Heartland Small Cap Value Plus Strategy 2Q17 Portfolio Manager Commentary

 Executive Summary

  • Stock selection was mixed with Financials and Health Care holdings leading on the upside, but the Strategy lagged its benchmark, the Russell 2000® Value Index, returning -1.02%† versus 0.67%.
  • Investors sought to maintain momentum of the equity markets by focusing on bond proxies, perceived safe havens, and companies with potential top-line growth.
  • The economic uncertainty felt on Wall Street seemed in contrast to the outlook of many business owners across the country.

Second Quarter Market Discussion

Political discord in Washington hit a feverish pitch, and skepticism grew that a tax overhaul, infrastructure spending, and regulatory relief will materialize in the near term. With hopes of a corresponding reflation trade on hold, investors sought to maintain momentum in the equity markets by focusing on bond proxies, perceived safe havens and companies with potential top-line growth. The approach drove the major indexes to new highs and provided a tailwind to some larger names. 
The economic uncertainty felt on Wall Street was in stark contrast to the outlook of business owners across the country. As shown, small business optimism hit a recent high. The survey results are consistent with the general upbeat sentiment we’ve observed in meetings with management teams of the businesses we own.
Great Expectations
Heartland Small Cap Value Plus Portfolio Manager Commentary Small Business Optimism Chart
Source: Bloomberg L.P., 3/31/2007 to 5/31/2017
Economic predictions are based on estimates and subject to change. All indexes are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Attribution Analysis

Security selection was mixed with Financials and Health Care holdings leading the way on the upside. Our stocks in Utilities and Consumer Staples lagged on a relative basis, and the Strategy trailed its benchmark, the Russell 2000® Value Index. An overweight to Energy was a key detractor during the quarter. Our holdings in Industrials hurt relative results, but an overweight to the group offset some off the weakness. 
Heartland Advisors value investing portfolio commentary financials sector iconCash is king. Our Financials holdings boosted results and contained a top contributor. First Cash Financial Services, Inc. (FCFS), which operates pawn stores in the U.S. and Latin America, was up sharply after it posted better than expected results driven by cost cutting and a strengthening peso.
We remain constructive on the company and believe it can grow earnings by opening more locations in Latin America, and leveraging its existing cost structure. 
Heartland Advisors value investing portfolio commentary materials sector iconPainted with a macro brush. Expectations of slowing growth weighed on Materials. The Strategy’s holdings in the sector were down modestly but outperformed those in the Index. Despite the flat performance of some of our companies, we continue to see names with improving margins and results.   
Schnitzer Steel Industries, Inc. (SCHN) was up after reporting strong earnings growth on a year-over-year basis. Revenue from its autos, metals, and recycling (AMR) business were up 12% on greater volume and stronger pricing. Management remains focused on increasing its operating leverage while paying down debt. 
The company is also integrating its steel manufacturing business with its AMR unit, which we believe will lead to greater production flexibility and cost savings. 
Steel prices have begun to firm, and we expect them to stabilize as demand increases. Schnitzer’s technological advantages over competitors—which allow the company to produce more cost-effectively— should result in greater benefits from an incremental gain in pricing. Additionally, the company has already reduced costs and should be able to drive additional efficiency in its operations.
With the stock trading at 6.0x enterprise value/earnings before interest, taxes, depreciation and amortization (EV/EBITDA), we believe the market isn’t fully valuing the company’s operating leverage and is too pessimistic on steel prices. 
Heartland Advisors value investing portfolio commentary technology sector iconTactical defense. The Strategy’s Information Technology names were up on an absolute basis and kept pace with those in the benchmark. During the quarter, we initiated a new position in former holding ManTech International Corporation (MANT).
We had sold out of the government services company in January of this year after shares had appreciated due to strong results in the latter half of 2016. Since that time, ManTech’s stock has receded and the risk-reward balance, in our view, warranted re-entering the name. 
We have long-been impressed with management’s capital allocation strategy and believe its focus on cyber services business will result in higher margins.  The business generates significant cash flow, which results in a free-cash-flow/enterprise value yield in excess of 7%. We believe the company is at an inflection point and strong business bookings in 2016 could result in mid-single digit revenue growth for 2017.

Portfolio Activity  

Regulatory relief may yet materialize, and we view Washington’s focus on improving the domestic business climate as an eventual tailwind for the economy. However, with the pace of change uncertain, we are focused on owning businesses that: 1) have strong or improving balance sheets, 2) are well positioned to expand operating margins through self-help initiatives, and 3) are currently profitable. 
Businesses with opportunities to reduce costs and improve margins through internally focused efforts should be able to capitalize on operating leverage in an expanding economy or modestly grow earnings should sales remain flat.
We’ve exited some holdings on recent strength and have redeployed assets into more attractively valued businesses in various industries. The result is a compact portfolio of approximately 50 names with nearly one-third of assets held in the 10 largest positions.

Outlook and Positioning

We believe a renewed interest in valuations and earnings prospects will be closely tied to improved clarity for the economy and the geopolitical backdrop. If the administration in Washington is able to deliver on expected regulatory relief, a further improvement of the business climate should materialize.
The strong run for equities and the length of the bull market has led some investors to question whether valuations have gotten ahead of themselves. The market as a whole appears fully valued, and bond-like sectors such as Real Estate Investment Trusts and Utilities have become even more challenging for valuation-sensitive investors. However, as bottom-up investors we are focused on the valuations and business prospects of individual names we hold as opposed to the price/earnings of a broad index.
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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Bradford A. Evans

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 22 years of industry experience, 19 at Heartland.

Heartland Advisors Value Investing Research Analyst Andrew Fleming

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 8 years of industry experience, 5 at Heartland.

Composite Returns*

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

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†Composite return is net of advisory fees.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 11/30/2007.
**Shown as supplemental information.

Past performance does not guarantee future results.

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.

As of 6/30/2017, First Cash Financial Services, Inc., Schnitzer Steel Industries, Inc., and ManTech International Corporation represented 3.5%, 2.3%, and 1.6%, respectively.

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

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.

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Because of ongoing market volatility, performance may be subject to substantial short-term changes.

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

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