Heartland Small Cap Value Plus Strategy 2Q20 Portfolio Manager Commentary

 Executive Summary

  • The portfolio remains meaningfully ahead of its benchmark, the Russell 2000® Value Index, for the first half of the year.
  • Market breadth was weak with shares of many companies failing to recoup previous losses.
  • Hopes of a V shaped economic recovery prompted equity investors to stampede back to equities.
  • We remain focused on businesses that are poised to be disrupters in their fields and that have strong cash flows.  

Second Quarter Market Discussion

With the Federal Reserve signaling it was willing to backstop the economy and prop up even the weakest businesses, investors flocked back to the equity markets. The stampede was heightened by hopes of a V shaped economic recovery, which was based on economic data and earnings reports that were less bad than expected.

The risk-on sentiment was in stark contrast to much of the first quarter when widespread COVID-19 fears roiled the markets. The speed and strength of the rebound paused late in the period as investors grew wary of a second wave of new virus infections across several states.

While the move higher for the quarter was a welcome relief for battered portfolios, a closer look at winners and losers painted a less optimistic picture. Breadth was weak with shares of many companies failing to recoup previous losses. Additionally, as shown below, shares of businesses with low returns on equity, as a whole, materially outperformed their higher quality counterparts. Lower quality names often lead in rallies following selloffs, but the magnitude of the bounce back was noteworthy.

Dash to Trash?
 

Source: FactSet; FTSE Russell; Jefferies. This chart shows companies held in the Russell 2000 Index. The 2020 bear market is representing data gathered during 1/16/2020 to 3/18/2020. The average bear market data is calculated based on bear markets taking place during 12/31/1985 to 6/18/2020. Bottom was on 3/18/2020. The average 3-month after bear market data is calculated based on 3 months following each bear market taking place during 12/31/1985 to 6/18/2020. Return on equity (ROE) measures the net income after taxes a firm is able to earn as a percentage of shareholders’ equity. A bear market occurs when the price of a group of securities is falling or is expected to fall. 

Attribution Analysis

The portfolio remains meaningfully ahead of its benchmark, the Russell 2000® Value Index, for the first half of the year. However, strong stock selection in several sectors couldn’t overcome weakness in Health Care and Materials and the portfolio lagged during the quarter. 

Given the low-quality nature of the recent rally, results, while disappointing, are not surprising. We believe, however, that the portfolio is prudently positioned, and investors should reap the benefits of our focus on balance sheet strength and internally driven catalysts over the long-term. 
 
Disruptors wanted. As part of our quest to find businesses with opportunities to improve sales and earnings, we have sought companies that are taking a differentiated path from competitors. We believe these disruptors will be well suited to compete in the aftermath of the global pandemic. Sonic Automotive Inc. (SAH), a top performer for the period, is an example of our thinking.

Sonic is one of the country’s largest automotive retailers, with 95 franchises in 12 states. The business operates in two segments—traditional new and used car sales locations and its EchoPark unit that operates standalone used cars outlets. Shares of the company were up sharply during the quarter as auto sales surged after a dismal first quarter due to COVID-19.

We welcomed the improvement but view Sonic as attractive for the long haul. Specifically, in our view, the company has one of the strongest balances sheets in the industry, a great new car dealer franchise and EchoPark offers a differentiated approach providing it exceptional growth potential in the fragmented and inefficient used-car market. 
 
On the mend?  Health Care, driven by Biotech shares, posted solid gains in the benchmark. Our names failed to keep pace and contained a key detractor, Cross Country Health Care Inc. (CCRN), a health care staffing company specializing in traveling nurses.

Shares of Cross Country were under pressure as demand for health care workers was down due to “elective” procedures being halted during COVID-19. As restrictions have eased and procedures have ramped up, the company has begun to see a rebound in revenue. We expect top-line trends to continue to improve and have been encouraged by meaningful share purchases made by company executives this year.

Solid wood.  Traditionally, rich valuations and lackluster growth prospects have created unique challenges for finding compelling opportunities in the REIT sector. However, we have been able to find attractive candidates in the space by looking in areas beyond retail or commercial real estate. This approach benefitted the portfolio as our holdings in the sector, led by Potlatchdeltec Corp (PCH), outperformed on a relative basis.

Potlatchdeltec owns significant timberland acreage and operates wood mills across the U.S. Shares of the company were up after reporting solid results and minimal impact on its operations due to social distancing. Additionally, Potlatchdeltec was one of the few REITs to maintain its dividend during the period.

We believe shares of Potlatchdeltec should benefit going forward given strong housing demand and stable lumber prices. The company also has strong capital allocation policies in place and has a history of buying back shares when they trade at a discount to net asset value (NAV). 

Despite the strong outlook for company, shares are trading at a 25% discount to NAV.  
 

Portfolio Activity 

The far-reaching economic impact caused by COVID-19 is likely to play out for several years. The pandemic will likely change the way consumers shop, where they eat and how they work. Against this still evolving backdrop, we have sought to identify companies trading at attractive valuations that have avenues to succeed under multiple scenarios. Commoditized areas of the market, such as in Energy, could continue to face headwinds due to excess supply and diminished demand. As such, we have struggled to find compelling opportunities in the space, and it remains an underweight for the portfolio.  


Outlook and Positioning

The flood of stimulus unleashed by the U.S. government and its willingness to prop up even the weakest businesses has caused investors to lose their inhibitions. As a result, shares of companies with shaky balance sheets, operating in declining industries and those with questionable capital allocation strategies, have been snapped up. While those types of companies soared during the most recent period, we believe it is a short-sighted approach doomed to failure.

Instead, we are investing in businesses that are well positioned to drive free cash flow growthand those that are financially strong, in our view. We believe this tactic is the most prudent approach given the current environment. 

Thank you for the opportunity to manage your capital.

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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 24 years of industry experience, 21 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 11 years of industry experience, 8 at Heartland.

Composite Returns*

6/30/2020

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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)**5.697.203.432.69-5.80-11.6114.99
Small Cap Value Plus Composite (Net of Bundled Fees)4.826.422.912.81-6.27-11.8414.85
Russell 2000® Value4.667.821.26-4.35-17.48-23.5018.91

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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©2020 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.

As of 6/30/2020, Heartland Advisors on behalf of its clients held approximately 2.15%, 1.17% and 0.62% of the total shares outstanding of Cross Country Health Care Inc., Sonic Automotive Inc., and Potlatchdeltec Corp, respectively. 
 

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 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.

Composite statistics and holdings are based on 5/31/2020 composite members’ account data as of 6/30/2020. Not all accounts in the strategy are included in the composite.

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.

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 2020 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

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

Bear Market occurs when the price of a group of securities is falling or is expected to fall. Cyclical Stocks cover Basic Materials, Capital Goods, Communications, Consumer Cyclical, Energy, Financial, Technology, and Transportation which tend to react to a variety of market conditions that can send them up or down and often relate to business cycles. 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. 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. Return on Equity is a measure of the net income after taxes that a firm is able to earn as a percent of stockholders equity. 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.

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