Heartland Small Cap Value Plus Strategy 4Q18 Portfolio Manager Commentary

 Executive Summary

  • The portfolio’s holdings in Energy, Materials, and Health Care outperformed on a relative basis but the Strategy lagged its benchmark, the Russell 2000® Value Index, returning -20.41%† versus -18.67%.
  • Investors exited equities as they wrestled with the potential impact of macro concerns.
  • Late in the quarter, investors showed some interest in balance sheet strength.
  • We remain confident that while the pace of earnings growth may slow in 2019, underlying economic fundamentals remain relatively solid.

Fourth Quarter Market Discussion

The year closed with the major indices buckling under the weight of “what if?” During the period, employment remained relatively strong, economic forecasts pointed to continued expansion, and manufacturing activity maintained its solid footing. Yet investors fled as they wrestled with the potential impact of ongoing macro concerns. 
 
Among the sources of concern were trade tensions with China, rising interest rates, and slowing earnings growth. The result was a widespread selloff, with economically sensitive areas under the most pressure.
 
As the pessimistic tone gained strength, investors late in the quarter showed a tentative interest in balance sheet strength. The new scrutiny of debt levels is prudent, in our view, and due to aggressive corporate borrowing over the past decade, as shown, could have a meaningful impact on share performance for levered companies.
 
S&P 500 Index
Total Debt/ LTM EBITDA
 

Heartland Advisors Value Investing Total Debt/LTM EBITDA Chart
Source: Cornerstone Macro LP and Standard & Poor’s, 12/31/1996 to 12/31/2018
Last twelve months (LTM); Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA)
All indices are unmanaged. It is not possible to invest directly in an index.

Attribution Analysis

Holdings in Energy and Health Care held up on a relative basis but couldn’t overcome weakness in Financials and Consumer Staples and the portfolio lagged its benchmark, the Russell 2000® Value Index. Allocation decisions also hampered results. 
 
Heartland Advisors Value Investing Utilities Sector IconPower Play. While selling was widespread with all 11 sectors of the Russell 2000® Value down for the quarter, Utilities fared somewhat better as investors sought safety and less volatile earnings. Due to rate regulations under which most utilities operate, the group can be a challenging area to find compelling opportunities for margin expansion. However, we have still been able to find some attractive opportunities such as Portland General Electric Company (POR) by focusing on balance sheet strength of power companies that operate in growth markets. 
 
Portland General, which provides electric and gas service to Oregon, was up after reporting better than expected earnings for its most recent quarter. Results were aided by a favorable legal settlement the previous quarter that led to an additional influx of cash. Management used the windfall to pay down debt and further bolster an already strong balance sheet.
 
We believe Oregon is a burgeoning manufacturing and data industries region, which should lead to net growth in power demand versus projections of flat or negative demand nationally. Despite its financial strength and positive growth outlook, Portland Electric trades at 8x enterprise value/earnings before interest, taxes, depreciation and amortization—well below its peer range of 10x-11x.    
 
Heartland Advisors Value Investing Industrials Sector IconTemporary Dip? The portfolio’s Industrials names were down for the quarter but held up better than those in the benchmark, and we remain confident in our names in the space. For example, Powell Industries, Inc. (POWL), a manufacturer of complex power management systems continues to show promise. 
 
The Houston-based company reported results that beat analysts’ expectations, but shares sold off as orders were weaker than anticipated. However, management indicated that bookings for the first quarter were robust and on pace to meet or exceed projections. We expect the positive revenue trend will continue as major petrochemical, oil and gas, liquefied natural gas, and other power-intensive industrial projects commence in 2019 and 2020. 
 
Despite the improving market for its products, Powell remains undervalued in our view. At 1x tangible book value, its shares are trading well below their 10-year average of 1.6x.   
 
Heartland Advisors Value Investing Financials Sector IconFallout in Financials. An underweight to and selection in Financials hurt results. We’ve sought to take advantage of weakness in the sector by adding to positions where we believe investors have overreacted to temporary setbacks for otherwise solid companies. Hanover Insurance Group, Inc. (THG) is an example of this approach.
 
Shares of Hanover, a specialty property and casualty insurer, were down despite the company reporting solid earnings for the quarter excluding the results from its recently divested specialty international business, Chaucer. Going forward, we expect improved profitability, higher premium growth profile, and a higher return on equity. In addition, the transaction should add to tangible book value and allow the business to increase its dividend payout and potentially repurchase shares.
 

Portfolio Activity  

We remain confident that while the pace of earnings growth may slow in 2019, underlying economic fundamentals remain relatively solid. However, we also recognize that until there is a resolution to some of the macro questions that are concerning investors, volatility and selling pressure may persist for many businesses. Our response has been to take advantage of excessive market reactions and put money to work as valuations warrant.
 
For example, we have added to a handful of our Financials holdings. As the economic outlook has become less clear, sentiment towards the group has cooled. As a result, valuations based on tangible book value (TBV) have dropped by as much as 40%. At 1.5x TBV, banks are trading more in line with a recessionary backdrop. This view, in our opinion, is overly pessimistic and valuations are not reflective of our estimates of the underlying intrinsic value of these businesses.
 
While we have added to some positions, we have also acted decisively to eliminate holdings when management teams have made what we view as ill-advised acquisitions or expenditures that have negatively impacted balance sheet strength.
 

Outlook and Positioning

Heartland Advisors Value Investing Quote Image
Economic data continues to reflect a healthy, albeit slightly decelerating, economy. A focus on hard data as opposed to the latest speculation about the impact of trade wars and rising interest rates reveals a backdrop where corporate earnings are up, unemployment is at lows not seen in more than a decade, and manufacturing activity remains relatively strong. However, we acknowledge the pace of growth is likely to slow in the months ahead, 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 idiosyncratic catalysts
  3. Are generating strong free cash flows, and
  4. Are undervalued. 
We continue to believe businesses that demonstrate financial discipline and that have opportunities to reduce costs and improve margins through internally focused efforts should be well-positioned to capitalize on operating leverage in an expanding economy or modestly grow earnings should sales plateau.
 
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 9 years of industry experience, 6 at Heartland.

Composite Returns*

12/31/2018

Scroll over to view complete data

Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Small Cap Value Plus Composite (Net of Advisory Fees)**5.458.60-0.346.52-13.16-13.16-20.41
Small Cap Value Plus Composite (Net of Bundled Fees)4.557.72-0.806.06-13.41-13.41-20.34
Russell 2000® Value5.9410.403.617.37-12.86-12.86-18.67

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

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©2019 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 12/31/2018, Hanover Insurance Group, Inc., Portland General Electric Company, and Powell Industries, Inc. represented 4.03%, 2.82%, and 3.31% 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®.

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.

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

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.

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