Heartland Value Fund 3Q18 Portfolio Manager Commentary

Executive Summary

  • Your portfolio benefited from strong stock selection in Financials and Information Technology.
  • Rising rates and political uncertainty are raising investor concerns about the future economic growth.
  • The current excess in valuations for growth and momentum reflects a misguided response to a rational concern.
“Excesses are never permanent.”
 
—Bob Farrell
Wall Street Veteran and Legendary Investor
 

Third Quarter Market Discussion

With the eighth Fed Funds rate hike now in the books, and political uncertainty from the upcoming November elections on the horizon, investors are asking “Without a Fed punch bowl, will the economic party come to an end?” After more than nine years of expansion, it’s a fair question. Unfortunately, some of the responses we’re seeing to the uncertainty could lead to disaster. 
 
Instead of focusing on time-tested investment principles like valuations and balance sheet strength, many are ignoring prices and are paying top dollar for growth and momentum. Why? Because they hope that yesterday’s winners will carry the day if economic growth stumbles.
 

Reefer Madness 

Tilray, Inc. (TLRY) is one of the more vivid examples to surface. In less than a quarter, shares for this budding marijuana grower have shot up 13-FOLD giving it a market cap of more than $20 billion at its peak. With the stock registering a nearly 40% gain on a single day last month, we can’t help but wonder if investors have noticed they are paying 500x sales of just $40 million.
 
Of course no discussion of cannabis and risky investments would be complete these days if it didn’t include Tesla Inc. (TSLA) and Elon Musk. The soap opera of Musk’s behavior and the company’s crushing debt load rolls on. Shares pulled back some during the quarter but still trade at over 100x next year’s estimated earnings and 13x book value. Those valuations strike us as hard to defend on their own—but add in the company’s need to refinance nearly $2 billion in debt in 2019, and they have the makings of a potential disaster for investors.  
 
The above examples may seem like anomalies with little risk to rational investors; however, we’d argue they represent an approach that has been choking off interest in many small, attractively valued companies.
 

Pent-up Energy

Energy is a prime example of an area unloved and overlooked but filled with what we believe are compelling values. As you can see in the chart below, oil prices are well off their lows of 2015, yet small energy stocks have hardly budged. While the disconnect hurt performance for your portfolio’s holdings in the space this period, it also created an opportunity to pick up a cash-rich, low-cost energy producer, Berry Petroleum Corporation (BRY).
 
Untapped Value?
Heartland Advisors Value Investing Energy Sector vs. Brent Crude Oil Price
Source: FactSet Research Systems Inc. and Russell®, 9/28/2015 to 9/28/2018
All indices are unmanaged. It is not possible to invest direction in an index.
Past performance does not guarantee future results.
 
The independent exploration and production company focuses on conventional oil reserves in the Western United States, primarily in California. Berry possesses a long-lived, high-margin asset base and should be uniquely positioned to generate top-tier returns and positive free cash flow in a broad range of energy prices. This operating model offers great visibility regarding production (the company expects 15% average compounded annual growth rate from 2018-2021) and low leverage—1.2X net debt/2018 estimated earnings before interest, taxes, depreciation and amortization (EBITDA). 
 
With shares trading at just 4.5x estimated 2019 EBITDA, we see Berry as an opportunity to tap into an improving oil market with a business that offers a significant dividend yield and strong free cash flow generation trading at a material discount to net asset value. 
 
Our other two exploration and production holdings in the space are SRC Energy Inc., (SRCI) and Abraxas Petroleum Corporation (AXAS).  Both companies had strong performance during the first half of the year, but each were under pressure during the most recent quarter.  
 
SRCI and AXAS offer attractive free cash flow, are trading well below net asset value and have relatively low leverage. 
 
However, SRCI has been hampered by a bottleneck in pipeline capacity to transport natural gas out of the Basin where it operates. Additionally, a ballot initiative that could lead to drilling restrictions in Colorado has weighed on shares. We believe the transport capacity issue has begun to ease and we see little chance of the ballot initiative being passed into law.
 
AXAS has sold off because of similar bottlenecks in takeaway capacity in the Permian Basin, which accounts for about 50% of production. However, we expect output to rebound for the remainder of the year.
 
SRCI trades at just 6.3x 2019 earnings, while AXAS is similarly discounted at 7.3x. We believe both businesses should enjoy strong 2019 growth production.
 

Home is Where the Value is

Concerns about the impact of higher interest rates has taken a toll on housing stocks this year including portfolio holdings such as Century Communities, Inc. (CCS)
 
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 at a hefty premium.  
 
CCS is now the 10th largest public builder and, as of 2017, the fastest growing. The company has 5-year compounding revenue growth of over 70%, and its EBITDA has grown at a 61% compounding annual rate. Their strength in the low-priced home segment targeting first-time buyers, we believe, should position it to sustain the impressive growth. 
 
Despite its dominant position among builders, the company is trading at just 6.4x projected 2019 earnings—a significant discount to peers, and less than half the valuation for the S&P 500.
 
As long-term investors we believe concerns about interest rates are overdone. With eight rate hikes already in the books and the yield curve continuing to flatten, we believe the Fed’s days of tightening are winding down. At the same time, housing starts are well below previous peaks and long-term average, despite a pending surge in demand as the 90 million-strong millennial cohort continues to move out of their childhood homes.
 

Dangers of Debt 

As bottom-up investors, much of our focus is on understanding a company’s financial strength. A look at your portfolio shows that on average, the businesses you own have considerably less debt than those found in the Russell 2000® Index. 
 
When evaluating investment opportunities, we look at things such as debt/capital and debt/cash flow. Simply put, we seek companies that have manageable debt levels and can withstand bumps in the economic cycle. 
 
Unfortunately, strong balance sheets can sometimes deteriorate quickly due to an ill-advised acquisition or an unexpected loss of a critical customer as was the case for two holdings in your portfolio. These respective events created significant pressure on share prices, and the names accounted for the vast majority of negative performance this quarter. 
 
The drop in both companies serves as a stark reminder of how quickly things can change for leveraged businesses. We were too slow reacting to developments and have heightened our focus on taking decisive action when warranted.
 

Opportunities vs. Excesses 

The current excess in valuations for growth and momentum reflects, in our view, a misguided response to a rational concern. Investors are understandably cautious about the ability of companies to grow in the face of rising rates and political uncertainty. By chasing yesterday’s winners, however, investors have created excesses in valuations and as Mr. Farrell rightly noted, excesses are never permanent. 
 
We’ve taken what we believe is a more prudent approach—buy well run companies with strong balance sheets that are trading at discounts on an absolute basis. Our commitment to this time-tested approach is reflected in the valuations below.
 
Value Fund Valuations
Heartland Advisors Value Investing Value Fund Valuations
Source: Heartland Advisors, Inc., as of 9/30/2018
Price/Earnings and EV/EBITDA are calculated as weighted harmonic average and Total Debt/Capital as weighted average.
Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA)
These valuations are based on Heartland Advisors’ calculations. Certain outliers may be excluded. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change. 
Past performance does not guarantee future returns.
 
The fact that we continue to find exceptional valuations in a nine-year-old bull market is striking and a reminder of the value of a bottom-up approach. We remain unwavering in our focus on finding these compelling opportunities and believe these are the types of companies that will thrive long after today’s market darlings fade from memory.
 
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 50 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 9/30/2018, Abraxas Petroleum Corporation, Berry Petroleum Corporation, Century Communities Inc., D.R. Horton Inc.,  SRC Energy Inc., Tesla Inc., and Tilray, Inc. represented 0.61%, 1.32%, 1.37%, 0.00%, 1.50%, 0.00%, and 0.00% 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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