Heartland Value Plus Fund 2Q19 Portfolio Manager Commentary

Executive Summary

For the quarter and first half of the year, the portfolio outperformed its benchmark, the Russell 2000® Value Index.
Heavy debt loads continued to be tolerated for many companies, but investors punished leveraged businesses that failed to meet earnings expectations.
We remain confident that underlying fundamentals remain solid and expect the economy to continue to grow at a measured pace.
The economy is still expanding, and, barring unforeseen shocks, we believe will continue to do so during the second half of the year.

Second Quarter Market Discussion

A dizzying combination of trade wars, escalating tensions in the Middle East, and domestic political gamesmanship left investors struggling for direction during the period. While the markets alternated between defensive and offensive leadership, the underlying focus was on mitigating perceived risks.

With this mindset, investors favored large companies over small, low volatility over high volatility, and investors sought safe havens with predictable revenue. Valuations remained an afterthought.

Heavy debt loads continued to be tolerated for many companies, but investors punished leveraged businesses that failed to meet earnings expectations or those that gave lackluster guidance.

The skittish tone drove volatility higher and provided opportunities for active managers to harvest gains and deploy capital into overlooked opportunities.

Attribution Analysis

Security selection was strong in several areas, and the portfolio outperformed its benchmark, the Russell 2000® Value Index, for the quarter and first half of the year. Industrials and Consumer Discretionary holdings were key drivers of relative performance during the period, while Energy names lagged.

The right environment. Strength among the portfolio’s Industrials was widespread and the group contained a top contributor, Harsco Corporation (HSC). The company has historically provided industrial services and engineered products for multiple industries including energy, steel and railways.

Shares of Harsco jumped after it reported better than expected earnings and the company announced it was selling off its low-margin, cyclical, industrial services segment and acquiring a high-margin, more consistent environmental solutions company.

We expect momentum in Harsco’s end markets will continue in the near-term and should translate to continued top-line improvements. We are pleased with management’s move to refocus the business on environmental solutions and believe the company should be able to generate more than $500 million in earnings before interest, taxes, depreciation and amortization (EBITDA) by 2021. Based on our sum-of-the-parts analysis, we believe shares are trading at more than 35% discount to our price target.

Toll of tariffs. Looming tariffs took a toll on names in the Consumer Discretionary sector. The portfolio’s holdings outperformed those in the benchmark, but the group still contained a key detractor, Wolverine Worldwide (WWW).

Wolverine, a maker of premium casual footwear, delivered better than expected earnings during the quarter but shares sold off as a result of disappointing sales guidance for the first half of the year. Additionally, the company strategically increased inventories in anticipation of higher costs due to potential tariff increases. Investors focused on the inventory build as a negative instead of seeing the move as a strategic approach to controlling costs. We view both challenges as temporary.

The company has seen growth for its top three brands—Sperry, Merrell, and Saucony—that should bode well for the second half of the year. As sales inflect higher, inventories should return to normal levels.

We continue to believe Wolverine’s strong brands, high margins, and cost-cutting initiatives continue to make the company compelling. We’ve been impressed with company leadership’s prudent capital management as it funds organic growth, pays down debt and buys back shares. Trading at 10x estimated 2019 EBITDA versus the 11x to 12x range for its low-growth peers, we view the company with its 7% free cash flow yield as a prudent investment in an improving retail environment.

Material issue. Throughout much of the current economic expansion we’ve been struck by the disconnect between growth and the cost of raw materials. While commodities have shown life during the past few years, their performance, as shown below, has significantly lagged that of equities.

Commodities Lag

CRB RIND Index Relative to S&P 500 Index

Heartland Advisors Value Investing Commodities Chart

Source: Bloomberg L.P. and Standard & Poor's, 1/4/1985 to 6/28/2019
Commodity Research Bureau BLS Spot Raw Industrials (CRB RIND Index): is a measure of price movements of 22 basic commodities, whose markets are usually among the first to be influenced by changes in economic conditions. The 22 commodities are combined into an "All Commodities" grouping, with two major subdivisions: Raw Industrials, and Foodstuffs. Raw Industrials include burlap, copper scrap, cotton, hides, lead scrap, print cloth, rosin, rubber, steel scrap, tallow, tin, wool tops, and zinc. Foodstuffs include butter, cocoa beans, corn, cottonseed oil, hogs, lard, steers, sugar, and wheat.
Past performance does not guarantee future returns.

Despite this dynamic, we have been able to find compelling opportunities in the Materials space by identifying players with self-help opportunities that are able to generate consistent sales regardless of the economic backdrop.

For example, we initiated a position in P.H. Glatfelter Company (GLT), a manufacturer of fiber and pulp-based engineered materials such as coffee filters and hygiene products.

Glatfelter has dramatically changed its business in the last year away from highly cyclical specialty paper market and toward household staples where it can generate higher margins and more consistent sales while serving growing end markets.

We expect free cash flows to accelerate for Glatfelter as business investments made over the past 12 months begin to bear fruit. Additionally, the company removed a long-term cloud overhanging the stock by resolving environmental liability litigation. Based on our sum-of-the-parts analysis, shares are trading at a 20% discount to our 2020 estimates of fair value.

Portfolio Activity

We remain confident that underlying fundamentals remain solid and expect the economy to continue to grow at a measured pace. However, we also recognize that short-cycle data may cause temporary concerns for investors and could result in bouts of volatility and selling pressure. Our response has been to use volatility to trim positions where we believe valuations reflect excessive optimism and buy businesses that offer compelling idiosyncratic opportunities and valuations.

For example, we have reduced the portfolio’s exposure to select companies in the Information Technology sector. The trade impasse with China is likely to have a meaningful impact on the industry if supply chains that currently include domestic players are reconfigured to suppliers elsewhere. We believe the market has not fully discounted this possibility and have been actively reducing our exposure to tech-focused businesses.

Outlook and Positioning

The economy is still expanding, and, barring unforeseen shocks, we believe will continue to do so during the second half of the year. At the same time, gridlock in Washington D.C., and ongoing trade tensions have taken a toll on the rate of growth. As such, we are inclined to take any sharp moves higher in the portfolio’s cyclical holdings as an opportunity to harvest gains.

As growth continues to decelerate, companies with no or low debt should be well-positioned to endure and opportunistically take market share from those hobbled by excessive debt. The importance of balance sheet strength also makes us wary of holding businesses that are aggressive acquirers of competitors.

We continue to put an emphasis on businesses that are actively seeking to reduce costs and improve margins through internally focused efforts.

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Portfolio Management Team

Bradford A. Evans

Evans, CFA, is Senior Vice President and Portfolio Manager of the Value Plus Fund and its corresponding separately managed account strategy. He has 23 years of industry experience, 20 at Heartland.

Heartland Advisors Value Investing Research Analyst Andrew Fleming

Andrew J. Fleming

Fleming, CFA, is Vice President and Portfolio Manager of the Value Plus Fund and its corresponding separately managed account strategy. He has 10 years of industry experience, 7 at Heartland.

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Fund Returns

6/30/2019

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	Since Inception (%)	20-Year (%)	15-Year (%)	10-Year (%)	5-Year (%)	3-Year (%)	1-Year (%)	YTD* (%)	QTD* (%)
Value Plus Investor Class	9.76	8.55	7.19	9.80	1.73	12.24	-4.50	18.10	3.66
Value Plus Institutional Class	9.88	8.70	7.39	10.07	1.94	12.50	-4.28	18.23	3.70
Russell 2000® Value	9.56	8.64	7.28	12.40	5.39	9.81	-6.24	13.47	1.38

*Not annualized

The inception date for the Value Plus Fund is 10/26/1993 for the investor class and 5/1/2008 for the institutional class.

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In the prospectus (pdf) dated 5/1/2019, the Gross Fund Operating Expenses for the investor and institutional class of the Value Plus Fund are 1.18% and 0.95%, 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.

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 6/30/2019, Harsco Corporation, P.H. Glatfelter Company, and Wolverine Worldwide represented 3.61%, 1.98%, and 2.02% of the Value Plus 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.

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

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The Value Plus Fund invests in small 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 70) 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.