Heartland Opportunistic Value Equity Strategy 2Q20 Portfolio Manager Commentary

Executive Summary

  • Security selection was strong on an absolute basis, and holdings in Health Care and Consumer Discretionary boosted relative results.
  • Aggressive action by the Federal Reserve fueled an assertive tone from investors.
  • As equities have recovered, the pool of attractively valued companies has narrowed.
  • Businesses with pricing power should have an advantage in an economy with excess supply and weakened demand

Second Quarter Market Discussion

After spending much of the first quarter preoccupied by worst-case scenarios related to COVID-19, investors switched to a risk-on stance and the major indices erased a majority of the damage done in February and March.

The more assertive tone was fueled in part by aggressive action by the Federal Reserve, which signaled a willingness to prop up equity and fixed income markets. Economic data and earnings reports that were less bad than expected added to the bullish tone. 

While the move was welcome relief for battered portfolios, buyers appeared to be motivated by a fear of missing out more so than fundamentals. For example, as shown below, shares of companies with low returns on equity, materially outperformed their higher quality counterparts. Lower quality names often lead in rallies following selloffs, but the magnitude of the bounce back was noteworthy.

A FOMO Rally?
Source: FactSet; FTSE Russell; Jefferies. This chart shows companies held in the Russell 2000 Index. The 2020 bear market is representing data gathered during 1/16/2020 to 3/18/2020. The average bear market data is calculated based on bear markets taking place during 12/31/1985 to 6/18/2020. Bottom was on 3/18/2020. The average 3-month after bear market data is calculated based on 3 months following each bear market taking place during 12/31/1985 to 6/18/2020. Return on equity (ROE) measures the net income after taxes a firm is able to earn as a percentage of shareholders’ equity. A bear market occurs when the price of a group of securities is falling or is expected to fall. 


Attribution Analysis

Security selection was strong on an absolute basis, and holdings in Health Care and Consumer Discretionary boosted relative results. Our names in Energy and Materials were up but couldn’t keep pace with those in the Russell 3000® Value Index, and the portfolio lagged its benchmark for the period. 
 
The ABCs of quality. Despite weaker businesses leading the charge for the broader index, our work of adding market leading names during the downturn of the first quarter began to pay off. For example, shares of Alphabet Inc. (GOOGL), the parent company of Google, snapped back after selling off earlier in the year due to fears of a pandemic-driven slump in ad sales revenue.  

Wall Street analysts cut their outlook for Alphabet earnings for the next 12 months by roughly 15% during the first quarter, however, shares of the company fell by more than twice that amount during the height of the selloff. 

Near-term economic challenges have muddied the picture for predicting digital ad spending, however, we believe that Alphabet is an excellent business that should be able to grow at a rate in excess of GDP growth in the years ahead. Additionally, the company’s balance sheet is a standout among public companies, and management is investing more than $25 billion per year on research and development, which should provide a catalyst for sustained, above-market earnings expansion. 
 
Riding the rails. As States started to ease stay-at-home restrictions during the quarter, investors showed signs of increasing confidence that the economy would bounce back quickly. The bullish sentiment boosted economically sensitive areas and helped portfolio holdings such as Canadian National Railway Company (CNI), a rail transport company with routes throughout the U.S.

Canadian National is an industry leader featuring a management team with a history of making innovative and forward-looking investments in the business. Under this approach, the company has built a rail network that spans coast to coast and from Canada south to the Gulf of Mexico. The efficiency and capacity gained through its rail network, in our view, provides the company with a competitive advantage it will be able to leverage for the foreseeable future.

When shares of Canadian National sold off late in the first quarter, we were quick to take a position at what we believed was a rare discount for an industry powerhouse. Our decision was rewarded this quarter as shares were up double digits from our purchase price.
 

Follow the money. Financials posted solid gains for the period with strength coming from a broad range of industries. Our holdings in the space were up soundly led by Raymond James Financial Inc. (RJF), a diversified financial services company offering wealth advisory, asset management, investment banking, and banking services to retail and institutional clients.

Shares of Raymond James began falling in February of this year as the market started pricing in the potential impact of COVID-19 on company profits. Raymond James earns advisory and management fees based upon client asset levels, interest income from lending activity, and banking fees based upon capital markets activity.  As equity and credit markets continued to deteriorate and as interest rates fell throughout the first quarter, the stock fell more than 40% from its peak.

Despite the near-term headwinds for the company, we are attracted to Raymond James due to its impressive history of growing market share and the opportunity it has to penetrate new markets outside of its stronghold of the Southeast. The potential for growth coupled with the company’s ability to generate returns on equity that far outpace peers should serve investors well in the years to come. Despite its strong position, shares are trading at just 1.7x tangible book value vs. a long-term median of more than 2x.

Portfolio Activity

The first half of the year has been tumultuous for the markets but has provided opportunities to add market-leading companies at significant discounts to long-term normalized multiples. As equities have recovered, the pool has narrowed, however, our team remains consistent in our approach of seeking financially sound businesses with favorable risk-reward profiles when viewed over a timeframe of 18 to 36 months.
   

Outlook and Positioning

The fallout from COVID-19 is far from over and we have no doubt that unforeseen effects from this evolving pandemic will ripple through the economy and equity markets for quarters to come. In the face of this ever-changing backdrop, we have sought to maintain a balanced approach by selling names that are approaching our estimates of intrinsic value and opportunistically buying market leaders we view as being undervalued. 

Balance sheet strength and catalysts that can result in a change in perception by investors remain a priority. We also believe businesses with pricing power will have an advantage in an economy that is likely to see excess supply and weakened consumer demand in the near-term. 

Thank you for your continued trust and confidence.
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Portfolio Management Team

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 18 years of industry experience, 11 at Heartland.

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value, Mid Cap Value, and Value Funds and their corresponding separately managed account strategies. He also is President and Director of Heartland Funds. He has 20 years of industry experience, 16 at Heartland.

Troy McGlone

McGlone, CFA, is Vice President and Portfolio Manager of the Select Value Fund and its corresponding separately managed account strategy. He has 12 years of industry experience, 6 at Heartland.

Composite Returns*

6/30/2020

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Opportunistic Value Equity Composite (Net of Advisory Fees)**8.748.123.250.77-15.31-19.0613.53
Opportunistic Value Equity Composite (Net of Bundled Fees)6.676.011.22-1.22-17.00-19.8913.00
Russell 3000® Value6.2510.234.411.41-9.42-16.7414.55

Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 9/30/1999. 
**Shown as supplemental information. 

The US Dollar is the currency used to express performance. Returns are presented net of advisory fees and net of bundled fees and include the reinvestment of all income. The returns net of bundled fees were calculated by subtracting the highest applicable sponsor portion of the separately managed wrap account fee from the net of advisor fees return.

©2020 Heartland Advisors | 790 N. Water Street, Suite 1200, 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.

Past performance does not guarantee future results.

The Opportunistic Value Equity Strategy seeks to capture long-term capital appreciation by investing in companies with market capitalizations greater than $500 million. The Strategy’s flexible pursuit of value positions it as a core holding for investors.
 

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.

As of 6/30/2020, Alphabet Inc., Canadian National Railway Company, and Raymond James Financial Inc. represented 2.80%, 2.24%, and 1.84% of the Opportunistic Value Equity Composite, respectively.  
 

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 Institutional Sales at Heartland Advisors, Inc. at the address listed below.

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.

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.

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.

Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

There is no assurance that dividend-paying stocks will mitigate volatility.

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

Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indices. Russell® is a trademark of the Frank Russell Investment Group.

Data sourced from FactSet: Copyright 2020 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

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

Bear Market occurs when the price of a group of securities is falling or is expected to fall. Book Value is the sum of all of a company’s assets, minus its liabilities. Cyclical Stocks cover Basic Materials, Capital Goods, Communications, Consumer Cyclical, Energy, Financial, Technology, and Transportation which tend to react to a variety of market conditions that can send them up or down and often relate to business cycles. Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. Return on Equity is a measure of the net income after taxes that a firm is able to earn as a percent of stockholders equity. Russell 3000® Value Index measures the performance of those Russell 3000® Index companies with lower price/book ratios and lower forecasted growth characteristics. S&P 500 Index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index.

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