Heartland Small Cap Value Strategy 4Q19 Portfolio Manager Commentary

 Executive Summary

  • In a market dominated by large-cap growth, the Strategy finished the year up double digits and beat its benchmark. 
  • Stampedes into mega-cap momentum names have historically ended painfully. 
  • We look forward to a new decade and a return of common sense.
“What does reversion to the mean, mean?”
—Bill Nasgovitz

A Year to Remember

In December, we celebrated our 35th anniversary of serving our clients as America’s Value Investor. We’re proud to report that since inception, three-fourths of our domestic-focused strategies have beaten their relevant benchmark. The Small Cap Value portfolio has delivered a compounded annual growth rate of almost 11%, outpacing its Russell 2000® Value Index benchmark since inception. 

The historic performance is particularly gratifying because it was achieved by following a single, disciplined philosophy—focus on small companies with solid growth prospects but buy them with an eye on the price paid. In a market where large-cap growth stocks dominated, the approach resulted in a 20+% return this year.

Keeping it Simple

When it comes to investing jargon, sometimes, the simplest definition is the best. Take reversion to the mean. In our view, it’s a complicated way of saying a return to common sense. But as any value investor who’s lived through the last 10 years of mega-cap growth mania knows, simple isn’t always easy—a fact that became only clearer in 2019.

So, what is behind this disconnect between fundamentals and performance? Some of it, in our view, is fear of missing out, and a misguided belief that large companies are somehow safer bets. The thinking creates a stampede of assets into the largest companies by market cap, which in turn drives performance and valuations even higher. Like a sugar rush, the ride up can be exhilarating but when the music stops and companies can’t produce the growth required to justify lofty earnings multiples and $1 trillion-plus valuations, the downfall can be quick and painful.

As the chart below shows, the 10 largest companies in the S&P 500 have a combined market cap of MORE THAN 3X THE ENTIRE RUSSELL 2000® INDEX of small companies. It looks to us like we could be approaching one of those painful inflection points.


Capped Out?

Source: Furey Research Partners, LLC,  Standard & Poor’s, and Russell®, 12/1/1985 to 12/31/2019. This chart
shows the aggregate market cap for the ten largest companies in the S&P 500 Index divided by the total
market cap of the Russell 2000® Index.
Past performance does not guarantee future results.

While the stubborn lack of interest in small companies priced at attractive valuations has been frustrating, we’ve also welcomed the striking opportunities that have emerged as a result. As headwinds such as an unheard-of three-year ramp up in rates has reversed, and trade wars have started to subside, your portfolio has reaped
some of the benefits of a market waking up to the bargains to be had in small-caps. The following are a few examples of the businesses that drove performance.

More than Where You Hang Your Hat

Low mortgage rates, strong employment and a massive, 90 million strong, millennial generation poised to buy into the American dream has been a boon for the housing market. During the past few years, your portfolio has benefited from this megatrend directly through a few select homebuilders, and indirectly from businesses like industry leading mortgage insurers Radian Group Inc. (RDN) and MGIC Investment Corporation (MTG).

Radian and MGIC were up sharply this quarter and for the year as the housing market for entry-level homes has been strong resulting in increased sales for both companies. The duo, with a combined $450 billion in insurance in force, has done an excellent job in strengthening credit underwriting since the financial crisis, in our view, and each should continue to benefit from current low mortgage rates.

Despite the strong performance, both are priced at less than 8X estimated earnings for an attractive earnings yield of 12%. Additionally, Radian trades at just 1.3X book value, while MGIC is at a lowly 1.2X book value. Given their growth prospects and attractive valuations, we continue to see opportunity for further appreciation.

Unheard of Success

As investors in small/micro-cap companies, our research analysts are on the lookout for niche businesses with unique models that provide a competitive advantage. The Bancorp, Inc. (TBBK) fits with this approach. The company, with $4+ billion in assets, may be one of the most widely used banks you’ve never heard of. As a white-label operation, TBBK provides behind-the-scenes banking services including prepaid gift and debit cards to more than 100 non-bank partners ranging from PayPal to Verizon. Through the card unit, the company can gather significant deposits at extremely low rates and then lend those assets out at open market rates. Additionally, TBBK generates high-margin fee income with each transaction completed using one of its cards.

TBBK came under regulatory scrutiny in 2014, relating to some issues in their prepaid card business. We sensed an opportunity and took a stake in the company when valuations created what we viewed as a favorable risk/reward dynamic.

Shares received a boost in early December when regulators lifted all remaining operating restrictions on the business, which frees up management to reinstitute a dividend. Despite the competitive advantage of low-cost assets, TBBK trades at a nearly 17% discount on tangible book value to its peers. We expect a bright future for the company and further appreciation for shares.

Joined Forces

Longtime holding SRC Energy Inc., (SRCI), an oil and gas producer, has been hampered by political challenges in Colorado and by a bottleneck in pipeline capacity to transport natural gas out the Denver-Julesburg (DJ) Basin where it operates. To enhance scale and efficiencies SRCI is merging with PDC Energy, (PDCE), to create the 2nd largest oil and gas producer in the DJ Basin. Negative political headlines notwithstanding, the combined entity should generate above peer group average debt adjusted growth with a robust free cash flow (FCF) yield.

This looks to us like a compelling value with a healthy balance sheet—net debt/EBITDA of just 1X—and shares trading at less than 3X pro-forma EBITDA (earnings before interest, taxes depreciation and amortization). The strong FCF should provide a potential return of capital optionality to shareholders via a stock buyback, debt repurchases and/or dividend initiation.


The Price Paid Matters

Market activity of the past several months has us optimistic that a return to common sense may be taking root. High-flying unicorns with dubious profitability prospects such as WeWork have crashed back to earth and many recent initial public offerings have disappointed speculators.

We believe the valuations of your portfolio are compelling with solid sales and earnings growth which could exceed that of many ridiculously priced market darlings.
Thus, 2020 may be shaping up as a rare opportunity where Reversion to the Mean finally pays off.

Thank you for your patience, it’s been a long wait. We look forward to a new decade and return of common sense.

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 12/31/2019
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.


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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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©2020 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. 
**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 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.

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 12/31/2019, MGIC Investment Corporation, PDC Energy, Inc., Radian Group Inc., SRC Energy Inc., and The Bancorp, Inc.  represented 2.91%, 0.00%, 2.80%, 2.61% and 2.92% of the Small Cap Value Composite, respectively.

Past performance does not guarantee future results.

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®.

Small-cap and large-cap investment strategies each have their own unique risks and potential for rewards and may not be suitable for all investors. Small-cap investment strategies emphasize the significant growth potential of small companies, however, small-cap securities, are generally more volatile and less liquid than those of larger companies. Large-cap investment strategies emphasize the stability of large companies, however, large-cap securities are more susceptible to momentum investments and may quickly become overpriced or suffer losses.

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.

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.

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

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.