Heartland Small Cap Value Strategy 2Q17 Portfolio Manager Commentary

 Executive Summary

  • Investors doubled down on their love affair with momentum and big cap growth stocks.
  • Massive flows into Index funds, which focus on capitalization, not valuation, pushed major indices to all-time highs.
  • Despite the headwinds, your Value portfolio kept pace with its index—and we remain disciplined to our philosophy of seeking out undervalued businesses.
  • On a price/sales basis, the Value portfolio trades at an almost 48% discount to its benchmark.
  • The current Indexation Mania is setting up distortions, including mispricing of businesses, which we hope to capitalize on.
“The secret of success is constancy of purpose.” 
— Benjamin Disraeli, 19th century British Prime Minister
Second Quarter Market Discussion
Many investors spent the quarter balancing a mixed economic outlook against fears of being left behind from the ongoing equity market surge. Their response was to bid up what has worked the past few years—momentum and growth stocks.
The effect was magnified by a continued rush into passive funds and exchange traded funds (ETFs) that don’t look at valuations—just size. History has shown us how this can end and, in June, we may have gotten a preview of things to come as the largest market darlings hit the skids. 
The value of being active
The economic uncertainty shadowing today’s markets is nothing new. Conflicting views are essential to every buy and sell trade. What is unprecedented, however, is the level of indifference investors are showing toward valuations. The infatuation with growth at any price has reached an historic extreme, as shown, and sets up for a reversion to the mean, which should be meaningful for value investors.
Historic Outperformance of Growth vs. Value
Russell 2000® Value Index Less Russell 2000® Growth Index 

Heartland Small Cap Value Strategy Portfolio Manager Commentary Growth vs Value Chart

Source: Furey Research Partners, LLC and Russell®, 12/31/1978 to 6/30/2017, annualized return over rolling 10-year periods
Additional information for indexes shown at end of commentary. All indexes are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

We view our purpose as the opposite of this approach. Instead of bidding up companies based on market cap, we continue to be price sensitive, seeking businesses addressing unique needs, producing top-line growth, with exceptional balance sheets, and that are capable of generating strong free cash flow.
In recent months we’ve trimmed back some winners as valuations became stretched and reinvested in opportunities that were priced at a discount to estimated intrinsic value. These efforts have resulted in a portfolio far different than that of an index or ETF. The Strategy has less than 47% of its assets invested in companies that are included in the Russell 2000® Index and less than 10% that are included in the S&P SmallCap 600. Our deliberate approach is reflected in valuation metrics. The Small Cap Value Strategy trades at an almost 48% discount to the Russell 2000® Value Index on a price/sales. The portfolio is also less expensive on a price/book, price/cash flow, and enterprise value/earnings before interest, taxes, depreciation, and amortization (EBITDA) basis. 
In today’s era of pervasive passivity, we believe this is the best approach to producing superior performance over the long run.

Portfolio Activity

Stock selection was mixed with holdings in several sectors outperforming on a relative basis—positions in Financials, Consumer Discretionary, and Materials boosted returns, helping the portfolio outperform its benchmark, returning 1.38%† versus 0.67%. Allocation decisions detracted from performance as did holdings in Information Technology (IT). 
Smart shopping
The rapid rise of online sales and an oversupply of brick-and-mortar stores has made investing in consumer-oriented businesses a challenge. Despite the difficulties, the Strategy’s Consumer Discretionary names were up sharply on an absolute basis and outperformed the benchmark. 
Our research has led us away from hard-hit mall retailers and into areas such as select homebuilders and for-profit education. Both industries should receive a boost from maturing Millennials. We’ve also been encouraged by a new tone out of Washington toward private education companies that can provide a vital service in closing the skills gap for many workers. 
Golden years
Long-time holding CareTrust REIT, Inc. (CTRE) continued its impressive showing for the year. The real estate investment company specializes in managing and acquiring skilled nursing, assisted living, and independent senior housing. The company’s focus on regional, mid-market locations along with its seasoned management team makes it a differentiated player in the industry. 
With 165 properties and nearly $1.2 billion in assets, we estimate the company’s pro forma debt/capitalization stands at a conservative 23% and its interest coverage ratio at a robust 4.9x. The company has been able to stand out in a strong performing sector by bolstering its balance sheet, which should provide it with dry powder to use to opportunistically acquire additional properties. CareTrust’s accomplished management team has been able to generate an impressive 9% yield on its properties in 2017. With a payout ratio estimated at only 60% of funds from operations, the company has ample opportunity to grow its 3.9% dividend yield. We believe factors such as aging population, industry supply constraints, and increased cost of treatment alternatives should boost this well-run operator. 
Energy sapped
Oil prices retreated as the outlook for economic growth grew less certain. Energy was the weakest-performing group for the broad index, and the Strategy’s names performed in line. While we are disappointed by returns for the group, we believe our holdings are well positioned for an uptick in the price of crude.
Willbros Group, Inc. (WG), a specialty energy pipeline contractor and utility transmission provider, was down for the quarter but we view the company as a compelling opportunity. The business faced significant financial pressure during the plunge in oil prices in late 2014. Impressed with a new management team brought in to navigate the rocky energy market we maintained our position in the company.

Heartland Value Fund Portfolio Manager Commentary Energy Chart

Source: FactSet Research Systems Inc., 6/29/2012 to 6/30/2017
Closing prices charted on a weekly frequency. Management purchases include only open-market transactions.
Statements regarding securities are not recommendations to buy or sell.
Past performance does not guarantee future results.

Well down from its high, WG has been building a long-term base.


Although shares remain under pressure as the price of crude struggles, we are encouraged by a 25% spike in Willbros’ order backlog to a new recovery high of $840 million and recent wins of new pipeline construction bids in the Marcellus region. The company recently netted $50 million in new construction contracts for power boosting stations in the Midwest. The utility transmission and distribution (UTD) business is solid. In 2016, UTD accounted for half of the firm’s revenues and is the fastest growing segment— first quarter revenues were up 19% year-over-year. 
Despite the progress, shares are trading at just 1.2x book value versus 1.9x for the peer group average and 4.1x for the S&P 500 Index.
SRC Energy Inc. (SRCI) specializes in oil and natural gas exploration and production using unconventional horizontal drilling in the United States. The company has a total of about 60,000 acres in the Greater Wattenberg Area of Colorado. Shares had a strong run in the second half of 2016 but have since pulled back despite the business reporting solid earnings results and carrying a pristine balance sheet.
Investors have grown concerned that proposed local restrictions could hamper production. The drilling regulations are unlikely to impact SRC, in our view, because the restrictions focus on curtailing vertical wells, which accounts for just 2% of the company’s production. We believe regardless of the anticipated rule changes the company is on track to double its output in 2017.
SRC’s use of horizontal drilling technology increases efficiency and reduces costs. At current prices, shares are trading at a more than 40% discount to our estimates of net asset value.


Committed to our process

The enormous pressure to throw in the towel and join the herd has worn down some of our long-time peers. We’ve recently seen traditional value managers join the FAANG*** chase in hopes of keeping up in the near term.
We continue to follow a different path and remain true to our Principles™ by refusing to pay up for momentum or the promise of top-line increases. Instead, we focus on valuations, dig into balance sheets, seeking businesses that can exploit unique niches to grow in today’s business climate. 
Thank you for the opportunity to manage your capital.
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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Bill Nasgovitz

Bill Nasgovitz

Nasgovitz is Chairman and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He also is President and Director of Heartland Funds. He has 49 years of industry experience, 35 at Heartland.

Heartland Advisors Value Investing Research Analyst Eric Miller

Eric Miller

Miller is Vice President and Portfolio Manager of the Heartland Value Fund and its corresponding separately managed account strategy. He has 24 years of industry experience, 14 at Heartland.

Composite Returns*

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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 10/1/1988.
**Shown as supplemental information.
***FAANG stands for Facebook, Inc., Apple Inc., Amazon.com, Inc., Netflix, Inc., and Google (Alphabet Inc.)

Past performance does not guarantee future results.

The Small Cap Value 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.

The U.S. dollar is the currency used to express performance.

As of 6/30/2017, CareTrust REIT, Inc., Willbros Group, Inc., SRC Energy Inc., Facebook, Inc., Amazon.com, Inc., Apple Inc., Netflix, Inc., and Alphabet Inc. represented 2.8%, 3.1%, 3.0%, 0.0%, 0.0%, 0.0%, 0.0%, and 0.0% of the Small Cap Value 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 as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems Inc.

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®.

Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued.

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

Additional Information for Indexes in Chart (calendar year returns %):

    1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 YTD 2017*
Russell 2000® Growth Index   20.37 20.17 -17.41 51.19 7.77 13.37 -2.43 31.04 11.26 12.95 1.23 43.09 -22.43 -9.23 -30.26 48.54 14.31 4.15 13.35 7.05 -38.54 34.47 29.09 -2.91 14.59 43.29 5.62 -1.38 11.32 9.97
Russell 2000® Value Index   29.47 12.43 -21.77 41.70 29.14 23.77 -1.54 25.75 21.37 31.78 -6.45 -1.49 22.83 14.02 -11.43 46.03 22.25 4.71 23.48 -9.78 -28.92 20.58 24.50 -5.50 18.05 34.50 4.22 -7.47 31.74 0.54

*Not annualized as of 6/30/2017
Source: FactSet Research Systems Inc. and Russell®

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.