Heartland Select Value Fund 4Q17 Portfolio Manager Commentary

Executive Summary

  • Security selection in Consumer Staples and Consumer Discretionary boosted relative performance and helped the Strategy outperform its benchmark, the Russell 3000® Value Index, returning 5.79% versus 5.08%.
  • Strong employment data, continued solid gross domestic product (GDP) growth, and new tax legislation drove the major indices to new highs during the period.
  • Valuations have been on a steady climb for the past few years and are pricing in a best case scenario.
  • We are seeking businesses that have already endured a bear market and where recent improvements in earnings are being overlooked.

Fourth Quarter Market Discussion

Strong employment data, continued solid GDP growth, and progress on tax legislation provided fuel for the aging bull market and the major indices notched new highs during the period. The euphoria led to broad strength with each of 11 sectors in the Russell 3000® Value Index gaining ground. A firming consensus that the economy had room to run, ushered in a wave of speculation as Bitcoin surged as did the use of margin on the New York Stock Exchange. 
While investors focused on the positive, areas of concern remain. Corporate debt is hitting levels not seen since before the great recession and the yield curve has flattened.

Attribution Analysis

Security selection was positive and the portfolio’s Consumer Staples names propelled the Strategy to outperform its benchmark, the Russell 3000® Value Index. Our Industrials names also boosted results and were up on an absolute and relative basis. The price of crude moved up for the quarter but the portfolio’s Energy holdings were down and detracted from relative results. Allocation decisions had little impact. 
Heartland Advisors Value Investing Portfolio Commentary Consumer Staples Sector IconSpending spree. A rosy economic outlook put consumers in a spending mood and Consumer Discretionary and Consumer Staples names benefited. The portfolio enjoyed broad strength in each group and the Staples sectors contained a top contributor. 
Retail giant Wal-Mart Stores, Inc. (WMT) was up after posting its 13th consecutive quarter of same store sales growth. The department store has successfully reduced inventory levels, but, more importantly, the company continues to see improved online sales—jumping 50% in the third quarter. The increase is consistent with management’s view that future gains will be driven by e-commerce.
As the world’s largest retailer, we believe Walmart is well positioned to successfully compete with Amazon.com (AMZN) and maintain market share at a time when many smaller competitors can’t make investments necessary to stay relevant.
Heartland Advisors Value Investing Portfolio Commentary Health Care Sector IconHealthy outperformance. The strong run Health Care enjoyed in the third quarter cooled as investors looked to more economically sensitive sectors for opportunities. However, the Strategy’s holdings outperformed on a relative basis and contained a top contributor.  
Triple-S Management Corporation (GTS), a managed care company in Puerto Rico that operates under the Blue Cross name, continued its strong run after posting results that beat consensus estimates. The company is up 45% in the past six months on continued improvement of its loss ratios, and management’s progress cutting costs. We remain constructive on the name and believe there are emerging signs reimbursement rates it receives from Medicaid are on the cusp of improving. Despite the run up in share prices, the company trades at just 70% of book value versus 2x to 10x for peers.
Heartland Advisors Value Investing Portfolio Commentary Financial Sector IconAn ebb in flows. The portfolio’s Financials holdings were up on an absolute basis but lagged the average for the benchmark. Banks have been able to maintain exceptional credit quality on loans for the past several years and we believe it may be difficult to continue to increase lending without an uptick in charge offs. In response, we’ve found compelling valuations elsewhere in the group. For example, Franklin Resources, Inc. (BEN) remains an attractive opportunity in our opinion.
Shares of the global investment management company were down as an improvement in asset flows stalled. Despite the setback, we believe, management has been prudent capital allocators as shown by its willingness to buy back shares at depressed prices as opposed to paying up for acquisitions. While the popularity of index investing and growth stocks may persist in the near-term, we believe when the tide changes, Franklin will be well positioned to succeed.

Portfolio Activity

We’ve taken strength in many of our names as an opportunity to harvest gains and redeploy assets elsewhere. In other cases, such as in the Energy space, we’ve rotated holdings within a sector based on risk-reward profile of a given stock. These moves, we believe, have resulted in a portfolio that should be well positioned whether the economy continues to climb, or begins to plateau. 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. The Strategy’s exposure to Consumer Staples is down, however, the sector contains a recent addition. 
Snap, crackle, pop? Recent addition Kellogg Company (K) is an example of the type of business we’ve found attractive. The company manufactures breakfast cereals under well-known brands such as Special K, Rice Krispies, and Frosted Flakes. Shares have slumped as consumers have increasingly gravitated to organic offerings and private label products. Much of the loss of revenue can be traced to declining sales of Special K and its Protein line of offerings as the low-carb trend has begun to fade. 
Headwinds for the company are well known and shares have been in a slump. However, as shown in the chart, investor outlook isn’t keeping pace with the improving story. Through the first three quarters of 2017, the sales trend for Special K appears to be stabilizing and could signal an inflection point for the marquee brand.
A Disconnect in Value?
Kellogg Company

Heartland Select Value Fund Portfolio Manager Commentary Kellogg vs EPS Chart

Source: FactSet Research Systems Inc., 1/2/2013 to 12/29/2017
Next Twelve Months (NTM)
Past performance does not guarantee future results.

The focus on Special K overlooks the larger story for the company. The company spends 30% more than competitors on overhead and has ample room to cut costs. Kellogg recently hired a new CEO from an outside firm which we view as providing additional energy to improved efficiencies and cost-cutting initiatives. Despite the compelling stable of established brands and potential to rein in costs more in line with competitors, shares of the business trade at 15x earnings compared to the long-term average of 17x.

Outlook and Positioning

Heartland Select Value Fund Portfolio Manager Commentary QuoteEconomic optimism seems rampant—and for good reason. Business investment is projected to jump in the New Year, corporate earnings have been on a winning streak, and manufacturing data paints a robust picture worldwide. But with heightened expectations come greater risks. Valuations have been on a steady climb for the past few years and are pricing in a best case scenario. As such, even mildly negative news could trigger a sharp pull back in equities. 
In response, we continue to comb through all sectors and industries looking for opportunities with leading industry players where we believe risk is mispriced. In particular, we are seeking businesses that have already endured a bear market and where recent improvements in bottom-line results are not yet reflected in its stock. 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. 
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, 14 at Heartland.

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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.

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As of 12/31/2017, Amazon.com, Franklin Resources, Inc., Kellogg Company, Triple-S Management Corporation, and Wal-mart Stores Inc. represented 0.00%, 2.04%, 1.16%, 2.12%, and 2.95% of the Select Value Fund’s net assets, respectively.

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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.

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