Heartland Small Cap Value Strategy 2Q19 Portfolio Manager Commentary

 Executive Summary

  • The strategy posted double-digit gains and beat its benchmark through the first half of the year.
  • Year-to-date, more than 60% of your holdings have seen meaningful buying by insiders.
  • Our unwavering focus on buying businesses at steep discounts should lead us to successful investments.
“No one cares about value.” 

— Milwaukee-based, 40-year veteran wealth manager

Second Quarter Market Discussion

Value is dead! That isn’t our conclusion but is the message appearing almost daily in the financial press. The drumbeat of negativity is so prevalent that we’ve begun to collect some of the most extreme examples to line the walls of our new headquarters when we move in November.
 
Despite the dire assessments on the state of value and active investing, the strategy posted double-digit gains and beat its benchmark through the first half of the year.
 

Chew on this

But back to the value-agnostic. So, if focusing on the price paid for old-fashioned concepts like earnings or cash flows are dead, what is alive and thriving? SALES GROWTH. 
 
In fact, being profitless seems to be an advantage in the land of unicorn growth stocks.
 
Whether it’s money-losers like Beyond Meat Inc. (BYND) or its earnings-challenged peer Chewy Inc. (CHWY), the sky is the limit when it comes to investor interest in projected sales growth. Consider the following table, which highlights market value, the price/sales ratio and earnings of recent IPOs and market darlings. As you can see, the market is paying $180 billion for net losses. For perspective, the average price/sales ratio in the Small Cap Value strategy is less than 1X and 2019 forward price/earnings is 11.1X.*
 
Not Earning Their Keep?
Heartland Advisors Value Investing Valuation Table
Source: FactSet Research Systems Inc. and Heartland Advisors, Inc., as of 6/21/2019
Economic predictions are based on estimates and are subject to change.
Past performance does not guarantee future results.
 
Maybe it’s because we saw how the last growth-at-any-cost bubble ended during the 2000-2002 return to sanity, but nose-bleed valuations like those above are troubling and historically haven’t lasted. When lofty sales growth momentum fails to materialize or to translate into cold, hard profits, stock prices eventually tumble, and growth investors are often left holding the bag.
 
Fortunately, there are still a few savvy buyers of attractively priced businesses and many of them are running the companies held in your portfolio. A quick review of activity in the strategy’s holdings show considerable insider buying and company-backed share repurchases. 
 
During the first half of the year, more than 60% of your holdings have seen meaningful buying by insiders. Add in companies with share buybacks, and the folks who run the businesses, and should know best their businesses’ intrinsic worth, are pointing to a bright future for your portfolio. 
 
Here are a few examples of compelling opportunities where business insiders are putting their money to work and/or management has put capital to work by investing in the business through share buybacks. 
 

Value in the house

Longtime holding Radian Group Inc. (RDN), a private mortgage insurer, is up nicely this year and has helped the portfolio beat its benchmark through the first half of 2019. A solid housing market and improved credit underwriting since the financial crisis has provided a solid foundation for strong operating performance.
 
From 2014 to 2018, revenue grew at an annual rate of 10.2%. New management has come in and restructured operating costs resulting in a return on equity that stands at an enviable 16%. Given the increase of first-time homebuyers—think more than 90 million Millennials entering the ranks of homeowners—and mortgage rates hovering near two-year lows, we believe the good times should continue for Radian.
 
Management’s history of insider buying over the past few years, an aggressive share repurchase program, and the company’s strengthened balance sheet all bolster our confidence in Radian. Shares continue to trade at just 1.3x book value and only 8.0X earnings (a 12% earnings yield), despite our view that earnings and book value should grow at a high single-digit pace.
 

Powering up

As investors continue to scramble for income in a low-rate environment, some traditional high-yield areas like Utilities have become increasingly expensive. The challenge for value investors is to find differentiated business where the market is overlooking or misunderstanding a compelling opportunity. 
 
Vistra Energy Corp. (VST) is a prime example of what our bottom-up research approach has unearthed. This independent power producer provides retail electricity and wholesale power generation to the unregulated utility markets. New management and a restructured balance sheet have enabled the company to reduce debt while producing substantial free cash flow.  
 
Vistra should have excellent visibility in producing free cash flow due to it combination of retail and wholesale business, along with its use of hedging to mitigate volatility in gas and electricity exposure.  
 
We’ve been impressed with leadership’s ability to pay down debt and its shareholder-friendly actions including initiating a dividend this year and buying back $1.1 billion—or approximately 8%—of shares outstanding. Trading at just 6.1X enterprise value/earnings before interest, taxes, depreciation, and amortization (EBITDA), and with an equity free cash flow yield of 18%, Vistra’s shares, in our view, offer a compelling opportunity. We are further encouraged by significant recent insider buying.
 

Communication is key

Calix, Inc. (CALX), a communications equipment and services provider that also offers cloud-based data analytics capabilities, is another holding where management’s enthusiasm seems to mirror ours. We took a stake in the company earlier this year after shares came under pressure due to an isolated loss of a customer and some temporary issues tied to a shift in suppliers. 
 
We take a longer view of company prospects and see a compelling opportunity. Calix is in the process of fundamentally transforming its business model. Early results have been promising as margins have expanded and the company has seen steady high single-digit growth in bookings. 
 
Importantly, new platform sales products are expected to reach roughly 75% of total sales by the end of 2019 and are growing at a double-digit rate.
 
Despite the promising outlook, Calix trades at only 7.4X 2020 estimated EBITDA—less than half the multiple enjoyed by its peers. Our confidence in the investment is further bolstered by knowing that management has purchased more than 350,000 shares in the business valued at $2.6 million during the past year. 
 

Time to care

We understand what prompted our wealth manager friend to declare value just doesn’t matter in today’s markets, but that outlook strikes us as foolhardy.
 
By chasing dubious growth projections from the latest and greatest story stock, investors are setting the stage for potential pain if promised revenues fail to materialize and sky-high multiples can no longer be supported. 
 
We’ve taken what we believe is a more prudent approach—buy well-run companies with strong balance sheets that are trading at discounts, as shown below, on both an absolute and relative basis. In many cases, our research and valuation process has led us to names where company management is investing alongside us. 
 
Small Cap Value Composite Valuations 
Heartland Advisors Value Investing Valuation Chart
Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 6/30/2019
Price/Earnings and EV/EBITDA are calculated as weighted harmonic average and Dividend Yield as weighted average.
Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA). Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Certain outliers may be excluded. Any forecasts may not prove to be true. Economic predictions are based on estimates and are subject to change. All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future returns.
 
This isn’t the first growth bubble we’ve seen, and it may not be the last. But with nearly four decades of experience as our guide, we feel confident that our unwavering focus on buying companies at steep discounts to their intrinsic worth will lead us to investments that will thrive long after today’s market darlings fade from memory.
 
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 51 years of industry experience, 36 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 25 years of industry experience, 16 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value, Mid Cap Value, and Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 19 years of industry experience, 15 at Heartland.

Composite Returns*

6/30/2019

Scroll over to view complete data

Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Small Cap Value Composite (Net of Advisory Fees)**10.665.27-4.123.64-4.3513.70-0.57
Small Cap Value Composite (Net of Bundled Fees)9.014.48-4.613.33-4.6413.54-0.64
Russell 2000® Value10.2812.405.399.81-6.2413.471.38

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

*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 10/1/1988. 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.

**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 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 6/30/2019, Beyond Meat, Inc., Calix, Inc., Chewy, Inc., Lyft, Inc., Pinterest Inc., Radian Group Inc., Slack Technologies Inc., Tesla, Inc., Uber Technologies, Inc., and Vistra Energy Corp. represented 0.00%, 1.18%, 0.00%, 0.00%, 0.00%, 2.78%, 0.00%, 0.00%, 0.00%, and 2.83% 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 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.

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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