Heartland Small Cap Value Strategy 3Q19 Portfolio Manager Commentary

 Executive Summary

  • Year-to-date, the Strategy remains up double digits.
  • This is only the third time in the past 35 years that the gap in valuations between large and small stocks has reached this level.
  • A contrarian streak, compelling valuations, and a laser focus on fundamentals are key to capitalizing on opportunities. 
Omne trium perfectum
—Latin phrase meaning “Everything that comes in threes is perfect”


Third Quarter Market Discussion

The rule of three is an age−old trick used by writers to make a piece more compelling. The idea is that a group of three provides perfect symmetry and makes for a more satisfying conclusion to a piece–think The Three Little Pigs, or Goldilocks and the Three Bears. 
So, what does a writing concept have to do with investing? The chart below suggests plenty. As you can see, this is only the third time in the past 35 years that the gap in valuations between large and small stocks has reached this level of extreme. In the past, this disconnect has provided significant upside for those willing to stay the course with small stocks. Following the other two periods—during the recession of 1990 and again when dotcom mania was at its peak—small−cap investors in particular saw outsized returns in the months and years that followed.
Small−Cap to Large−Cap Historical P/E Ratio
Heartland Advisors Value Investing Valuation Table
Source: ©2019 The Leuthold Group, 1/31/1983 to 8/31/2019
The Leuthold Group created this chart using their proprietary Leuthold 3000 Universe. This universe is defined as
the largest 3,000 securities traded on U.S. exchanges and was segregated into large− and small−cap tiers. Gray
bars identify recessionary periods of July 1990 to March 1991, March 2001 to November 2001, and December
2007 to June 2009.
Price/Earnings Ratio (P/E): non−normalized trailing operating earnings
Past performance does not guarantee future results.

Now, like then, we believe a contrarian streak, compelling valuations, and a laser focus on fundamentals are needed to capitalize on opportunities. Your portfolio, in our view, is filled with names that represent those three elements.

A Higher Power

For example, Vistra Energy Corp. (VST), with its unconventional mix of business, was up double digits as it continued to reap benefits from management’s decision to restructure and reduce debt load. This independent power producer provides retail electricity and wholesale power generation to the unregulated utility markets.
Vistra has demonstrated excellent visibility in producing free cash flow due to its 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 both initiating a dividend this year and buying back $1.3 billion—or approximately 9%—of shares outstanding. Trading at just 6.2X enterprise value/earnings before interest, taxes, depreciation, and amortization (EBITDA), and with an equity free cash flow yield of roughly 14%, Vistra’s shares, in our view, offer a compelling opportunity. We are further encouraged by significant recent insider buying.


Healthy Eating?

Holdings in the food products space handily outperformed the benchmark average and were helped by a unique niche player among the group. Landec Corporation (LNDC), which is comprised of a natural health foods business and a biomedical unit, was up sharply following a mid−summer shake−up in leadership. The board was restructured, and a food industry veteran was installed as CEO. The changes should result in a greater focus on free cash flow generation as the company seeks to cut costs in its low−margin, high−volume Curations Foods business and ramp up growth in its Lifecore biomedical division.
Curation foods generates over $500 million in sales—about 85% of Landec’s revenues—but costs have kept a lid on margins. Management is cutting underperforming lines/brands within the food group and has targeted $20 million in savings through increased use of automation in production. 
Landec’s potential for expanding margins in its food line, along with Lifecore’s double−digit revenue growth and 30% EBITDA margins should, in our view, attract increased investor interest. 

Golden Opportunity?

To spur economic activity and inflation, central banks around the globe continue to print money and expand their balance sheets through purchasing bonds, mortgages, exchange traded funds (ETFs), and other financial instruments. As a result, interest rates have plunged to record lows, with over $17 trillion of negative yielding sovereign bonds in the global financial system.  
Prudent investors have taken note and are increasingly attracted to hard assets to preserve their buying power. This renewed interest includes the historic storehouse of value, gold.
For some time, we have been attracted to the metal and hold a few miners that should benefit from these developments. Here’s one of our favorites.

Centerra Gold Inc. (CAGDF) is a Toronto based company with mines on three continents: North America, Eastern Europe and Asia. We like this diversification and its rock−solid balance sheet with minimal debt exceeded by a growing cash hoard. Centerra is benefitting from higher gold prices that have led to a record year with more than $1 billion in sales, and, based on our research, record earnings.
Investors have noticed and have bid the stock up 100% this year.  We’ve trimmed a bit but continue to hold since the business is priced at only 5X current EBITDA and less than 4X our estimate for 2020. The business is also selling at only 70% of our estimate of net asset value. 

Why we’re Optimistic

We can’t predict the future, of course, but recent market activity has us cautiously optimistic that a change in market leadership may be on the horizon.  After watching investors for years gravitate toward large, sexy growth names or pay up in a quest for low volatility, we saw a sharp trend reversal in mid−September. Small−cap stocks started to outpace large companies, formerly hot initial public offerings softened with some of the market darlings we skeptically pointed to last quarter (“Not Earning Their Keep?”) down 20% to 35% year-to-date. At long last, investors finally seem to be paying attention to valuations. 
If, as we hope, the growth−at−any−price delirium of the past decade is finally breaking, we believe the valuations and strong balance sheets held in your portfolio and shown below will go a long way in helping investors capitalize on what we view as a third−in−a−lifetime opportunity. 
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 9/30/2019
Price/Earnings and EV/EBITDA are calculated as weighted harmonic 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. 
With that, we’ll leave you with one more Latin phrase. A saying that fits with the approach we commit to daily at Heartland:
Carpe Pretium! 
(Seize the value)


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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 has 51 years of industry experience, 37 at Heartland.

Heartland Advisors Value Investing Research Analyst Eric Miller

Eric Miller

Miller is a Research Analyst. He has 26 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 President and Director of Heartland Funds. He has 19 years of industry experience, 16 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 Composite (Net of Advisory Fees)**10.533.44-1.37-0.75-2.8312.50-1.06
Small Cap Value Composite (Net of Bundled Fees)8.892.68-1.84-1.05-3.1212.25-1.14
Russell 2000® Value10.1710.067.176.54-8.2412.82-0.57

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

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

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.

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As of 9/30/2019, Centerra Gold Inc., Landec Corporation, and Vistra Energy Corp. represented 2.64%, 3.59%, and 4.31% of the Small Cap Value Composite, respectively.

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Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

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