Heartland Small Cap Value Plus Strategy 3Q20 Portfolio Manager Commentary

 Executive Summary

  • The portfolio remains meaningfully ahead of its benchmark, the Russell 2000® Value Index, through the first nine months of the year.
  • Investors gravitated toward high-beta and highly leveraged businesses.
  • Government deficits and private sector leverage shot into unprecedented territory.
  • Stimulus has cushioned some of the economic damage from COVID-19, but long-term expansion could be tepid.   

Third Quarter Market Discussion

During much of the period, the major indices built on strength from late Spring as investors charged head-first into equities despite an uncertain outlook for the global economy. The momentum stalled in the final few weeks as investors grew wary of extended valuations for many areas of the market. The risk-on stance in place for most of the summer was fueled by an accommodative Federal Reserve and ongoing effects from the trillions in relief dollars pouring out of Washington D.C. over the past several months.

The prevailing sense that the Federal Reserve would backstop even the weakest businesses, led investors to what appeared to be riskier names in the market and bid up high-beta and highly leveraged businesses. Traditional safety nets such as strong balance sheets or attractive valuations were an afterthought and reasonably priced businesses lagged.

While Wall Street showed a willingness to look past debt levels, government deficits and private sector leverage shot into unprecedented territory raising questions about the sustainability and true underlying strength of the U.S. economy. If the economy is less robust than conventional wisdom suggests, many of the richly valued businesses with rosy growth forecasts could stumble in the quarters ahead. 

Nonfinancial Debt as a Share of GDP
 

Source: The Federal Reserve. Quarterly data 1/1/1951 to 6/30/2020. This chart shows nonfinancial debt in the United States as a percentage of gross domestic product (GDP). Debt includes debt securities (commercial paper, Treasury securities, agency- and GSE-backed securities, municipal securities, and corporate and foreign bonds) and loans (depository institution loans, other loans and advances, mortgages, and consumer credit). 
Past performance does not guarantee future results.

Attribution Analysis

The portfolio remains meaningfully ahead of its benchmark, the Russell 2000® Value Index, through the first nine months of the year. An underweight to and selection in Energy boosted relative results, however, couldn’t overcome weakness in Health Care and the portfolio lagged during the period. 

Given the appetite investors showed for leveraged, high-beta names for much of the quarter, we believe results, while disappointing, should be viewed in the context of one data point in a multi-year investment horizon. From this perspective, the portfolio, in our view, is prudently positioned, and investors should reap the benefits of our focus on balance sheet strength and internally driven catalysts over the long-term. 
 
Narrowing the spectrum. While investors spent much of the period bidding up businesses based on sales growth expectations, the portfolio reaped the benefits of some holdings that were driving an improved outlook through self-help measures. Spectrum Brands Holdings (SPB), a household products company, is one such example.

Spectrum sells a variety of home goods through its market-leading brands including Kwikset, Black and Decker, Pfister and Remington. Of the company’s $3.8 billion in annual sales, roughly 80% are driven by its top 15 brands. During the past 18 months, management has undertaken an initiative to exit non-core business lines such as auto care and batteries, reduce debt and improve efficiencies. These efforts have begun to produce results and sales figures have exceeded expectations during the COVID-19 downturn.

We believe Spectrum is in the early innings of its transformation and should also see continued organic sales growth as it invests proceeds from divestitures into its business. Despite recent improvements in its share price, the company still trades at a meaningful discount to its peers on an enterprise value/earnings before interest, taxes, depreciation and amortization basis.
 
 
Add hock. An underweight to Financials boosted relative results. Stringent regulations and a low rate environment have created an undifferentiated landscape in the Banking industry. In response, the team continues to focus on identifying standout institutions that can benefit from management initiatives or serve untapped markets. For example, we added to our stake in First Cash Financial Services, Inc. (FCFS), a pawn store operator with locations in the U.S. and Latin America.  

Shares of First Cash Financial were down as COVID-19 fears roiled the markets earlier this year. The stock has continued to languish based on concerns that additional stimulus checks will erode future demand for pawn loans. Our thesis is that unemployment will remain elevated and political compromise is unlikely before the Presidential election and thus demand for pawn loans will increase near-term.

 

Portfolio Activity 

The business climate remains cloudy. As such, we continue to seek companies trading at attractive valuations, with strong management teams and that have avenues to succeed under multiple scenarios. For example, we initiated a position in Ralph Lauren Corp. (RL), a global lifestyle company that sells clothing, accessories and home goods.

Shares of Ralph Lauren tumbled earlier this year during the COVID-19 selloff. The stock has yet to fully recover as investors continue to cast a skeptical eye toward apparel companies and retail brands in the Consumer Discretionary space. While the global pandemic has been a severe blow to the beleaguered apparel industry, we view Ralph Lauren as a relative winner in the space.

Ralph Lauren is a best-in-breed brand with high gross profit margins and a loyal clientele. Management is using the disruption from the pandemic to accelerate cost-cutting efforts and pivot to an e-commerce growth model. With approximately $800 million in net cash on its balance sheet, we believe Lauren is well prepared to weather current headwinds in retail and should increase sales and earnings in the long-term. Despite our favorable outlook, shares are trading at roughly 6x enterprise value/next year’s earnings before interest, taxes, depreciation and amortization.


Outlook and Positioning

COVID-19 is likely to cast a shadow over the global economy for several years. Government stimulus has cushioned some of the immediate effects of cratering production and demand, but we expect the long-term expansion to be tepid. 

Many investors have interpreted government intervention as an “all clear” to load up on shares of companies with shaky balance sheets, operating in declining industries and those with questionable capital allocation strategies. While those types of companies soared during much of this year, we believe it is a short-sighted approach fraught with risk.

Instead, we are taking a long-term view by investing in businesses that we believe may be well positioned to drive free cash flow growth and those with the financial strength to potentially weather long-term uncertainty caused by the pandemic. We believe this tactic could produce a portfolio of companies that may come out on the other side of the current environment in a much stronger position.

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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*

9/30/2020

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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)**5.566.396.740.15-5.53-11.78-0.19
Small Cap Value Plus Composite (Net of Bundled Fees)4.695.636.20-0.36-6.01-12.12-0.32
Russell 2000® Value4.787.094.11-5.13-14.88-21.542.56

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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†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 9/30/2020, FirstCash, Inc., Ralph Lauren Corporation Class A, and Spectrum Brands Holdings, Inc. represented 2.67%, 2.04%, and 3.81% of the Small Cap Value Plus Composite, 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.

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.

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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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