Heartland Small Cap Value Plus Strategy 4Q19 Portfolio Manager Commentary

 Executive Summary

  • Security selection was strong in several areas and the portfolio outperformed its Russell 2000® Value benchmark for the full year. 
  • Optimism has resulted in investors overlooking shaky fundamentals of individual companies. 
  • Unforeseen economic headwinds could be particularly damaging to highly levered companies.
  • We remain focused on balance sheet strength and prudent use of capital by management teams. 

Fourth Quarter Market Discussion

A spate of good news breathed new life into the markets and the major indices ended the year near all-time highs. While industrial data continued to paint a mixed economic picture, investors embraced a bright outlook that was inspired by a rate cut by the Federal Reserve and a resolution in December to some of the trade disagreements that had been casting a shadow over markets for much of the year.

Impeachment proceedings were one of the few remaining macro clouds yet to be resolved. However, investors seemed to shrug off the drama in Washington, D.C., concluding that hearings would not result in President Trump being removed from office.

The upbeat tone on Wall Street was a boon for lower quality businesses. After spending much of the previous quarter under scrutiny, many of these debt-laden companies were bid up as investors concluded balance sheet strength was a concern for another day. This approach is short-sighted in our view given the unprecedented levels of corporate debt, as shown below, that will need to be refinanced in the next few years.

Bingeing on Debt
 


Source: FactSet Research Systems Inc., 3/31/2005 to 9/30/2019
Debt is represented by Federal Reserve nonfinancial debt.
Past performance does not guarantee future results.

Attribution Analysis

Security selection was strong in several areas, and the portfolio outperformed its benchmark, the Russell 2000® Value Index, for the full year but lagged in the most recent period. Holdings in Industrials were key drivers of relative performance during the quarter, while Information Technology (IT) names lagged. The portfolio’s Consumer Staples names were also up during the period and full year.
 
Heartland Advisors Value Investing Industrials Sector IconPower move. The portfolio’s Industrial holdings outpaced those in the benchmark for the fourth quarter and full year. Among the top performers in the group was a manufacturer of power management solutions.

The company offers investors a compelling mix of a stable legacy business that generates significant free cash flow to fuel future investments, as well as a high growth advanced products segment that generates higher margins. Additionally, the firm holds a significant catalogue of patents, providing it with a defensible advantage in the marketplace.

Bookings for the business have been inflecting higher which should translate into materials sales and earnings growth in the near-term. The stock sports a strong free cash flow/enterprise value yield along with a pristine balance sheet, making it a compelling investment in our view.
 
Heartland Advisors Value Investing Consumer Discretionary Sector IconBank on it. An underweight to Financials boosted relative results. We continue to focus on identifying standout institutions in what has become a more commoditized space—for example, Associated Banc-Corp. (ASB), a regional bank with a dominant position in the Wisconsin market.

We view Associated as a solid, well-capitalized bank that has been able to produce loan growth in a mature market. The company has a clean book of loans and has been actively lowering risk by curtailing lending to the Energy sector.

While earnings expectations for 2020 have been tempered by the Federal Reserve’s rate cut in October, we do not expect any further pressure on net interest margins for the year and believe Associated’s 93% loan/deposit ratio gives the bank significant financial flexibility.

Health Check. The portfolio’s Health care names were up on an absolute basis and contained a key contributor, Phibro Animal Health Corporation (PAHC), an animal health and mineral nutrition company that produces vaccines, microbial products, and medicated feed additives.

Shares of Phibro ended up for the quarter despite reporting earnings that fell short of analysts’ expectations. Management reiterated guidance for 2020 including meaningful growth in the second half of the year as a recent acquisition of a competitor becomes accretive and the company brings some key products in its pipeline to market.

Shares of Phibro came under significant pressure earlier in the year as sales from the company’s medicated feed additives business were hit as a result of China’s African Swine Fever outbreak in mid-2019. The outbreak decimated hog populations causing a significant drop in demand for some of Phibro’s offerings.

We viewed the selloff in Phibro as an opportunity to take a stake in a pre-eminent player in the attractive animal-oriented healthcare field.  As the company’s capital spending cycle winds down in 2020, operating and free cash flow should inflect higher. Additionally, new products are expected to boost sales into 2021 and we expect shares will continue to move higher.

 

Portfolio Activity 

As bottom-up stock pickers, we continue to focus on individual companies and their ability to succeed in a variety of scenarios. However, we also recognize that any unforeseen economic headwinds could be particularly damaging to highly levered companies.

As such, our focus remains on balance sheet strength and prudent use of capital, and we continue to avoid companies that undertake large-scale transformative acquisitions. Instead, we prefer businesses that are involved in selling off noncore, underperforming business lines or those that have the financial wherewithal to opportunistically make small-scale, bolt-on purchases that further enhance core competencies.


Outlook and Positioning

The consensus economic outlook is more optimistic than it has been in the recent past and has resulted in a willingness by investors to overlook shaky fundamentals of individual companies in hopes that a rising tide will lift all boats.

The willingness to overlook idiosyncratic challenges is misguided, in our view. While macro headwinds have faded, we believe the economy is more likely to grind higher at a measured pace than it is to vault upward in a burst of growth.

A slow and steady trajectory could amplify the differences between high-quality businesses with a clear, achievable path to improvement from those that have binged on debt and benefited from macro investor calls. This dynamic should benefit active investors who focus on fundamentals and identifying catalysts for positive change.

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 10 years of industry experience, 7 at Heartland.

Composite Returns*

9/30/2019

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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)**6.568.564.059.24-6.2917.73-0.47
Small Cap Value Plus Composite (Net of Bundled Fees)5.657.713.538.69-6.7617.31-0.59
Russell 2000® Value6.6310.067.176.54-8.2412.82-0.57

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

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†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 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.

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As of 12/31/2019, Associated Banc-Corp. and Phibro Animal Health Corporation represented 3.48% and 1.42% 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.

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