Heartland Small Cap Value Plus Strategy 4Q17 Portfolio Manager Commentary

 Executive Summary

  • Strong security selection in Financials and Real Estate boosted results as the Strategy outperformed its benchmark, the Russell 2000® Value Index, returning 3.99%† versus 2.05%.
  • The investing-by-consensus approach that has dominated the past several years began to fray.
  • Companies that rely on commodities in production of goods could face margin pressure in the quarters ahead.
  • We have been finding compelling opportunities among businesses that will benefit from rising raw material prices.

Fourth Quarter Market Discussion

Tax cuts approved in late December provided a burst of energy for investors, and the major indices marked several new highs to close out the year. While the steady march upward has been commonplace in recent quarters, signs of a new underlying tone began to emerge. 
 
The investing-by-consensus approach that has dominated the past several years began to fray. Independent views led to seemingly contradictory results. For example, economic bullishness drove stocks higher at the same time the yield curve was flattening, which is often a sign of pessimism. Some economically sensitive sectors were up while defensive areas such as Consumer Staples also posted solid gains. 
 
A break from the groupthink mentality was also reflected in market internals: correlations of performance among individual stocks turned lower, indicating that investors were evaluating businesses on their individual merits. Despite the push and pull of competing viewpoints, market volatility remained subdued. The continued muted movements suggests to us that investors continue to hedge their bets by gravitating toward low-beta stocks.
 

Attribution Analysis

Security selection was strong in several sectors, led by Real Estate, and the Strategy outperformed its benchmark, the Russell 2000® Value Index. Allocation was positive with an underweight to Real Estate boosting results but an overweight to Information Technology (IT) detracting. 
 
Heartland Advisors Value Investing Portfolio Manager Commentary Real Estate Sector IconMGIC Investment Corporation (MTG), one of the largest private mortgage insurers in the U.S., was up after reporting better than expected earnings. The business continues to benefit from strong home sales, low unemployment, and an influx of first time buyers—a group that traditionally relies on mortgage insurance to secure loans. 
 
Rising home sales, a robust job market and favorable interest rate trends should continue to boost the private mortgage insurance market. MGIC has begun to stockpile reserves and has been aggressively buying back convertible debt. We would not be surprised to see management buy back shares or initiate a dividend.
 
Trading at 11x estimated 2018 earnings and only 1.7x tangible book value, the company, in our view, is an undervalued leader in an industry vital to the domestic economy. 
 
Heartland Advisors Value Investing Portfolio Manager Commentary Industrials Sector IconExploding to the upside? An overweight to and selection in Industrials contributed to the Fund’s outperformance. DMC Global Inc. (BOOM) was among the winners in the group.
 
Shares of the company, which provides completion systems and tools used in oil and gas wells, surged after management reported earnings that came in far better than expected. The company has been focused on reconfiguring its sales mix to focus on high-margin opportunities, and those efforts have begun to produce results. The company also continues to make measured progress on paying down debt.
 
North American oil and gas onshore production continues to recover, sparking rising well completion activity.  We believe DMC’s internal investments during the bear market in oil will continue to benefit shareholders as the Energy sector recovery continues. High margins for the company could translate to meaningful earnings growth on future sales growth.
 
Heartland Advisors Value Investing Portfolio Manager Commentary Information Technology Sector IconTaking the long view. The Fund’s IT holdings were down moderately and the group contained a key detractor. Shares of Benchmark Electronics Inc. (BHE) were down despite management reporting better-than-expected earnings. The company provides contract manufacturing and engineering and design services to OEMs in the medical, defense, aerospace, industrial, and IT industries. Revenue and earnings were up for the quarter as Benchmark continues to reposition itself to capitalize on higher-margin contracts.
 
While the quarterly results were strong, management left earnings guidance for the full year unchanged, which disappointed investors. We are taking a longer view and remain constructive on the name.
 
Benchmark appears to have plenty of operational levers to pull at this point. The most obvious of these comes in growing the top line, led by increased bookings. Benchmark is integrating its institutional sales process across the platform so it is now uniform, regardless of region. This should open the door to cross-selling and bundled services.  
 
Heartland Advisors Value Investing Portfolio Manager Commentary Real Estate Sector IconHot property? Throughout this period of historically low interest rates, we have avoided paying up for yield in so-called bond-proxies such as office real estate investment trusts. Instead, we have found what we believe are attractive valuations and return potential from less traditional real estate holdings such as Lamar Advertising Co. (LAMR), a billboard advertising company. This approach has been rewarded again this quarter as shares of Lamar were up after management reported better than expected funds from operations and an uptick in sales. 
 
Management has a simple focus—convert a portion of its existing billboards to digital and opportunistically acquire smaller industry players. We view this as a more sustainable business strategy than many of the other players in the Real Estate space and believe the company’s commitment to grow its dividend by 10% per year makes Lamar an attractive opportunity.
 

Portfolio Activity  

Throughout 2017, we highlighted tax cuts, an uptick in energy prices, and regulatory relief as potential catalysts that could lead to accelerating economic growth. The most recent quarter gave us a glimpse of what an economy with all three developments in play might look like. Corporate earnings were up, unemployment reached lows not seen in more than a decade, and manufacturing activity continued to rise. We acknowledge as these positive developments take root, the pace of improvement will ebb and flow, and so 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 undervalued. 
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.
 

Outlook and Positioning

The strong run for equities has led some investors to question whether valuations have gotten too rich. In many cases, we believe those concerns are warranted. Pockets of the market where volatility is low and areas that are perceived as safe havens, in our view, have become expensive based on their elevated multiples—and also because the potential of earnings expansion for many is lackluster. 
 
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. As such, we have been finding compelling opportunities among those that will benefit from rising raw material prices. 
 
Inflation has been building for the past several months and yet, as illustrated in the chart, commodities have been left behind as equities have moved higher. With economic activity accelerating, we believe raw materials and businesses that produce commodities will move higher. Conversely, companies that lack pricing power or which rely on commodities in production of goods could face margin pressure in the quarters ahead. 
 
Commodities: Overlooked and Unloved
Commodity Performance Relative to the S&P 500 Index
Heartland Advisors Value Investing Commodity Performance Relative to the S&P 500 Index Chart
Source: Bloomberg L.P. and Standard & Poor's, 1/4/1985 to 12/27/2017
Commodity performance represented by Commodity Research Bureau BLS Spot Raw Industrials (CRB RIND Index)
Past performance does not guarantee future returns.
 
Against this evolving backdrop, we continue to comb through all sectors and industries looking for opportunities where we believe risk is mispriced. 
 
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 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 9 years of industry experience, 6 at Heartland.

Composite Returns*

12/31/2017

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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)**7.507.608.535.239.799.793.99
Small Cap Value Plus Composite (Net of Bundled Fees)6.526.637.994.699.239.233.86
Russell 2000® Value8.018.1713.019.557.847.842.05

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

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©2018 Heartland Advisors | 789 N. Water Street, Suite 500, 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.
*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 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 12/31/2017, Benchmark Electronics Inc., DMC Global Inc., Lamar Advertising Co., and MGIC Investment Corporation represented 2.09%, 4.22%, 3.14%, and 2.86% of the Small Cap Value Plus Composite, respectively.

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.

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®.

There is no assurance that dividend-paying stocks will mitigate volatility.

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.

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

An original equipment manufacturer (OEM) is a company whose goods are used as components in the products of another company, which then sells the finished item to users.

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

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