Heartland Small Cap Value Strategy 4Q18 Portfolio Manager Commentary

 Executive Summary

  • The portfolio outperformed its passive benchmark, the Russell 2000® Value Index for the quarter and year.
  • Many of the holdings in the Value portfolio have seen insider buying by executives in the past six months.
  • Economic uncertainty could cause investors to seek more reasonably valued businesses over high-flying glamor names.
“Be fearful when others are greedy and greedy when others are fearful."

—Warren Buffett

Fourth Quarter Market Discussion

The year closed with the longest running bull market in the history of U.S. equities staggering badly. The speed in which investors switched from bullish to bearish was striking and left the broad markets with the worst performance in a single quarter in roughly 10 years.
Your portfolio outperformed its passive benchmark, the Russell 2000® Value Index for the quarter but finished the year in the red. 
In the broad market, mega-cap growth stocks were among the hardest hit, with the FAANGs* down an average of over 23% for the period. However, few names escaped the downdraft, and small, attractively valued businesses also struggled.

In the Know?

Given the broad-based selling, we think Mr. Buffett’s words are a timely reminder that in investing, short-term setbacks can often set the stage for future results. 
This view may be contrary to the hand-wringing taking place in the financial media, but seems to reflect the attitude of many of the management teams of the businesses we own.
A considerable number of the companies held by the Value Fund have seen insider buying by executives in the past six months. We view these purchases as meaningful because they align management’s interests with shareholders, and indicate confidence by those on the frontline.


These insiders may have an additional reason for optimism—the significant performance gap between attractively-valued businesses and those with lofty projected growth rates. Despite year-end selling, the gap between market darlings and value remains striking as shown below.
A Decade of Pain for Value
Heartland Advisors Value Investing Value of 100 Chart
Source: Cornerstone Macro, LP and Standard & Poor’s, 6/30/1995 to 12/31/2018
Chart shows the S&P 500 Growth and Value Indices divided by the S&P 500 Index.
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.
All indices are unmanaged. It is not possible to invest directly in an index. 
Past performance does not guarantee future results.
We have been surprised by the stubbornness of the performance gap but believe new economic uncertainty will cause investors to seek more reasonably valued businesses over high-flying glamor names. 

Solid Foundation

Investors looking to dip their toes back in to the value pool may want to give housing related businesses a look. With interest rates rising, home builders have taken it on the chin. As a result, many residential developers are trading at a fraction of book value. A widely-held rule of thumb has been that builders deserve a closer look when trading at less than 1.25X book value and may be candidates for sale at 2X. 
We hold a few names that fit the criteria of attractive including Century Communities Inc. (CCS), which we highlighted last quarter due to management’s successful track record in launching new homebuilding companies and reaping value from them.  
As 10th largest public builder and, the fastest growing as of 2017, we felt investors were being overly pessimistic about the impact modestly higher rates would have on the company. Despite the company’s impressive 5-year record of compounding revenue growth at over 70%, shares continued to weaken and the company now trades at only 4.5X estimated 2019 earnings and .68X book value—the lowest level in company history!

A Primed Pump

Energy was another area where selling was fierce and widespread with many small names in the space losing 40% or more of their value during the period. The names in your portfolio also got caught in the downdraft and hurt performance. 
The selloff has left the group trading near levels last seen during the great financial crisis—many of your holdings are trading at less than 3X cash flow. While painful, valuations could make them strong candidates for a snapback once market selling pressure eases.

Going with the Flow 

Economically sensitive areas struggled during the quarter but also contained some top performers for the portfolio. For example, Northwest Pipe Company (NWPX), a leading manufacturer of steel pipe water systems in North America, was up as a recovery in water transmission projects led to a surge in sales and the company returned to profitability.
We anticipate revenue and earnings growth will accelerate in 2019 and beyond as large projects, particularly in Texas and California, come to fruition. In early December, Northwest announced one of the largest bids booked by the company in the last five years, which should be near completion by the end of 2019.
With the recent purchase of Ameron Water Transmission Group LLC, Northwest has become the dominant supplier of water transmission pipes on the West Coast. As the recovery in water projects continues, we expect the company’s prospects will continue to improve. Despite strong performance in 2018, shares still trade at tangible book value.

Treating an Epidemic

After posting strong returns for much of the year, small Health Care names reversed course and were down double-digits in the period. Despite the challenging quarter, we find reason for optimism. Accuray Inc. (ARAY) is a vivid example of a company that could capitalize on compelling opportunities in 2019 and yet flies under the radar of most passive indices.
Accuray, a leader in radiation equipment used to treat cancer, is enjoying a year of meaningful milestones. Orders more than doubled during the September quarter and the company launched improved software for its flagship Cyberknife robotic radiotherapy product. The upgraded programming cuts treatment time 50% and planning time 90%, making the Cyberknife very economical for hospitals treating a variety of cancers—lung, prostate, brain, and pancreatic.    
More importantly, following a two-year delay, China announced it will issue licenses for 1,388 radiation machines over the next two years. During the last tender for machines in the country, Accuray landed a remarkable 87% share of orders. Using what we believe is a conservative 20% win rate for the new licenses, we expect near-term sales could increase $400 million—doubling current revenues.
Given the meaningful opportunity facing Accuray, we find current valuations hard to fathom. While its two closest competitors are priced at 3x-6x sales, ARAY is at a lowly .8X.

A Commitment to Value

Much of 2018 was humbling for committed value investors as the markets once again rewarded momentum and the promise of future growth over balance sheet strength and compelling valuations. In the face of this challenge we remained unwavering in pursuit of investments that fit with our principles but also unrelenting in our commitment to improving. The result of these efforts is a portfolio that is more diversified, with stronger balance sheets, and a dividend yield in line with the S&P 500 and yet is trading at roughly half the valuation. 
Our efforts are reflected in the valuations below.
Small Cap Value Composite Valuations
Heartland Advisors Value Investing Valuations Chart
Source: FactSet Research Systems Inc., Russell®, Standard & Poor’s, and Heartland Advisors, Inc., as of 12/31/2018
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.
As inflated former market darlings continue to wilt, we believe our commitment to a valuation-first approach to investing will be rewarded.
Thank you for your continued confidence.
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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, 36 at Heartland.

Heartland Advisors Value Investing Research Analyst Eric Miller

Eric Miller

Miller is a Research Analyst. 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 President and Director of Heartland Funds. He has 19 years of industry experience, 15 at Heartland.

Composite Returns*

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

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*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.

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As of 12/31/2018, Accuray Inc., Amazon.com, Apple Inc., Century Communities Inc., Facebook Inc., Google (Alphabet Inc.), Netflix, Inc., and Northwest Pipe Company represented 3.65%, 0.00%, 0.00%, 2.83%, 0.00%, 0.00%, 0.00%, and 3.30% of the Small Cap Value Composite, respectively. 

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Economic predictions are based on estimates and are subject to change.

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