Heartland Small Cap Value Plus Strategy 2Q21 Portfolio Manager Commentary

 Executive Summary

  • The portfolio added to its double-digit gains from the prior quarter but ended the period lagging its benchmark.  
  • The snap back from the pandemic has been impressive, but it loses some of its luster when looking at the amount of debt it generated.
  • The flood of fiscal stimulus unleashed to restart the economy has created distortions in the supply/ demand balance in many industries.
  • The willingness to extrapolate the current goldilocks backdrop of low interest rates, easy sales comparisons, and low inflation into the foreseeable future is misguided, in our view.   

Second Quarter Market Discussion

It was full steam ahead for the rampant economic optimism that has reigned over the markets since the year began. Plummeting COVID-19 cases, high demand for workers, and a steady stream of proposals out of Washington D.C. to pump ever-more trillions of dollars into the economy left investors with a sense of invincibility. 
 
The euphoria continued this year’s surge for equities, and the major indices hit record highs during the closing days of the period. With investors seemingly fixated on only positive headlines, little attention was paid to fundamentals of individual companies. The indifference toward risk led to a surge for so-called meme stocks, such as AMC Entertainment Holdings Inc. (AMC), a money-losing business with a shaky balance sheet whose shares were up 2,500% through the first half of the year.
 
As fundamental investors, we are always wary of markets driven by momentum and macro events, and the current situation is no different. While the snap back from the pandemic has been impressive, it loses some of its luster when looking at the amount of debt it generated.

The correlation between ballooning balance sheets at the Federal Reserve and the fortunes of the equities market, as shown below, is striking. The willingness of the Fed to open up its balance sheet to save debt-laden businesses is unsustainable in our view and underscores the importance of active managers who make clear-eyed risk assessments of prospects for individual companies.
A Fed-Funded Party  

Heartland Advisors Value Investing FARBAST to S&P 500 Index

Source: Bloomberg L.P., Standard & Poor’s, Daily data from 7/1/2020 to 6/29/2021. The FARBAST Index outputs the US Federal Reserve’s balance sheet in millions of USD, updated weekly. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Attribution Analysis

The portfolio added to its double-digit gains from the prior quarter but ended the period lagging its benchmark, the Russell 2000® Value Index. Stock selection in Financials was strong as were holdings in the Health Care sector. The portfolio’s holdings in Industrials were down and lagged the benchmark average for the group.  
 
Heartland Advisors Value Investing Health Care Sector IconEnergized. Oil prices remained firm during the period, and Energy stocks benefited. Stock selection in the group boosted absolute portfolio returns. Holdings in the Equipment and Services space were particularly strong, including Dril-Quip Inc. (DRQ), which specializes in serving the offshore/subsea markets.
 
Dril-Quip’s sales were slightly weaker than forecasted for the most recent period, but the company reported strong margin growth as efforts undertaken to boost bottom-line results began to pay off. Additionally, bookings for future projects were up, and we expect expenses will continue to improve as management’s plan for reducing inventory levels continues to progress.   

Despite the promising outlook, Dril-Quip trades at less than 8x estimated 2022 earnings before interest, taxes, depreciation, and amortization. 
 
Heartland Advisors Value Investing Information Technology Sector IconNo pain no gain. The portfolio’s Health Care names were up on a relative and absolute basis but also contained a key detractor, Avanos Medical Inc. (AVNS).
 
Avanos, a medical device company that focuses on the pain management and chronic care markets, saw its shares weaken after its gross profit margins shrank due to a combination of short-term supply chain issues and a sales mix for the most recent period that was light on some of its high-margin products.

We remain constructive on Avanos and believe the issues with its supply chain are temporary and that management has a sound plan for driving margins back up to the 60% level the business previously enjoyed. Additionally, the improved outlook for elective procedures should drive a resumption of demand for Avanos products.
 
While the outlook remains positive for the company, shares trade at 2.5x estimates of 2022 enterprise value/sales—well below the 4x multiple commanded by its medical device peers.
 
Heartland Advisors Value Investing Information Technology Sector IconCash is king. Financials in the broad market were flat despite better than expected loan performance. The portfolio’s holdings in the sector outperformed on a relative basis, and the group included FirstCash Inc. (FCFS), a top contributor for the period. 
 
Shares of FirstCash, which operates pawn stores in the U.S. and Latin America, jumped as the impact of COVID-19 stimulus checks began to fade and pawn loan demand started to improve. We remain constructive on the business due to its high margins and view it as uniquely positioned to thrive should the financial resiliency of consumers soften. 

Despite the favorable move for shares of the company, the stock trades at just 1.5x tangible book value vs. a long-term average of 2.5x.
 

Portfolio Activity 

The flood of fiscal stimulus unleashed to restart the economy has created distortions in the supply/demand balance in many industries. As the last of the stimulus checks are spent and enhanced unemployment payments wind down, we believe some of those anomalies will be righted. The sustainability of consumer spending and the outlook for companies in the Consumer Discretionary sector is an area that could be ripe for revised expectations. 

An analysis of recent trends shows that the growth in retail sales over the past year has coincided with the amount of stimulus being doled out to consumers, as opposed to base wages. While consumer spending might remain elevated in the short term, we believe spending will begin to fade as government payments wind down. In response, we remain underweight the group as we seek businesses where our clients will in our view be adequately rewarded for the heightened risk that could come as stimulus funds wane.
 

Outlook and Positioning

There was plenty for investors to cheer during the first half of the year, yet sensible bullishness toward an economy that was regaining its previous form has morphed into excessive optimism and an intense focus on immediate rewards without consideration of longer-term challenges. 

The willingness to extrapolate the current goldilocks backdrop of low interest rates, easy sales comparisons and low inflation into the foreseeable future seems misguided—and fraught with risks. 

As such, we believe as active managers it is important to maintain a focus on appropriately managing risks in the portfolio. That means seeking out businesses that are well positioned to drive free cash flow growth and those with the financial strength and pricing power necessary to weather the long-term uncertainty of a world awash in debt. We believe this approach will produce a portfolio of companies that should have enduring strength for the long haul.

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Portfolio Management Team

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 25 years of industry experience, 22 at Heartland.

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 12 years of industry experience, 9 at Heartland.

Composite Returns*

6/30/2021

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Small Cap Value Plus Composite (Net of Advisory Fees)**8.979.1415.9712.9659.9724.343.35
Small Cap Value Plus Composite (Net of Bundled Fees)8.098.4315.3912.4159.2024.043.23
Russell 2000® Value8.6210.8513.6210.2773.2826.693.35

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 11/30/2007. 
**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.

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©2021 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 Small Cap Value Plus Strategy primarily invests in companies that have a market capitalization between $250 million and $4 billion, with a majority of its assets invested in companies that pay dividends. The Strategy intends to capture the long-term appreciation of small-caps, while minimizing the volatility of returns inherent in the small-cap market.

The Small Cap Value Plus Strategy invests in small companies selected on a value basis. Such securities generally are more volatile and less liquid than those of larger companies.

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, Inc. at the address listed below.

GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

As of 6/30/2021, Avanos Medical Inc. (AVNS), Dril-Quip, Inc. (DRQ), and FirstCash Inc. (FCFS) represented 1.60%, 1.61%, and 3.01% of the Small Cap Value Plus Composite’s net assets, respectively. AMC Entertainment Holdings Inc. (AMC) was unowned.  

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change.

Current and future 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 this article are those of the presenter(s). 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 2021 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

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

Absolute Value is a business valuation method that uses discounted cash flow analysis to determine a company's financial worth. Absolute value models try to determine a company's intrinsic worth based on its projected cash flows. Active Management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund's portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell. Bull Market occurs when the price of a group of securities is rising or is expected to rise. Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) measures a company’s financial performance. It is used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. Enterprise Value/Sales Ratio is a financial indicator used to determine the value of a company including debt. It is equal to a company’s Enterprise Value divided by its annual sales. Free Cash Flow is the amount of cash a company has after expenses, debt service, capital expenditures, and dividends. The higher the free cash flow, the stronger the company’s balance sheet. Inflation Risk is the possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency. Momentum investing is an investment strategy that aims to capitalize on the continuance of existing trends in the market. To participate in momentum investing, a trader takes a long position in an asset that has shown an upward trending price, or the trader short-sells a security that has been in a downtrend. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend. Relative Value is a method of determining an asset's value that takes into account the value of similar assets. Calculations that are used to measure the relative value of stocks include the enterprise ratio and price-to-earnings ratio. Russell 2000® Value Index measures the performance of those Russell 2000® companies with lower price/book ratios and lower forecasted growth characteristics. All indices are unmanaged. It is not possible to invest directly in an index. Tangible Book Value is the sum of all of a company’s assets, minus its liabilities and intangible assets, such as goodwill.

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