Heartland Small Cap Value Strategy 2Q20 Portfolio Manager Commentary

 Executive Summary

  • The Small Cap Strategy handily outperformed the Russell 2000® Value Index for the quarter and through the first half of the year.
  • Investors have gone from panic-based selling to clamoring to bid up shares of bankrupt businesses. 
  • Mass herding into weak businesses and mega-caps has left profitable small cap companies trading at historical discounts.
"Stocks only go up, this is the easiest game I’ve been part of!”
—David Portnoy, Internet Celebrity and Founder of website Barstool Sports


Despite recent headwinds, your portfolio handily outperformed the Russell 2000® Value Index for the quarter and through the first half of the year.

Maybe it’s too much time spent in isolation due to social distancing or it could just be something in the water. Whatever it is, there seems to be no shortage of speculative behavior among investors these days. While Mr. Portnoy has been the poster child for the new mentality in the market, a look at valuations and balance sheets of some of the big winners during the past quarter, shows his bet-first-analyze-later approach is common in the age of COVID-19. Consider the following:

  • Shares of Hertz, the bankrupt rental car company, surged after management proposed flooding the market with a new issue of equity.
  • Retailer JC Penney with $3.7 billion in debt saw its shares jump 55% weeks after filing for bankruptcy.  
We’d be tempted to overlook these examples as outliers if it weren’t for the data below. The mass herding into weak businesses and mega-caps has resulted in profitable small cap companies trading at historical discounts—the most in 30+ years—to the S&P 500 as reflected by earnings yield. 
Median Earnings Yield Spread vs. S&P 500 
Profitable Companies Only

Universe is the 3,000 largest U.S. stocks by market cap according to FactSet Research, calculated monthly. Top 1000 basket includes companies ranked 1 to 1,000 by market cap.  Second 2000 includes companies ranked 1,001 to 2,000 and Third 1000 includes companies ranked 2,001 to 3,000. Universe is rebalanced monthly. Earnings Yield is defined as Net Income for the last 12 months, divided by Market Cap, calculated monthly. Median Earnings Yield Spread for each basket is defined as the median company EY of each basket after excluding companies with negative income over the last 12 months, minus the median EY of S&P 500 companies after excluding money losers. Calculated monthly. Standard Deviation of Earning Yield Spread indicates how far the current EY reading deviates from the average.  Negative S.D. means the EY is more expensive than average, positive S.D. means the current EY is cheaper than average. Calculations run from 12/31/1986 through 6/27/2020. Data as of June 30, 2020. 

Process Driven

The portfolio was up more than 35% for the quarter yet work remains to undo the damage from the pandemic-fueled selloff of spring. In a market driven by momentum and speculation, the fact that the Strategy outpaced its benchmark is encouraging given the team’s commitment to fundamental research and focus on valuations. The foundation laid by Heartland’s 10 Principles of Value Investing has led us to well managed businesses, that are financially strong and have what we view as compelling opportunities for bottom-line growth in the years ahead. The following are just a few examples.

A Home Run?

We highlighted portfolio holding MDC Holdings Inc. (MDC), as a casualty of the COVID-19 selloff earlier in the year. The company, like other homebuilders, saw its shares fall due to investor concerns about shrinking demand. 

Despite the weakness, we were steadfast in our confidence in the company’s management team as well as growth prospects going forward. That commitment was rewarded as shares rebounded sharply on an uptick in orders. 

We believe the homebuilding industry, and MDC in particular, are on the cusp of a surge in demand as Millennials faced with working remotely out of small, urban, apartments have started to seek more space in homes in the suburbs. 

Millennials are projected to generate over 30 million additional households over the next 15 years. MDC’s expertise in meeting the needs of entry-level buyers positions the company to thrive during the coming demographic tsunami.
Despite its impressive history and exceptional management team, shares of the business are trading at 1.2X tangible book value and the company boasts a return on equity of 14% in 2019. At its current valuation the stock throws off an earnings yield of 8%. 

Masked Opportunity

Information Technology (IT) was a source of strength for the portfolio during the period, and we believe holdings such as Photronics Inc. (PLAB) have further room to run. 

Photronics is a global manufacturer of photomasks used to transfer circuit patterns onto semiconductor wafers and flat panel displays during the fabrication process. The company operates nine manufacturing facilities throughout the world and is an established player in fast-growing markets, such as China and Korea.

We took a stake in Photronics when shares were under pressure as it was investing in expanding its capacity. While other investors were fixated on the short-term effect capital spending put on profit margins, we saw a business that was positioning itself to meet the needs of the high-growth IT industry. 

Photronics is now set to reap the benefits of several years of growth investments. Along with an expected jump in sales, margins should expand as capital improvements wind down leaving the company well situated to generate robust cash flow going forward. We also view the business’ financial position, with $2.76/share of cash on the balance sheet, as a competitive advantage.

A Wolf in Sheep’s Clothing

The sleepy Utilities sector is rarely seen as a place to look for businesses with strong growth prospects. However, for investors willing to do their homework, opportunities do exist. Recent portfolio addition National Fuel Gas Company (NFG) is a prime example.  

Although NFG is lumped in with plain vanilla power companies, it is much more diverse. In addition to its utility operations, a pipeline and storage division generates almost a quarter of its profits and the company generates nearly 40% of its bottom line from natural gas exploration and production. Given the current state of the energy industry, we believe NFG’s gas unit could be an overlooked source of growth.

During the first half of this year, domestic oil pumping fell significantly in response to weak demand and low crude prices. As a result, natural gas production—a byproduct of the oil drilling process—also shrank. The upshot is that the supply/demand dynamic may finally be shifting in favor of gas producers who have lacked pricing power for years. 

Sensing the improved outlook, NFG opportunistically expanded its gas producing footprint when it acquired assets from a subsidiary of Royal Dutch Shell in May. The deal is expected to immediately contribute to earnings and provides the company with additional fertile acreage and room to grow its 4% dividend yield.

A Golden Rule? 

As Washington D.C. pulls out all the stops to keep the economy afloat despite the ravages of COVID-19, deficits here and abroad have ballooned. As displayed below, historically, growing deficits have been a boon for the price of hard assets such as gold. Fortunately, we’ve been able to identify well-managed participants in the space priced at compelling valuations.

Mind the Gap

Source: Federal Reserve Bank of St. Louis (FRED) 
Quarterly data 4/1/1968 to 1/1/2020, Not Seasonally Adjusted
Past performance does not guarantee future results.

A Voice of Reason in Crazy Times

The first six months of 2020 have been anything but normal. In the course of just a few months, investors have gone from panic-based selling to clamoring to bid up shares of bankrupt businesses. For some, like Mr. Portnoy, the chaos has created a game like atmosphere where trading stocks is done for entertainment.

Maybe it’s the result of our decades of experience as value investors, but we find it hard to find joy in overpaying for inferior businesses. Instead of chasing the allure of a quick rush from buying shares of a questionable business in hopes there is a greater fool out there willing to pay a few cents more, we prefer a more diligent approach. Our satisfaction comes from digging into a business to determine its intrinsic value. We get to know the management team, identify catalysts for growth and look for mispriced valuations. 

This fundamental approach, in our view, is the best way to help our clients achieve their goal of capital appreciation. We believe the valuations of your portfolio, shown below, are compelling with solid sales and earnings growth which could exceed that of many ridiculously priced market darlings. 

Small Cap Value Strategy Valuations

Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 6/30/2020 Price/Earnings and EV/EBITDA are calculated as weighted harmonic average. 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.

While 2020 may continue to be defined by its unpredictability, we remain unwavering in pursuit of investments that fit with our principles but also unrelenting in our commitment to improving.

Thank you for your continued confidence. We look forward to a return of common sense.

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Portfolio Management Team

Bill Nasgovitz

Nasgovitz is Chairman and Portfolio Manager of the Value Fund and its corresponding separately managed account strategy. He has 52 years of industry experience, 37 at Heartland.

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Opportunistic Value Equity Strategy, as well as the Mid Cap Value Fund, the Value Fund, and their corresponding Mid Cap Value and Small Cap Value Strategies. He also is President and Director of Heartland Funds. He has 20 years of industry experience, 16 at Heartland.

Composite Returns*


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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Small Cap Value Composite (Net of Advisory Fees)**10.203.56-1.59-2.75-3.27-11.6335.59
Small Cap Value Composite (Net of Bundled Fees)8.592.86-1.95-3.04-3.56-11.7635.49
Russell 2000® Value9.287.821.26-4.35-17.48-23.5018.91

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 10/1/1988. 
**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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©2020 Heartland Advisors | 790 N. Water Street, Suite 1200, Milwaukee, WI 53202 | Business Office: 414-347-7777 | Financial Professionals: 888-505-5180 | Individual Investors: 800-432-7856

Past performance does not guarantee future results.

The Small Cap Value Strategy seeks long-term capital appreciation by investing in micro- and small-cap companies, generally with market capitalizations of less than $2.5 billion at the time of purchase. The micro- and small-cap segment of the stock market is robust with thousands of publicly traded issues, many of which lack traditional Wall Street research coverage. Thus, we believe this market is often inefficient, mispricing businesses and offering opportunities for fundamental research-minded investors such as Heartland.

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.

As of 6/30/2020, MDC Holdings, Inc., National Fuel Gas Company, and Photronics Inc. represented 3.12%, 0.91%, and 0.94% 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.

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.

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.

Book Value is the sum of all of a company’s assets, minus its liabilities. Dividend Yield is a ratio that shows how much a company pays out in dividends each year relative to its share price. Earnings Before Interest and Tax (EBIT) is an indicator of a company’s profitability, calculated as revenue minus expenses, excluding tax and interest to eliminate the effect of different capital structures and tax rates used by different companies. Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA) Ratio is a financial indicator used to determine the value of a company and is calculated by dividing the entire economic value of the company (enterprise value) by its earnings before interest, taxes, depreciation, and amortization (EBITDA). Earnings Yield is the reciprocal of the price to earnings ratio. Price/Earnings Ratio of a stock is calculated by dividing the current price of the stock by its trailing or its forward 12 months’ earnings per share. 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. S&P 500 Index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index. Tangible Book Value is the sum of all of a company’s assets, minus its liabilities and intangible assets, such as goodwill.