Heartland Opportunistic Value Equity Strategy 4Q17 Portfolio Manager Commentary

Executive Summary

  • Security selection in Consumer Staples and Consumer Discretionary boosted relative performance and helped the Strategy outperform its benchmark, the Russell 3000® Value Index, returning 6.07%† versus 5.08%.
  • Strong employment data, continued solid gross domestic product (GDP) growth, and new tax legislation drove the major indices to new highs during the period.
  • Valuations have been on a steady climb for the past few years and are pricing in a best case scenario.
  • We are seeking businesses that have already endured a bear market and where recent improvements in earnings are being overlooked.

Fourth Quarter Market Discussion

Strong employment data, continued solid GDP growth, and progress on tax legislation provided fuel for the aging bull market and the major indices notched new highs during the period. The euphoria led to broad strength with each of 11 sectors in the Russell 3000® Value Index gaining ground. A firming consensus that the economy had room to run, ushered in a wave of speculation as Bitcoin surged as did the use of margin on the New York Stock Exchange. 
 
While investors focused on the positive, areas of concern remain. Corporate debt is hitting levels not seen since before the great recession and the yield curve has flattened.
 

Attribution Analysis

Security selection was positive and the portfolio’s Consumer Staples names propelled the Strategy to outperform its benchmark, the Russell 3000® Value Index. Our Industrials names also boosted results and were up on an absolute and relative basis. The price of crude moved up for the quarter but the portfolio’s Energy holdings were down and detracted from relative results. Allocation decisions had little impact. 
 
Heartland Advisors Value Investing Portfolio Commentary Consumer Staples Sector IconSpending spree. A rosy economic outlook put consumers in a spending mood and Consumer Discretionary and Consumer Staples names benefited. The portfolio enjoyed broad strength in each group and the Staples sectors contained a top contributor. 
 
Retail giant Wal-Mart Stores, Inc. (WMT) was up after posting its 13th consecutive quarter of same store sales growth. The department store has successfully reduced inventory levels, but, more importantly, the company continues to see improved online sales—jumping 50% in the third quarter. The increase is consistent with management’s view that future gains will be driven by e-commerce.
 
As the world’s largest retailer, we believe Walmart is well positioned to successfully compete with Amazon.com (AMZN) and maintain market share at a time when many smaller competitors can’t make investments necessary to stay relevant.
 
Heartland Advisors Value Investing Portfolio Commentary Health Care Sector IconHealthy outperformance. The strong run Health Care enjoyed in the third quarter cooled as investors looked to more economically sensitive sectors for opportunities. However, the Strategy’s holdings outperformed on a relative basis and contained a top contributor.  
 
Triple-S Management Corporation (GTS), a managed care company in Puerto Rico that operates under the Blue Cross name, continued its strong run after posting results that beat consensus estimates. The company is up 45% in the past six months on continued improvement of its loss ratios, and management’s progress cutting costs. We remain constructive on the name and believe there are emerging signs reimbursement rates it receives from Medicaid are on the cusp of improving. Despite the run up in share prices, the company trades at just 70% of book value versus 2x to 10x for peers.
 
Heartland Advisors Value Investing Portfolio Commentary Financial Sector IconAn ebb in flows. The portfolio’s Financials holdings were up on an absolute basis but lagged the average for the benchmark. Banks have been able to maintain exceptional credit quality on loans for the past several years and we believe it may be difficult to continue to increase lending without an uptick in charge offs. In response, we’ve found compelling valuations elsewhere in the group. For example, Franklin Resources, Inc. (BEN) remains an attractive opportunity in our opinion.
 
Shares of the global investment management company were down as an improvement in asset flows stalled. Despite the setback, we believe, management has been prudent capital allocators as shown by its willingness to buy back shares at depressed prices as opposed to paying up for acquisitions. While the popularity of index investing and growth stocks may persist in the near-term, we believe when the tide changes, Franklin will be well positioned to succeed.
 

Portfolio Activity

We’ve taken strength in many of our names as an opportunity to harvest gains and redeploy assets elsewhere. In other cases, such as in the Energy space, we’ve rotated holdings within a sector based on risk-reward profile of a given stock. These moves, we believe, have resulted in a portfolio that should be well positioned whether the economy continues to climb, or begins to plateau. As part of this approach, we continue to seek businesses that are leaders in their fields where share price has deteriorated while earnings are moving higher. The Strategy’s exposure to Consumer Staples is down, however, the sector contains a recent addition. 
 
Snap, crackle, pop? Recent addition Kellogg Company (K) is an example of the type of business we’ve found attractive. The company manufactures breakfast cereals under well-known brands such as Special K, Rice Krispies, and Frosted Flakes. Shares have slumped as consumers have increasingly gravitated to organic offerings and private label products. Much of the loss of revenue can be traced to declining sales of Special K and its Protein line of offerings as the low-carb trend has begun to fade. 
 
Headwinds for the company are well known and shares have been in a slump. However, as shown in the chart, investor outlook isn’t keeping pace with the improving story. Through the first three quarters of 2017, the sales trend for Special K appears to be stabilizing and could signal an inflection point for the marquee brand.
 
A Disconnect in Value?
Kellogg Company

Heartland Select Value Fund Portfolio Manager Commentary Kellogg vs EPS Chart

Source: FactSet Research Systems Inc., 1/2/2013 to 12/29/2017
Next Twelve Months (NTM)
Past performance does not guarantee future results.

The focus on Special K overlooks the larger story for the company. The company spends 30% more than competitors on overhead and has ample room to cut costs. Kellogg recently hired a new CEO from an outside firm which we view as providing additional energy to improved efficiencies and cost-cutting initiatives. Despite the compelling stable of established brands and potential to rein in costs more in line with competitors, shares of the business trade at 15x earnings compared to the long-term average of 17x.
 

Outlook and Positioning

Heartland Select Value Fund Portfolio Manager Commentary QuoteEconomic optimism seems rampant—and for good reason. Business investment is projected to jump in the New Year, corporate earnings have been on a winning streak, and manufacturing data paints a robust picture worldwide. But with heightened expectations come greater risks. Valuations have been on a steady climb for the past few years and are pricing in a best case scenario. As such, even mildly negative news could trigger a sharp pull back in equities. 
 
In response, we continue to comb through all sectors and industries looking for opportunities with leading industry players where we believe risk is mispriced. In particular, we are seeking businesses that have already endured a bear market and where recent improvements in bottom-line results are not yet reflected in its stock. Our efforts have resulted in a portfolio that is less economically sensitive and a watch list that contains more small-cap companies than in the recent quarters. 
 
Thank you for the opportunity to manage your capital.

 

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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 15 years of industry experience, 8 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 17 years of industry experience, 14 at Heartland.

Composite Returns*

12/31/2017

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Opportunistic Value Equity Composite (Net of Advisory Fees)**10.487.4212.659.0113.6313.636.07
Opportunistic Value Equity Composite (Net of Bundled Fees)8.375.3410.456.8911.4011.405.57
Russell 3000® Value7.377.1913.958.7113.1913.195.08

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 12/31/2017, Amazon.com, Franklin Resources, Inc., Kellogg Company, Triple-S Management Corporation, and Wal-mart Stores Inc. represented 0.00%, 1.82%, 1.06%, 1.74%, and 3.09% 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. or the Global Industry Classification Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

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.

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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