Heartland Opportunistic Value Equity Strategy 2Q18 Portfolio Manager Commentary

Executive Summary

  • Security selection was strong and the portfolio’s Health Care names propelled the Strategy to outperform its benchmark, the Russell 3000® Value Index, returning 5.00%† versus 1.71%.
  • Higher interest rates, a steady climb in oil prices and growing inflation pressures stoked debate about whether the economy and markets were entering a new phase.
  • Sentiment among investors and corporate managers remained strong but showed some signs of pulling back as the quarter wore on.
  • The economy continues to impress, but valuations and profit margins for many companies are near peak levels.

Second Quarter Market Discussion

Employment remained robust during the period as did corporate earnings, but higher interest rates, a steady climb in oil prices and growing inflation pressures stoked debate about whether the economy and markets were entering a new phase. The result was an uptick in volatility and swings in performance between cyclical and traditionally defensive areas. 
 
The consensus remained that the economy was likely to remain on solid footing for the remainder of 2018, however views beyond the next six months were splintered. The lack of agreement was reflected in the mix of winners for the quarter. Economically-sensitive groups such as Energy performed well but so too did more defensive areas such as Real Estate.  
 
Sentiment among investors and corporate managers remained strong but showed some signs of pulling back as the quarter wore on.
 

Attribution Analysis

Security selection was strong and the portfolio’s Health Care names propelled the Strategy to outperform its benchmark, the Russell 3000® Value Index. Consumer Discretionary holdings also boosted results and were up on an absolute and relative basis. The price of crude edged higher, and the Energy sector led the broader market. The Strategy’s holdings in the group were up double-digits on an absolute basis but lagged those in the benchmark, however an overweight to the area more than offset the shortfall. The portfolio’s Real Estate holdings were up moderately but didn’t keep pace with those in the index. 
 
Heartland Advisors Value Investing Industrials Sector IconPulling its weight. Investors seemed to view higher interest rates and rising raw material prices as potential drags on future economic growth. Those concerns weighed on many Industrial names and the sector lagged the broader benchmark. The portfolio’s holdings, however, fared better and the group contained a strong performer.
 
Kirby Corporation (KEX), a Texas-based tank barge operator, continued to surge on news it was acquiring a competitor in the inland barge business. The deal is expected to add to Kirby’s already dominant position in the space. Management has demonstrated a knack for making timely acquisitions in the face of industry weakness and we view the latest deal as a continuation of the approach.
 
Additionally, the company has seen strong sales growth in its engine repair business, which helped it report better than expected earnings in the most recent quarter.
 
As Kirby’s engine repair orders and inland river barge business inflect higher, we believe the company’s earnings should continue to expand. Despite the positive developments, shares trade at 2.3x tangible book value, which is at the low end of its historical range.
 
Where’s the capex? Although many of the portfolio’s Industrials holdings were up, others fell victim to skepticism about whether the economic boom would continue. For example, Flowserve Corporation (FLS), a manufacturer and servicer of valves and pumps used in Energy production was down despite a rise in oil prices. The company is the only publically traded integrated business with the capability to manufacture seals. Because seals tend to fail at a relatively consistent pace, the capacity to make replacement parts provides it a competitive advantage among servicing peers and provides some consistency in cash flows.  
 
While rising Energy prices have historically translated to increased capital expenditures and stronger sales for Flowserve, investors have been waiting for clear signs that business investment will return to historic averages. We believe the consensus expectation of a three-year wait for an upturn in spending in the Energy sector is overly pessimistic. Further, we have confidence that management will be able to deliver on a plan to return margins to prior peak levels. Based on our expectations of improving sales and higher margins, we believe the company is trading at a significant discount to its Industrial peers.  
 
Heartland Advisors Value Investing Real Estate Sector IconRenting the American Dream. The portfolio’s Real Estate names were up on an absolute basis and helped boost results. While the group has become expensive over the last several years, we have still been able to find compelling opportunities that in our view have unique advantages. For example, American Homes 4 Rent (AMH), a real estate investment trust (REIT) that focuses on renting single family homes, offers exposure to a supply-constrained portion of the real estate market.
 
The company was founded by Wayne Hughes, an industry veteran with a track record of success launching two other successful REITs. AMH is the second-largest owner of single-family homes in the U.S. with a portfolio of more than 50,000 homes. With existing housing inventory near multi-decade lows and home prices appreciating at more than 5% per year, we believe AMH is well positioned to generate strong cash flow from rents and should see the value of its inventory appreciate. 
 
Despite being a market leader in the space, American Homes 4 Rent trades at a nearly 20% discount to its peers based on enterprise value/earnings before interest, taxes, depreciation and amortization. AMH’s strong balance sheet and cost of capital advantage should provide it a competitive advantage over peers and we view its inventory of units as providing a potential cushion should the single-family rental market soften.
 

Portfolio Activity

Although we monitor market volatility and the headlines of the day, our efforts remain focused on seeking attractively valued opportunities and identifying areas where we believe the risk-reward profile is mispriced. This work has led us to pare some of the strategy’s bank holdings.
 
During the past 18 months, banks have benefited from relatively low percentage of loans going bad as well as expectations that rising rates will improve net interest margins. The group began to rally sharply and valuations have moved higher as a result. 
 
Higher rates could benefit lenders, however, we believe that loan performance is unlikely to improve further and could deteriorate as interest costs for borrowers head higher. While sentiment remains bullish on the group domestically, as shown, investors have been more cautious when viewing European institutions. In the coming quarters, we would not be surprised to see some of that same caution spilling over to shares of U.S.-based banks.
 
A Warning From Overseas?
Heartland Advisors Value Investing Banks Chart
Source: FactSet Research Systems Inc. and Standard & Poor’s, 6/28/2013 to 6/29/2018
Past performance does not guarantee future results.
 
(Mis)rated PG?  Just as positive momentum has driven some banks to rich valuations, unchecked pessimism has also created opportunities to invest in high-quality companies at significant discounts. For example, the strategy initiated a position in The Procter & Gamble Company (PG), after shares slumped in response to concerns about eroding market share due to private label competition.  
 
Shares of the dominant household product company are trading at a nearly 20% discount to its historical relative price/earnings. We believe the discount is overdone and doesn’t reflect PG’s cost-cutting efforts and renewed focus on the business’ highest margin products. Additionally, we would not be surprised to see the company divest some of its business lines to unlock additional shareholder value.
 

Outlook and Positioning

Heartland Select Value Fund Portfolio Manager Commentary Quote
The economy continues to impress, but valuations and profit margins for many companies are near peak levels. For the first time in several years inflation has become a concern for some companies and if, as expected, interest rates continue to move higher, debt servicing costs will start to impact earnings. 
 
In response, we continue to comb through all sectors and industries in search of businesses where margins have troughed as well as those facing broad negative sentiment or where Street earnings expectations have failed to keep pace with improving sales and earnings trends. Strong balance sheets continue to be a focus as we believe they should provide a cushion if the strength of the economy softens. 
 
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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.

Composite Returns*

6/30/2018

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Opportunistic Value Equity Composite (Net of Advisory Fees)**10.358.0810.049.3213.952.885.00
Opportunistic Value Equity Composite (Net of Bundled Fees)8.255.977.897.1911.731.874.48
Russell 3000® Value7.108.6010.408.487.25-1.161.71

Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.

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©2018 Heartland Advisors | 789 N. Water Street, Suite 500, Milwaukee, WI 53202 | Business Office: 414-347-7777 | Financial Professionals: 888-505-5180 | Individual Investors: 800-432-7856

†Composite return is net of advisory fees.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 9/30/1999.
**Provided as supplemental information.

The U.S. dollar is the currency used to express performance.

Past performance does not guarantee future results.

In addition to stocks of large companies, the Opportunistic Value Equity Strategy invests in stocks of small- and mid-cap companies that are generally less liquid than large companies. The performance of these holdings generally will increase the volatility of the strategy’s returns.

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

Heartland Advisors, Inc. (the "Firm") claims compliance with the Global Investment Performance Standards (GIPS®). The Firm is a wholly owned subsidiary of Heartland Holdings, Inc., and is registered with the Securities and Exchange Commission. For a complete list and description of Heartland Advisors composites and/or a presentation that adheres to the GIPS® standards, contact the Institutional Sales Team at Heartland Advisors.

As of 6/30/2018, American Homes 4 Rent, Flowserve Corporation, Kirby Corporation, and Procter & Gamble Company, represented 2.22%, 2.20%, 2.27%, and 2.64% of the Opportunistic Value Equity Composite, respectively.

Statements regarding securities are not recommendations to buy or sell.

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 as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems Inc.

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.

Euro STOXX Banks (Price) Index is a capitalization-weighted index which includes countries that are participating in the European Economic and Monetary Union (EMU) that are involved in the banking sector. The parent index is SXXE. The index was developed with a base value of 100 as of 12/31/1991.

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

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

Separately managed accounts and related investment advisory services are provided by Heartland Advisors, Inc., a federally registered investment advisor. ALPS Distributors, Inc., is not affiliated with Heartland Advisors, Inc.

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