Heartland Select Value Fund 1Q20 Portfolio Manager Commentary

Executive Summary

  • Widespread selling pressure took a toll on the portfolio’s holdings, but as the downturn accelerated in March, many of our holdings with robust balance sheets showed some resilience. 
  • While fears related to Coronavirus were the driving force behind selling pressure, other factors added to the decline.

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.

First Quarter Market Discussion

Volatility ruled the day, as shown below, as investors struggled to quantify the impact of an unforeseen global health challenge. The rapid erosion of the markets was a stark contrast to the generally upbeat mood on Wall Street to start the year.

CBOE Volatility Index
Source: FactSet Research Systems Inc., 1/2/2004 to 3/31/2020
Chicago Board Options Exchange Market Volatility Index (CBOE VIX) is a mathematical measure of how much the market thinks the S&P 500 Index option will fluctuate over the next 12 months, based upon an analysis of the difference between current S&P 500 put and call option prices. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.


While fears related to Coronavirus were the driving force behind selling pressure, other factors added to the decline. A carryover of investor euphoria from the strong showing in 2019 left valuations rich even by robust growth expectations. As the number of COVID-19 cases spiked, and businesses and governments began taking more aggressive efforts to mitigate the spread of the illness, what had been considered reasonable economic projections were slashed and the consensus became that a recession was underway.
 
Oil prices plummeted in reaction to the prospect for lower crude demand in the months ahead and as a price war broke out after OPEC failed to reach an agreement on production cuts. Weakness in the Energy space had a carryover effect on many cyclically oriented businesses.

Finally, economic pessimism caused banks to tighten their lending activity to certain pockets of the economy, and investors grew wary of highly levered businesses. 

Attribution Analysis

Widespread selling pressure took a toll on the portfolio’s holdings, but as the downturn accelerated in March, many of our holdings with robust balance sheets showed some resilience. 

Holdings in Energy fared better than the average for the benchmark, as did names in the Information Technology space. An overweight to Consumer Discretionary detracted from relative performance.
 
Pumped up on quality. As fortunes reversed in the equity market throughout March, we were able to add to some high-quality names as their valuations became more attractive. For example, we had been selling shares of Gorman-Rupp Company (GRC), a global-leading manufacturer of pumps used in municipal water, industrial, agricultural and petrochemical applications early in the quarter as it approached our estimates of fair value. But as the market began to sell off, valuations once again reached attractive levels and we began to add shares. 

Because of the critical nature of the pumps Gorman-Rupp makes, customers place a premium on product reliability, and pricing is a not a leading driver of sales. As a result, Gorman-Rupp has consistently earned high returns on invested capital – averaging 13% over multiple decades. Additionally, the company has no outstanding debt and has historically maintained a conservative financial position, resulting in 46 consecutive years of dividend increases—top 50 of all publicly traded companies.
  
While we believe the industrial economy will be challenged in the intermediate term, Gorman-Rupp should benefit from demand for water projects throughout the country. Water infrastructure is funded with tax receipts and therefore is less sensitive to the economic cycle. We have seen several large municipalities raise money to upgrade their water pump station infrastructure, which we believe will benefit Gorman-Rupp in the years to come.
 
Heartland Advisors Value Investing Consumer Staples Sector IconThe CALM approach. Consumer Staples are often viewed as a safe haven in a faltering economy; however, we believe debt levels of businesses in the sector could separate the winners form losers against the current backdrop. Cal-Maine Foods, Inc. (CALM) is an example of our thinking.

Cal-Maine is the largest egg producer in the U.S., offering its products under the Egg-Land’s Best, Land-O-Lakes and Farmhouse brands as well as through its private label division. The egg industry is highly fragmented, and excess production during recent years has resulted in significant pricing pressure. 

Lower prices could disproportionately affect smaller players as well as those with marginal balance sheets. This dynamic should favor Cal-Maine with its greater scale and strong balance sheet.  The company is well-positioned to opportunistically acquire smaller players, which should translate into greater efficiency. Additionally, we believe egg prices will firm as production capacity shrinks due to industry consolidation. 

As supply/demand dynamics improve, we believe Cal-Maine could reach valuations of 3x book value, up from its current 1.9x level. 
 

Heartland Advisors Value Investing Financials Sector IconHealth Check. The global spread of COVID-19 has put a spotlight on the Health Care sector and many pharmaceutical companies in particular, as scientists race for a vaccine against the virus. We’ve long been scouring the space for compelling opportunities. That work led to our position in Johnson & Johnson (JNJ), a stalwart in the Health Care sector.

Shares of JNJ have been shadowed by concerns related to its liability tied to opioid production. Based on historical valuations, at the time we initiated our position, the market was assigning a $32 billion liability tied to opioid settlements. That liability figure was excessive in our view but provided an attractive opportunity to buy a well-run, industry leading business.
 
In the time since we initiated a position, valuations have improved, suggesting that others have begun to see the firm’s opioid liability as lower than originally forecast. We believe over the coming quarters, JNJ will return to trading at valuations equal to or slightly above those for the S&P 500. 

Portfolio Activity

We’ve been patient during the market sell off and let our process guide our buy and sell decisions. Following a consistent approach has resulted in opportunistic upgrades to the portfolio as valuations have come down and the risk-reward profile on market-leading companies has become more favorable when viewed over a timeframe of 18 to 36 months.
   

Outlook and Positioning

The toll form COVID-19 has been significant on both a personal and economic scale. Yet, the current environment, while painful, has created a pool of opportunity that is well-stocked with high-quality companies trading at compelling multiples. 

As we sort through the companies that hit our radar, we will not change our philosophy or process. The team continues to focus on valuations, balance sheet strength and catalysts that can result in a change in perception by investors. We believe this disciplined application of our process will be key to navigating the quarters ahead. 

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 17 years of industry experience, 10 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 President and Director of Heartland Funds. He has 19 years of industry experience, 16 at Heartland.

Heartland Advisors Value Investing Research Analyst Troy McGlone

Troy McGlone

McGlone, CFA, is Vice President and Portfolio Manager of the Select Value Fund and its corresponding separately managed account strategy. He has 11 years of industry experience, 5 at Heartland.

Fund Returns

3/31/2020

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Since Inception (%)20-Year (%)15-Year (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD* (%)QTD* (%)
Select Value
Investor Class
8.368.065.865.250.37-3.86-23.87-28.98-28.98
Select Value
Institutional Class
8.528.246.115.540.61-3.63-23.66-28.95-28.95
Russell 3000® Value7.315.475.337.471.62-2.67-18.02-27.32-27.32
*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 5/1/2020, the Gross Fund Operating Expenses for the investor and institutional classes of the Select Value Fund are 1.25% and 1.02%, 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. 

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 3/31/2020, Cal-Maine Foods, Inc., Gorman-Rupp Company, and Johnson & Johnson represented 3.05%, 1.73%, and 4.44% of the Select Value Fund’s net assets, respectively.  Statements regarding securities are not recommendations to buy or sell. Portfolio holdings are subject to change. Current and future holdings are subject to risk.

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.

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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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