Heartland Value Fund 2Q18 Portfolio Manager Commentary

Executive Summary

  • The rush into large-cap growth equities has left major swaths of the market out of favor.
  • Your portfolio was up for the quarter but lagged its benchmark despite strong performance in Information Technology and Real Estate.
  • Recent flows and strong performance of smaller companies may mark a turning point.
“Being out of fashion ultimately enhances opportunities on the other side.”
 
—John Neff
Investor and Philanthropist
 

Second Quarter Market Discussion

Staying power for the bigger-is-better investing trend has been remarkable. For most of the past nine years the markets have taken a one-size (i.e. Large) approach to everything the economy has produced. Revenue is growing too slow? Go mega. Tax cuts are coming? Buy large-cap growth. Rates are headed higher? Sounds like bigger is better.
 
The knee-jerk rush into large caps has left major swaths of equities out of favor and trading at attractive levels. But as Mr. Neff noted, meaningful upside can be had for those focused on the bargain bin. And while fashion can be fickle, we see reasons to be optimistic. Here are a few:
 
  • A stronger dollar and trade tariffs are a headwind for large corporations that sell products overseas but have minimal impact on small, domestic-focused businesses.
  • Tax reform is pro-growth and should reduce the burden on small companies and encourage business investment.
  • Higher interest rates traditionally favor active management. Not all businesses are impacted the same by higher borrowing costs; it takes active analysis to separate the winners from losers. 
  • Regulatory relief. As the current Administration revises existing policies, small businesses should find the environment more conducive to growth.
We’ve highlighted these themes in the past, and now market performance is pointing to others taking notice. Since the correction that knocked the S&P 500 off its highs set in January, the Index has yet to regain its momentum. The sideways move is striking in light of the 25% earnings growth the group posted during the first quarter. It’s also worth noting that during the period, small caps trounced their large-cap counterparts.
 
Regardless of whether large or small lead the way going forward, we do believe businesses with the following attributes will be rewarded:
 
  • They’ll serve unique niches
  • Strong balance sheets
  • Capable, committed management
  • Compelling valuations
Identifying these traits continues to be the focus of our work at Heartland, and we believe is a sound approach to capitalize on the opportunity Mr. Neff describes. The following highlights some of the compelling businesses in your portfolio that we’ve found in our hunt through the ranks of the overlooked.
 

Good Bones 

Household formations continue to climb spurring a boom in demand for housing—Millennials are finally buying. As shown, inventories are at all-time lows.  We view this as an opportunity for a well-managed builder such as Century Communities Inc. (CCS).
 
For Sale Inventory: 1988-2018
Existing and New Homes for Sale
Heartland Advisors Value Investing For Sale Inventory Chart
Source: National Association of Realtors, U.S. Census Bureau, and Raymond James Research. Data through May 2018.
Recession periods: July 1990 to March 1991, March 2001 to November 2001, and December 2007 to June 2009.
 
CCS was founded in 2000 by brothers Dale and Robert Francescon.  The two have a successful track record in launching new homebuilding companies and reaping value from them.  For example, in 1993 the pair owned and operated the largest builder in Colorado which they sold to D.R. Horton Inc. (DHI) in 1996.  
 
CCS is now the 10th largest public builder and the fastest growing as of 2017.  The company has 5-year compounding revenue growth of 71%, and its earnings before interest, taxes, depreciation and amortization has grown at a 61% compounded annual rate over that time frame. Acquisitions have played a major role in the trajectory of the company and management has shown a knack for acquiring assets when they are depressed. This shrewd approach was on display recently when the company announced it was buying Wade Jurney Homes, the fastest growing privately-held builder in the country. Wade Jurney focuses on the red-hot entry level segment with home and lot packages averaging just $155,000.
 
The recent acquisition positions CCS to capitalize on pent up housing demand and we expect industry-leading earnings growth. Despite its dominant position among builders, the company is trading at just 7x projected 2019 earnings—a 20% discount to the peer average, and less than half the valuation for the S&P 500.
 

Healing From a Minor Cut

The portfolio’s Financials holdings were up on an absolute basis and we continue to see compelling opportunities in select areas such as mortgage insurers. Longtime holding Radian Group Inc. (RDN) was down in response to price cuts from counterparts. The pricing pressure came on the heels of an announced deal between one of its competitors and Federal Home Loan Mortgage Corporation (FMCC) which would bypass mortgage insurers in a small portion of the market.
 
In both cases, we believe investors overreacted. The deal struck with FMCC amounts to a narrow group of borrowers that is dwarfed by the total mortgage insurance market. We also view the reduced pricing as a short-term setback for a business that is enjoying excellent fundamentals. First-time home ownership is on the rise, credit quality of the loans insured is strong and gradually increasing rates usually results in less refinancing and, in turn, homeowners keeping mortgage insurance for longer.
 
Trading at 7.3x estimated 2018 earnings and only 1.2x book value, the company, in our view, is a bargain in an industry vital to the domestic economy. A share buyback program and insider buying by management underscores our confidence in Radian.
 

Coming in From the Cold?

A cool spring in the Northeast and Midwest took its toll on one of the Portfolio’s Industrial names. Hudson Technologies, Inc. (HDSN) was down after prices for R-22 refrigerant were off in response to cold weather in parts of the country.
 
Following last year’s acquisition of one of its competitors, Hudson controls roughly 40% of the reclaimed R-22 market. The Environmental Protection Agency (EPA) enacted laws phasing out the virgin production of the refrigerant by 2020. Since then, production has dropped 85%. 
 
Based on history of other gases that have been phased out by the EPA, we believe that the value of R-22 will likely move higher and Hudson, as the dominant recycler of the gas, will reap the benefits. Management owns 13% of shares outstanding and insiders continue to buy more. With the stock trading at just 0.4x price/sales and at less than 75% of book value, we find valuations too compelling to pass up and have been adding to our position.
 

Value: A Timeless Classic 

Investors who have stuck to the classics of attractive valuations, strong balance sheets and excellent management teams have had to watch from the sidelines as money chased the latest and greatest in a parade of headline-grabbing, large-cap names. Recent flows and strong performance of smaller companies may mark a turning point. As evidence of widespread earnings growth continues to mount, we expect markets will once again focus on valuations. When that time comes, the so-called out of fashion businesses that once languished are likely to reward those who have remained patient.
 
Thank you for your continued confidence.
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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Bill Nasgovitz

Bill Nasgovitz

Nasgovitz is Chairman and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He also is President and Director of Heartland Funds. He has 49 years of industry experience, 35 at Heartland.

Heartland Advisors Value Investing Research Analyst Eric Miller

Eric Miller

Miller is Vice President and Portfolio Manager of the Heartland Value Fund and its corresponding separately managed account strategy. He has 24 years of industry experience, 15 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 Value Fund are 1.09% and 0.91%, 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. Without such waivers and/or reimbursements, total returns may have been lower.

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As of 6/30/2018, Century Communities Inc., D.R. Horton Inc., Federal Home Loan Mortgage Corporation, Hudson Technologies, Inc., and Radian Group Inc. represented 1.19%, 0.00%, 0.00%, 0.38%, and 1.73% of the 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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Small-cap and large-cap investment strategies each have their own unique risks and potential for rewards and may not be suitable for all investors. Small-cap investment strategies emphasize the significant growth potential of small companies, however, small-cap securities, are generally more volatile and less liquid than those of larger companies. Large-cap investment strategies emphasize the stability of large companies, however, large-cap securities are more susceptible to momentum investments and may quickly become overpriced or suffer losses.

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The Value Fund primarily invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

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