Investors returned to equities during the period and the major indices sprinted ahead, recouping nearly all their losses from the previous quarter.
 
Both cyclical and defensive areas advanced as investors responded to the Federal Reserve’s freeze on rate hikes and favorable signs from the credit market, where bond yields suggested stronger economic sentiment. 
 
However, later in the quarter, caution about economic strength emerged, as data pointed to slower growth in the quarters ahead and trade tensions continued to simmer globally. The rally lost steam and the equity markets were range bound for much of March.
 

Attribution Analysis

Security selection in Energy and Information Technology boosted relative results, but the Strategy lagged its benchmark, the Russell 3000® Value Index, for the quarter. Holdings in Consumer Services were particularly strong during the period. An overweight to and stock selection in Health Care detracted from relative results. The portfolio’s holdings in Financials were up on an absolute basis but failed to keep pace with those in the benchmark. 
 
Heartland Advisors Value Investing Energy Sector IconBlack gold. Oil prices broke free of their prolonged slump and Energy stocks surged. The portfolio’s holdings in the sector were up sharply and contained a key contributor, Berry Petroleum Corporation (BRY). 
 
Berry, an oil producer focused on reserves in California, was up in response to stable demand and firmer prices. The company’s production footprint is a differentiator in our view. Because it operates outside of the red-hot Permian basin, Berry faces less competition in attracting skilled labor and therefore benefits from lower production costs. Additionally, with fewer domestic producers of Brent crude, prices have been firmer than other grades of crude. 
 
With the stock trading at just 7.4x 2019 earnings per share compared to a 20-year median of 14.5x for the industry, we view Berry as significantly undervalued. Given its plans to grow oil production by 13% this year and ability to continue to pay a meaningful dividend, the company should have a clear path to generate multiple expansion on earnings. 
 
Heartland Advisors Value Investing Health Care Sector IconPrescription for improvement? The portfolio’s Health Care holdings were up for the period and we continue to see opportunity in the group in names such as pharmaceutical holding, Sanofi (SNY).
 
Shares of the France-based Sanofi have been under pressure due to rising competition for its diabetes franchise of drugs. So far, runoff in the segment has been slower than projected and we believe the bulk of the declines have already occurred. Additionally, diabetes and cardiovascular medicines account for just 13% of sales for the company making it the smallest of its five areas of focus.  
 
Recently there have been signs that Sanofi’s other products may be making up for erosion in its diabetes business as sales estimates have begun to improve. Trading at a mid-teens priced/earnings discount relative to its peers, and offering a 4% dividend yield, the company is a compelling opportunity in the Health Care space, in our view.
 
Heartland Advisors Value Investing Financials Sector IconFinancially sound. The strategy’s Financials holdings were up with double-digit gains in several industries. Shares of Berkshire Hathaway Inc. (BRK.B), a multi-business holding company run by legendary investor Warren Buffett, however, were off modestly during the period despite the company announcing better than expected earnings for its most recent quarter. 
 
We believe the lackluster near-term performance of shares has been driven by investors chasing greater growth elsewhere. We view many of those opportunities as offering inadequate upside potential relative to the downside risk should they fail to achieve optimistic growth targets in an aging economic expansion. 
 
Despite strong returns in 2018, Berkshire continues to trade at a nearly 30% discount to its peers, and nearly 40% lower than the broader market based on our analysis. We view these valuations as compelling and anticipate further upside for the shares.
 

Portfolio Activity

A sharp runup for stocks to start the year provided opportunities to harvest gains and redeploy assets into names where valuations have receded resulting in an attractive risk/reward profile. Through our research, we have sought companies that are poised to succeed against a variety of backdrops or those that are priced at significant discounts to mid-cycle earnings levels.
 
For example, we initiated a position in ManpowerGroup Inc. (MAN), a global staffing firm. With offices in 80 countries and a mix of industrial and IT staffing services, the company is the third-largest agency of its type in the world. 
 
Shares of Manpower had been under pressure recently due to a slowing European economy, where the company generates two-thirds of its revenue. While we expect revenue to decline in the short term, we see the shares as offering an attractive risk/reward profile, particularly relative to industrial stocks with a greater mix of domestic exposure. 
 
Longer term, we expect margins to expand as a result of management’s strategy of reducing costs and leveraging its scale to gain share in the high-margin recruitment outsourcing industry. Manpower’s balance sheet is strong, and the board has approved opportunistic share repurchases in the past resulting in 4% fewer shares outstanding in 2018 relative to 2017. Higher margins with a lower share count should drive higher cycle-to-cycle earnings power. 
 
With Manpower trading at less than 6.5x 2019 earnings before interest, taxes, depreciation, and amortization (EBITDA), versus a peer group average of over 8x, we believe valuations are overstating the bear case for the stock. Additionally, relative to U.S. industrials, Manpower’s stock is trading at the low end of its 20-year historical average across several valuation metrics.
 

Outlook and Positioning

The sell-off to close out 2018 and the subsequent snap back to start this year highlight the uncertainty about where the economy goes from here. While we could make equally compelling arguments for a continued expansion or a global slowdown, we believe our energy is better spent identifying companies where future downside appears to already be priced into the stocks.
 
For example, we’ve taken advantage of weakness in the Consumer Discretionary space over the last several months and purchased names that have stumbled, as shown below, due to a tepid outlook for the economy.
 
Opportunities in Consumer Discretionary 
Heartland Advisors Value Investing Consumer Discretionary Chart
Source: Bloomberg L.P. and Heartland Advisors, Inc., 12/31/2014 to 3/29/2019
Portfolio holdings are subject to change. Current and future holdings are subject to risk. 
Past performance does not guarantee future prices.
 
While broad indices could continue their bumpy ride for the next several quarters, we believe there will be ample opportunities for individual companies to distinguish themselves in the eyes of investors. This dynamic should benefit active investors who focus on fundamentals and identifying catalysts for positive change.
 
Thank you for the opportunity to manage your capital.
 
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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, 15 at Heartland.

Fund Returns

3/31/2019

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Since Inception (%)20-Year (%)15-Year (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD* (%)QTD* (%)
Select Value
Investor Class
10.0710.208.7913.676.8111.987.4210.6310.63
Select Value
Institutional Class
10.2310.379.0213.987.0712.237.6710.6710.67
Russell 3000® Value8.606.877.6014.507.5610.505.3011.9311.93
*Not annualized

The inception date for the Select Value Fund is 10/11/1996 for the investor class and 5/1/2008 for the institutional class.

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In the prospectus (pdf) dated 5/1/2018, the Gross Fund Operating Expenses for the investor and institutional classes of the Select Value Fund are 1.23% and 1.01%, 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. Also, through 11/30/01, the Advisor voluntarily waived a portion of the Fund’s expenses. Without such waivers and/or reimbursements, total returns may have been lower.

Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance information for institutional class shares of Funds that existed prior to their initial public offering is based on the performance of investor class shares. The investment return and principal value will fluctuate so that an investor's shares, when redeemed may be worth more or less than the original cost. All returns reflect reinvested dividends and capital gains distributions, but do not reflect the deduction of taxes that an investor would pay on distributions or redemptions. Subject to certain exceptions, shares of a Fund redeemed or exchanged within 10 days of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual's return.

An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the prospectus (pdf). To obtain a print prospectus, call 800-432-7856. Please read the prospectus carefully before investing.

As of 3/31/2019, Berkshire Hathaway Inc., Berry Petroleum Corporation, D.R. Horton Inc., ManpowerGroup Inc., Mohawk Industries, Inc., Sanofi, and Thor Industries, Inc. represented 5.24%, 1.09%, 1.57%, 1.48%, 1.32%, 1.99%, and 1.33% 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.

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.

Sector and Industry classifications are sourced from GICS®.The Global Industry Classification Standard (GICS®) is the exclusive intellectual property of MSCI Inc. (MSCI) and S&P Global Market Intelligence (“S&P”).  Neither MSCI, S&P, their affiliates, nor any of their third party providers (“GICS Parties”) makes any representations or warranties, express or implied, with respect to GICS or the results to be obtained by the use thereof, and expressly disclaim all warranties, including warranties of accuracy, completeness, merchantability and fitness for a particular purpose.  The GICS Parties shall not have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of such damages.

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.

Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

Brent Crude is a type of petroleum classification given to oil from the North Sea and is used as a common benchmark in European oil pricing. 

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

The above individuals are registered representatives of ALPS Distributors, Inc.

The Heartland Funds are distributed by ALPS Distributors, Inc.

CFA® is a registered trademark owned by the CFA Institute.

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.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

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