Heartland Opportunistic Value Equity Strategy 4Q18 Portfolio Manager Commentary

Executive Summary

  • The Strategy outperformed its passive benchmark, the Russell 3000® Value Index returning -11.22%† versus -12.24%.
  • A cautious mindset took a toll on mega-cap Technology companies and growth areas that had rallied during the first half of the year.
  • We have been patient in the face of recent volatility and have opportunistically put money to work in some of our existing holdings.
  • Broad indices could struggle over the next several quarters, but we believe there will be ample opportunities for individual companies to excel.

Fourth Quarter Market Discussion

Looming behind the wild market swings that closed out the year was a growing sense that the economy may be reaching the late stages of expansion. While selling pressure was widespread, energy, housing and auto stocks took much of the pain. Performance in those areas suggests investors believe companies will struggle to meet the lofty earnings expectations that, as shown, are just beginning to adjust from near-peak highs.
 
Past Peak?
Heartland Advisors Value Investing One-Year Earnings Chart
Source: © Copyright 2019 Ned Davis Research, Inc. and Standard & Poor’s. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. 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. Earnings per share (EPS).
Past performance does not guarantee future results.


In addition, concerns of an escalating trade war, the effects of rising interest rates, and higher input costs all contributed to the more sober outlook. In response to the new tone, investors sought out traditional safe-havens such as Utilities and Consumer Staples.

The cautious mindset also took a toll on mega-cap Technology companies and growth areas that had enjoyed positive momentum during the first half of the year. 

Attribution Analysis

Security selection was strong with holdings in Financials and Industrials boosting relative results and the Strategy beat its benchmark, the Russell 3000® Value Index, for both the quarter and full year. Our holdings in Utilities outperformed the broader market during the quarter. Oil prices continued to fall and Energy stocks suffered as a result; an overweight to and stock selection in the group detracted from results.
 
Heartland Advisors Value Investing Financials IconA Financial advantage. The portfolio’s Financials holdings were down but outperformed those in the benchmark during the period. Shares of Berkshire Hathaway Inc. (BRK.B), a multi-business holding company run by legendary investor Warren Buffett, were off modestly during the period as earnings from the company’s manufacturing and rail businesses continued to improve, and as its insurance units recovered from hurricane-related losses incurred during 2017.    
 
Shares have benefited from a change announced mid-year to the company’s share buyback policy. Under the new guidelines, management has greater flexibility to initiate stock repurchases. Given Berkshire’s significant cash reserves, the move has been well received. Leadership has capitalized on recent volatility and began repurchasing shares.
 
Despite appreciating for the full year, Berkshire continues to trade at a nearly 30% discount to the broader market and 20% below peers, based on our analysis.  We find the valuations particularly compelling given the company’s $80 billion in cash and reserves, which will allow it to make strategic acquisitions if competitors stumble, or provide a cushion in the face of economic uncertainty.
 
Heartland Advisors Value Investing Information Technology Sector IconNo longer the “it” sector?  After spending most of the past two years as a top performing sector, Information Technology (IT) was weak and the group sank with the broader market. The strategy’s holdings in the space also lagged, but we continue to hold what we believe are high quality businesses.
 
For example, Cisco Systems, Inc. (CSCO), the world’s leading computer networking provider, was down moderately for the period but remained a top contributor for the year. The company’s focus on recurring-revenue businesses has gained traction and robust sales have produced strong free cash flow. 
 
We believe the positive results in the current sales cycle should continue. Despite a strong run, shares are trading at a reasonable 16x earnings. 
 
Heartland Advisors Value Investing Health Care Sector IconGood long-term prognosis? The portfolio’s Health Care names outpaced those in the benchmark; however, the group contained a key detractor. Long-time holding Quest Diagnostics, Inc. (DGX), a diagnostic testing and services company trading at 14x estimated 2018 earnings, was down after issuing lower-than-expected guidance for the fourth quarter. Management sought to temper expectations after seeing a jump in the number of billing claims rejected by insurers. The company believes the contested charges are an isolated incident and is working to recoup at least a portion of the outstanding balances owed.
 
The poor recent results have, in our view, temporarily masked what is a great long-term story. Quest should benefit from regaining its status as an “in-network provider” with UnitedHealth Group (UNH). The designation should help Quest as it seeks to capture business from United’s large book of insured population. 
 
Quest should also benefit by growing its hospital outreach business as hospitals either outsource lab operations or look to team with a third-party to help them run the business. The company is a low-cost provider of diagnostic testing services—with competitors often 2x to 5x more expensive—which we believe provides a competitive advantage over peers.
 
The stock remains attractively valued in our view, and we believe that growth and cost-reduction initiatives are now accelerating.
 

Portfolio Activity

We have remained patient in the face of recent volatility and have opportunistically put money to work in some of our existing holdings. Additionally, broad selling pressure has led to new names appearing on our watch list and we have acted decisively when warranted by valuations.
 
For example, we initiated a position in Thor Industries, Inc. (THO), the largest recreational vehicle (RV) manufacturer in the world. The company owns iconic brands including Airstream, Dutchmen, Jayco and Keystone among others.  
 
The RV market has enjoyed a strong run following the financial crisis but stumbled going into the 2018 selling season as aggressive pre-ordering by dealers was met with sluggish retail demand. The resulting excess inventory has put pressure on margins and investors have punished industry players. However, we believe Thor is making meaningful progress on reducing dealer inventory, and the company is on the cusp of closing on the acquisition of a large European operator in the coming months. Company management has a proven track record of prudent acquisitions, and we believe this transaction could add 25%-30% to earnings per share over several years.
 
With the company trading at less than 7x our view of normalized earnings compared to a historical average of 13.5x, we believe the current share-price slump offers a compelling opportunity to own a market-leading player with meaningful upside potential in the years ahead.
 

Outlook and Positioning

Economic data suggests that the economic expansion remains intact, yet energy markets and the yield curve highlight a sense of caution for 2019 and beyond. The gathering headwinds are just beginning to show up in downward revisions of earning estimates and, as shown below, tepid expectations for broad market performance over the next few years. 
 
Lowered Expectations
S&P 500 Index

Heartland Advisors Value Investing Trailing 10 Year Chart

Source: Stifel Equity Research and Standard & Poor’s, Trailing 10-year December 1955 to December 2018 (December 2018 estimated); CAPE Ratio December 1955 to September 2028 (December 2018 to September 2028 estimated).
Cyclically Adjusted Price/Earnings (CAPE) is moved forward 120 months to show where the S&P 500 10-year annualized return may be at future dates.
Economic predictions are based on estimates and subject to change.
All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future results.

While broad indices could struggle to maintain traction over the next several quarters, we believe there will be ample opportunities for individual companies to distinguish themselves in the eyes of investors. This dynamic should benefit active investors who focus on fundamentals and identifying catalysts for positive change.
 
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 17 years of industry experience, 10 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

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 CEO of Heartland Funds. He has 19 years of industry experience, 15 at Heartland.

Heartland Advisors Value Investing Research Analyst Troy McGlone

Troy McGlone

McGlone, CFA, is Vice President and Portfolio Manager of the Opportunistic Value Equity Strategy. He has 11 years of industry experience, 5 at Heartland.

Composite Returns*

12/31/2018

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Opportunistic Value Equity Composite (Net of Advisory Fees)**9.6711.235.268.98-4.13-4.13-11.22
Opportunistic Value Equity Composite (Net of Bundled Fees)7.589.073.206.85-6.01-6.01-11.67
Russell 3000® Value6.4811.125.777.01-8.58-8.58-12.24

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

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©2019 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. 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.

**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 12/31/2018, Berkshire Hathaway Inc., Cisco Systems, Inc., Quest Diagnostics, Inc., Thor Industries, Inc., and UnitedHealth Group represented 4.84%, 2.85%, 1.90%, 0.60%, and 0.00% 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 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.

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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