Heartland Small Cap Value Plus Strategy 4Q20 Portfolio Manager Commentary

 Executive Summary

  • The portfolio finished the year meaningfully ahead of its benchmark, the Russell 2000® Value Index.
  • Investors have been lulled into a false sense of security by low interest rates and a flood of cash. 
  • It is still unknown how quickly COVID-19 vaccines will lift the cloud hanging over the economy. 
  • If budding inflation takes root, many businesses could see their profit margins shrink.  

Fourth Quarter Market Discussion

The major indices charged higher as investors responded to the rollout of two COVID-19 vaccines and assurances by the Federal Reserve that it would continue to pump money into the economy for the foreseeable future. The developments were widely viewed as an all clear to bid up large growth companies and many debt-laden businesses based on the belief that they could grow their way out of problems posed by shaky balance sheets.

The prevailing sense that the Federal Reserve would backstop even the weakest businesses continues a trend that has been in place for most of the second half of the year and has led investors to riskier names in the market. 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, signs emerged that the torrent of currency flooding the economy as a results of government and Federal Reserve policy was beginning to cause a ripple in the price of raw materials used in manufacturing, as the chart below shows. If inflation takes root, many of the richly valued businesses with rosy growth forecasts could see their profit margins shrink as they struggle to pass along rising input costs.

Budding Inflation Pressures?   

Source: Bloomberg L.P., 12/31/2015 to 12/31/2020 Raw industrials are represented by the Commodities Research Bureau BLS US Spot Index Raw Industrials Subdivision. Past performance does not guarantee future results.

Attribution Analysis

The portfolio finished the year meaningfully ahead of its benchmark, the Russell 2000® Value Index. For the quarter, the strategy was up more than 25%, however, holdings in Industrials and Consumer Staples failed to keep pace, and the portfolio lagged the benchmark during the period. 

The flood of liquidity injected into the market along with historically low interest rates, in our view, has lulled investors into a false sense of security when it comes to betting on elevated growth projections and has papered over the potential risk of owning debt-laden companies. 
Health check. The portfolio’s Health Care names were up on a relative and absolute basis and the group contained a contributor, Phibro Animal Health Corp. (PAHC), an animal health and mineral nutrition company that produces vaccines, microbial products, and medicated feed additives.

Shares of Phibro were up after reporting better than expected earnings in November. We anticipate the company should continue to see healthy gains in free cash flow generation in 2021, as it begins to reap the benefits of investments made in 2020.

Additionally, Phibro has seen growing demand for its products as animal production has rebounded following a slowdown in the meat packing industry due to COVID-19. Despite the favorable outlook for the company, shares trade at 9x estimates of 2021 enterprise value/earnings before interest, depreciation and amortization (EV/EBITDA).

Good advice? Stock selection in Financials was strong, and the portfolio’s holdings in the space outperformed the average for those in the benchmark. With rates expected to be historically low for the foreseeable future, we have found the Banking Industry to be largely undifferentiated. In response, the team continues to focus on identifying standout institutions that can benefit from management initiatives or grow in a specialized niche. For example, we added to our stake in B. Riley Financial Inc. (RILY), a financial services company offering investment banking, corporate finance, securities lending, and wealth management services, amongst other businesses.

The diversified company has grown its EBITDA to well over $200 million as demand for its investment banking, capital raising, and investment advisory services has been strong throughout COVID-19. In the quarters ahead, we expect this little-followed company will catch the attention of more investors as it continues to grow recurring earnings.

Despite its success, the company is trading at only 4x EV/Core Operating EBITDA. As attention grows for B. Riley, we believe this multiple will grow.


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 work remains centered on balance sheet strength and prudent use of capital, and we seek 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 investors excusing 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 the outlook has improved given the development of COVID-19 vaccines, the speed and degree to which they will translate into sustainable economic growth is still unknown. Instead of a quick end to the global pandemic, we believe the impact of the virus is likely to linger for several quarters, if not years. Additional Government stimulus may offer a temporary reprieve to 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 a potential safety net providing an opportunity to load up on shares of companies with shaky balance sheets, operating in declining industries or those with questionable capital allocation strategies. We view it as a dangerous precedent that may lead to a sharp reversal in fortunes for overvalued businesses when the government spigot is finally turned off. 

As such, we are taking a long-term view by investing in businesses that may be well positioned to drive free cash flow growth and those with the financial strength and pricing power necessary to potentially weather the long-term uncertainty caused by the pandemic. We believe this approach can produce a portfolio of companies that should have enduring strength for the long haul. 

Thank you for the opportunity to manage your capital.

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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*


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)**7.527.3911.627.5813.7213.7228.90
Small Cap Value Plus Composite (Net of Bundled Fees)6.646.6511.067.0413.1513.1528.75
Russell 2000® Value7.018.669.653.724.634.6333.36

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 12/31/2020, B. Riley Financial Inc. and Phibro Animal Health Corp. represented 4.39% and 2.19% 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.

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

CFA® is a registered trademark owned by the CFA Institute.

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.