Heartland Value Plus Fund 3Q18 Portfolio Manager Commentary

Executive Summary

  • Security selection in several areas including Real Estate, Industrials and Consumer Discretionary boosted results and helped the Fund beat its benchmark, the Russell 2000® Value Index, returning 1.71% versus 1.60%.
  • A conflicted macro backdrop resulted in defensive areas and pockets of the market with strong momentum performing well.
  • Recent strong performance for equities has heightened the risk for market overreaction to macro events.
  • We remain confident in the strength of the economy but acknowledge the pace of growth will ebb and flow.

Third Quarter Market Discussion

This steady climb by the major domestic indices during the quarter masked a tumultuous period as investors sought to make sense of conflicting macro headlines. On the positive side, employment remained robust, manufacturing activity continued to impress and consumer optimism, as shown, reaching near historic highs. Conversely, tough trade rhetoric, political uncertainty due to the upcoming elections, and higher interest rates weighed on investor optimism.
 
Bullish Consumer
Heartland Advisors Value Investing Consumer Sentiment Chart
Source: Bloomberg L.P., University of Michigan Consumer Sentiment Index, September 2008 to September 2018
Economic predictions are based on estimates and are subject to change. All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future results.
 
The conflicted macro backdrop resulted in defensive areas and pockets of the market with strong momentum performing well. In contrast, economically sensitive sectors such as Materials and Energy lagged.
 

Attribution Analysis

Security selection in several areas including Real Estate, Industrials, and Consumer Discretionary boosted results and helped the Strategy beat its benchmark, the Russell 2000® Value Index. The portfolio’s Information Technology names were down for the period and lagged on a relative basis. 
 
Heartland Advisors Value Investing Industrials Sector IconCaptain of Industry. Strength among the portfolio’s Industrials was widespread and the group contained a top contributor, Harsco Corporation (HSC). The company provides 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 raised guidance for the remainder of 2018. The impressive results reflected operating margin expansion, which management noted had reached highs not seen in the past decade. 
 
We expect momentum in Harsco’s end markets will continue into 2019 and should translate to top-line improvements. Further margin expansion is also possible as underperforming facilities are shuttered or sold. 
 
Right on the Label. Performance was also boosted by our stake in Brady Corporation (BRC). The maker of safety labels and security products was up after posting better-than-expected revenue and excellent gross margins of 50%. 
 
Brady continues to devote resources to research and development in an effort to enhance growth opportunities; however, its strong free cash flow has allowed management to grow its cash position. The company has been using free cash flow to pay down debt and continues to benefit from cost-cutting measures instituted in 2015.
 
The company could see 3% to 5% organic growth in the coming year, and we believe management has positioned the business to consistently generate 50+% gross margins. With its 6%-7% free-cash-flow yield and shares trading at 11x estimated 2019 earnings before interest, taxes, depreciation and amortization, we continue to see Brady as an attractive opportunity. 
 
Chopping Wood? While the majority of the strategy’s Industrial holdings enjoyed a strong quarter, one of the holdings, which makes equipment for road construction, aggregate processing and energy processing including oil, gas and wood, was a key detractor. The company reported solid results from operation during the period; however, shares sold off due to management’s unexpected decision to shutter a troubled wood pellet plant and initiate a strategic review of the business line. 
 
We share in the market’s frustration with the move as well as the way company management handled the situation. While we see opportunities for success—the company has low debt levels, improving gross margins, and requests for bids from its primary business lines remain strong, we have lost faith in management’s ability to execute on its strategy and exited the position.
 

Portfolio Activity  

We remain confident in the strength of the economy but recognize that with major indices hitting new highs, investors face increased risks of an outsized reaction to headlines and stock specific news. Our response to this backdrop has been to opportunistically add attractively valued businesses that, in our view, are well-positioned to generate margin expansion. By doing so, the team is attempting to reduce the size of the impact any single company will have on performance.
 
For example, we recently added Hain Celestial Group, Inc. (HAIN), a packaged food company with a focus on organic and natural products. The company is well known to us, having been a portfolio holding in the past. After exiting the position we kept an eye on management’s efforts to improve margins and operational efficiency. Early results have been impressive, including progress on strengthening its balance sheet.
 
The progress Hain has made in improving results should continue with its planned sale of its non-core protein business. Additionally, management is focused on streamlining product offerings, and focusing on driving sales growth in its top 11 brands. With shares trading at just 1.2x enterprise value/sales compared to a peer average of 2x, we believe Hain offers considerable upside based on its obtainable goals for operational improvements.
 

Outlook and Positioning

Heartland Advisors Value Investing Quote Image
Economic data continues to reflect a buoyant economy. A focus on hard data as opposed to the latest speculation about the impact of upcoming elections and rising interest rates reveals a backdrop where corporate earnings are up, unemployment is at lows not seen in more than a decade, and manufacturing activity remains strong. However, we acknowledge the pace of growth will ebb and flow, and so we are focused on owning businesses that:
 
  1. Have strong or improving balance sheets
  2. Are well positioned to expand operating margins through self-help initiatives and idiosyncratic catalysts
  3. Are generating strong free cash flows, and
  4. Are undervalued. 
We continue to believe businesses with opportunities to reduce costs and improve margins through internally focused efforts should be well-positioned to capitalize on operating leverage in an expanding economy or modestly grow earnings should sales plateau.
 
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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Bradford A. Evans

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 22 years of industry experience, 19 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 9 years of industry experience, 6 at Heartland.

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In the prospectus (pdf) dated 5/1/2018, the Gross Fund Operating Expenses for the investor and institutional class of the Value Plus Fund are 1.19% and 0.97%, 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 9/30/2018, Brady Corporation, Hain Celestial Group, Inc., and Harsco Corporation represented 2.35%, 1.62%, and 3.41% 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.

Consumer Sentiment Index is a telephone survey conducted by the University of Michigan Consumer Research Center, which phones 500 consumers to ask their opinion on personal finances and business conditions. Consumers are asked five questions concerning household financial conditions and their expectations for household financial conditions in one year; their expectations for business conditions in one year as well as expectations for the economy in five years, and their buying plans. This release provides an early indication of consumer expectations that are a leading indicator for the business cycle. The monthly survey has a moderate impact on the financial markets because if consumer confidence declines, then consumer spending is likely to weaken. The data is seasonally adjusted. With consumer spending making up two-thirds of gross domestic product, consumer behavior is closely watched.

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

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CFA® is a registered trademark owned by the CFA Institute.

The Heartland Funds are distributed by ALPS Distributors, Inc.

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.

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