Heartland Small Cap Value Plus Strategy 3Q22 Portfolio Manager Commentary

Executive Summary

  • The economic backdrop continues to deteriorate, with credit spreads widening, liquidity weakening, and the Federal Reserve raising rates aggressively.
  • Rather than seeking shelter in defensive areas of the market, we believe in identifying companies with defensive traits across all sectors.
  • A focus on quality is key to our process, as investors may soon begin focusing on balance sheet strength.

Third Quarter Market Discussion

The backdrop we’ve been expecting — and fearing — started to take shape in the third quarter. The economy continued to slow, credit spreads widened, and liquidity began to weaken. The Federal Reserve also kept raising interest rates aggressively at a time of worrisome levels of sovereign, corporate, and consumer debt. The Federal Reserve may not think it has a choice but to keep lifting rates to tamp down inflation, even if it drives the economy straight into a painful recession.   

Yet one thing we haven’t seen so far — but are anticipating — is the point at which balance sheet strength becomes a primary focus of investors again. That’s the type of environment where we should shine, with profitable, high-quality, low-volatility, low-leverage, free-cash-flow-generating companies being valued for their ability to weather any economic condition.  

With the amount of monetary stimulus that has been poured into the economy in recent years, a good deal of aggregate demand has been pulled forward. And with the Federal Reserve’s foot off the accelerator and firmly on the brakes, we could be in store for a long period of slower-than-average growth. In that scenario, future returns may be challenging.

While this may seem like a frustrating situation for investors, it is precisely the type of environment where active value-minded managers can demonstrate their worth.

Downside Protection

Our focus is on high-quality companies with good management teams that we think will be winners on a longer-term basis, not just in the current environment. In other words, we are looking for secular winners, not just cyclical survivors. 

Within this framework, the themes running through our portfolio include companies with compelling self-help strategies, the ability to raise their dividends over time, and the strength to self-finance organic growth. We are also looking for companies with durable competitive advantages throughout not just this cycle but beyond. 

More than a year ago, we began looking for ways to reduce our portfolio’s supply chain risks stemming from exposure to China, which is still enforcing its “zero-Covid” policy that continues to include lockdowns and economic restrictions. And about nine months ago, we took a long, hard look at reducing our exposure to Europe. In our view, Europe is likely to be severely impaired on a long-term basis as a result of energy issues stemming from the Russia-Ukraine war. At the moment, we are trying to stay as U.S.-centric as possible.

Attribution Analysis

Make no mistake: We are not simply hiding in defensive areas of the market. We are, for example, overweight in economically sensitive Industrials and Materials relative to the Russell 2000 Value® Index. And our second-largest weighting, after Industrials, is in Financials, another classic cyclical part of the market. 

Instead, we have focused on companies throughout our portfolio, across all sectors, that tend to have defensive characteristics and margins of safety. In the quarter, this posture contributed to underperforming the small-cap value benchmark, which witnessed a rebound in speculative securities in July and early August. But it also contributed to outperforming the Russell 2000 Value® Index year to date, during which time the broader market seems to have fallen into a bear market.

Heartland Advisors Value Investing Consumer Discretionary Sector IconIndustrials. An example of a high-quality company in an economically sensitive area is Douglas Dynamics (PLOW). Douglas, an Industrial company, manufactures commercial vehicle attachments such as snowplows, salt spreaders, and lawn-care equipment. If you live in the Northeast and see a snowplow, there’s a good chance that it is either a “Western” device made by Douglas, or a BOSS snowplow made by the Toro Company. Douglas and Toro are leaders in what is effectively an oligopoly.

PLOW is a vivid example of a good business with low leverage and the potential to buy back its stock and grow its dividend. In fact, the company has consistently raised its payout every year for more than a decade.

But the stock has been weighed down because roughly two-thirds of its revenues are tied to snow- and ice-removal equipment, and there has been lower-than-average snowfall over the past several years. The stock is currently priced as if a traditional winter will never occur again. If we see a winter with simply average snowfall, it could be a catalyst for the stock. Meanwhile, the stock is currently yielding more than 4%, so investors are being paid for their patience.

Outlook and Positioning

Against this economic backdrop, one of our primary responsibilities is to protect investors from the downside. We feel we are well-positioned in companies that can help us fulfill this goal, such as Douglas.

The markets are likely entering a period of negative earnings revisions, as we began to see in mid- to late-September. While our portfolio won’t be immune to those effects, we think our companies will be less affected than the broader market. Meanwhile, our companies seem to be positioned to weather an economic slowdown. 

We believe our current portfolio construction and a disciplined application of our Ten Principles of Value Investing™, will serve our clients well and help us navigate the quarters ahead.  

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Portfolio Management Team

Bradford A. Evans

Senior Vice President and Portfolio Manager

Andrew J. Fleming

Vice President and Portfolio Manager

Composite Returns*


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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)**6.776.955.807.63-14.82-18.03-7.48
Small Cap Value Plus Composite (Net of Bundled Fees)5.946.395.287.11-15.24-18.34-7.60
Russell 2000® Value6.247.942.874.72-17.69-21.12-4.61

Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.
*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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Past performance does not guarantee future results.

The Small Cap Value Plus Strategy primarily invests in companies that have a market capitalization consistent with the capitalization range of the Russell 2000 Value Index, 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.

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As of 9/30/2022, Douglas Dynamics Inc (PLOW) represented 1.83% of the Small Cap Value Plus Composite’s net assets. 

The future performance of any specific investment or strategy (including the investments discussed above) should not be assumed to be profitable or equal to past results. The performance of the holdings discussed above may have been the result of unique market circumstances that are no longer relevant. The holdings identified above do not represent all of the securities purchased, sold or recommended for the Advisor’s clients.

Statements regarding securities are not recommendations to buy or sell. 

Portfolio holdings are subject to change. Current and future holdings are subject to risk.

In certain cases, dividends and earnings are reinvested.

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Economic predictions are based on estimates and are subject to change.

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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.

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Data sourced from FactSet: Copyright 2022 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. Defensive Stocks include Health Care, Utilities, and Consumer Staples. These companies usually don’t suffer as much in a market downturn as they relate to basic needs. Dividend Yield is a ratio that shows how much a company pays out in dividends each year relative to its share price. 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. Leverage is the amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. It is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets. Margin of Safety is a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. 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. Volatility is a statistical measure of the dispersion of returns for a given security or market index which can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security. 10 Principles of Value Investing™ consist of the following criteria for selecting securities: (1) catalyst for recognition; (2) low price in relation to earnings; (3) low price in relation to cash flow; (4) low price in relation to book value; (5) financial soundness; (6) positive earnings dynamics; (7) sound business strategy; (8) capable management and insider ownership; (9) value of company; and (10) positive technical analysis.