Heartland Small Cap Value Plus Strategy 2Q19 Portfolio Manager Commentary

 Executive Summary

  • For the quarter and first half of the year, the portfolio outperformed its benchmark, the Russell 2000® Value Index.
  • Heavy debt loads continued to be tolerated for many companies, but investors punished leveraged businesses that failed to meet earnings expectations.
  • We remain confident that underlying fundamentals remain solid and expect the economy to continue to grow at a measured pace.
  • The economy is still expanding, and, barring unforeseen shocks, we believe will continue to do so during the second half of the year. 

Second Quarter Market Discussion

A dizzying combination of trade wars, escalating tensions in the Middle East, and domestic political gamesmanship left investors struggling for direction during the period. While the markets alternated between defensive and offensive leadership, the underlying focus was on mitigating perceived risks.
 
With this mindset, investors favored large companies over small, low volatility over high volatility, and investors sought safe havens with predictable revenue. Valuations remained an afterthought.
 
Heavy debt loads continued to be tolerated for many companies, but investors punished leveraged businesses that failed to meet earnings expectations or those that gave lackluster guidance.
 
The skittish tone drove volatility higher and provided opportunities for active managers to harvest gains and deploy capital into overlooked opportunities.
 

Attribution Analysis

Security selection was strong in several areas, and the portfolio outperformed its benchmark, the Russell 2000® Value Index, for the quarter and first half of the year. Industrials and Consumer Discretionary holdings were key drivers of relative performance during the period, while Energy names lagged. 
 
Heartland Advisors Value Investing Industrials Sector IconThe right environment. Strength among the portfolio’s Industrials was widespread and the group contained a top contributor, Harsco Corporation (HSC). The company has historically provided industrial services and engineered products for multiple industries including energy, steel and railways.
 
Shares of Harsco jumped after it reported better than expected earnings and the company announced it was selling off its low-margin, cyclical, industrial services segment and acquiring a high-margin, more consistent environmental solutions company.  
 
We expect momentum in Harsco’s end markets will continue in the near-term and should translate to continued top-line improvements. We are pleased with management’s move to refocus the business on environmental solutions and believe the company should be able to generate more than $500 million in earnings before interest, taxes, depreciation and amortization (EBITDA) by 2021. Based on our sum-of-the-parts analysis, we believe shares are trading at more than 35% discount to our price target. 
 
Heartland Advisors Value Investing Consumer Discretionary Sector IconToll of tariffs. Looming tariffs took a toll on names in the Consumer Discretionary sector. The portfolio’s holdings outperformed those in the benchmark, but the group still contained a key detractor, Wolverine Worldwide (WWW). 
 
Wolverine, a maker of premium casual footwear, delivered better than expected earnings during the quarter but shares sold off as a result of disappointing sales guidance for the first half of the year. Additionally, the company strategically increased inventories in anticipation of higher costs due to potential tariff increases. Investors focused on the inventory build as a negative instead of seeing the move as a strategic approach to controlling costs. We view both challenges as temporary.
 
The company has seen growth for its top three brands—Sperry, Merrell, and Saucony—that should bode well for the second half of the year. As sales inflect higher, inventories should return to normal levels.
 
We continue to believe Wolverine’s strong brands, high margins, and cost-cutting initiatives continue to make the company compelling. We’ve been impressed with company leadership’s prudent capital management as it funds organic growth, pays down debt and buys back shares.  Trading at 10x estimated 2019 EBITDA versus the 11x to 12x range for its low-growth peers, we view the company with its 7% free cash flow yield as a prudent investment in an improving retail environment.
 
Material issue. Throughout much of the current economic expansion we’ve been struck by the disconnect between growth and the cost of raw materials. While commodities have shown life during the past few years, their performance, as shown below, has significantly lagged that of equities.
 
Commodities Lag
CRB RIND Index Relative to S&P 500 Index
Heartland Advisors Value Investing Commodities Chart
Source: Bloomberg L.P. and Standard & Poor's, 1/4/1985 to 6/28/2019
Commodity Research Bureau BLS Spot Raw Industrials (CRB RIND Index):  is a measure of price movements of 22 basic commodities, whose markets are usually among the first to be influenced by changes in economic conditions. The 22 commodities are combined into an "All Commodities" grouping, with two major subdivisions: Raw Industrials, and Foodstuffs. Raw Industrials include burlap, copper scrap, cotton, hides, lead scrap, print cloth, rosin, rubber, steel scrap, tallow, tin, wool tops, and zinc. Foodstuffs include butter, cocoa beans, corn, cottonseed oil, hogs, lard, steers, sugar, and wheat.
Past performance does not guarantee future returns.
 
Despite this dynamic, we have been able to find compelling opportunities in the Materials space by identifying players with self-help opportunities that are able to generate consistent sales regardless of the economic backdrop.
 
For example, we initiated a position in P.H. Glatfelter Company (GLT), a manufacturer of fiber and pulp-based engineered materials such as coffee filters and hygiene products.   
 
Heartland Advisors Value Investing Materials Sector IconGlatfelter has dramatically changed its business in the last year away from highly cyclical specialty paper market and toward household staples where it can generate higher margins and more consistent sales while serving growing end markets.
 
We expect free cash flows to accelerate for Glatfelter as business investments made over the past 12 months begin to bear fruit. Additionally, the company removed a long-term cloud overhanging the stock by resolving environmental liability litigation. Based on our sum-of-the-parts analysis, shares are trading at a 20% discount to our 2020 estimates of fair value.
 

Portfolio Activity  

We remain confident that underlying fundamentals remain solid and expect the economy to continue to grow at a measured pace. However, we also recognize that short-cycle data may cause temporary concerns for investors and could result in bouts of volatility and selling pressure. Our response has been to use volatility to trim positions where we believe valuations reflect excessive optimism and buy businesses that offer compelling idiosyncratic opportunities and valuations. 
 
For example, we have reduced the portfolio’s exposure to select companies in the Information Technology sector. The trade impasse with China is likely to have a meaningful impact on the industry if supply chains that currently include domestic players are reconfigured to suppliers elsewhere. We believe the market has not fully discounted this possibility and have been actively reducing our exposure to tech-focused businesses. 
 

Outlook and Positioning

The economy is still expanding, and, barring unforeseen shocks, we believe will continue to do so during the second half of the year. At the same time, gridlock in Washington D.C., and ongoing trade tensions have taken a toll on the rate of growth. As such, we are inclined to take any sharp moves higher in the portfolio’s cyclical holdings as an opportunity to harvest gains.
 
As growth continues to decelerate, companies with no or low debt should be well-positioned to endure and opportunistically take market share from those hobbled by excessive debt. The importance of balance sheet strength also makes us wary of holding businesses that are aggressive acquirers of competitors.
 
We continue to put an emphasis on businesses that are actively seeking to reduce costs and improve margins through internally focused efforts.
 
Thank you for the opportunity to manage your capital.
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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 23 years of industry experience, 20 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 10 years of industry experience, 7 at Heartland.

Composite Returns*

6/30/2019

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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)**6.7510.191.9111.65-4.3418.293.70
Small Cap Value Plus Composite (Net of Bundled Fees)5.839.321.4011.09-4.8218.013.58
Russell 2000® Value6.8412.405.399.81-6.2413.471.38

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. 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.

**Shown as supplemental information.

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

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 6/30/2019, Harsco Corporation, P.H. Glatfelter Company, and Wolverine Worldwide represented 3.61%, 2.01%, and 2.00% of the Small Cap Value Plus Composite, respectively.

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Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

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