Heartland Advisors

Heartland Value Fund 2Q24 Portfolio Manager Commentary

Executive Summary

  • The Heartland Value Fund outperformed its benchmark in the quarter — as it has year to date and over the past 1, 3, and 5 years.
  • Active management is already helping investors identify opportunities that could shine once mega-caps’ stranglehold loosens.  
  • Though popular equity indices are priced at historically high levels, we have been able to initiate new positions at admirable valuation discounts.

Past performance is no guarantee of future results and investment returns and principal value of the Fund will fluctuate so that shares, when redeemed, may be worth more or less than the original cost. Current performance may be higher or lower than the performance quoted. Call 800-432-7856 or visit heartlandadvisors.com for current month end performance.

“You can’t take the same actions as everyone else and expect to outperform.”
— Howard Marks

The esteemed value investor Howard Marks wisely pointed out the fallacy of thinking you can follow the herd while expecting to outpace it at the same time. Successful investing, he noted, is “the exact opposite” of trend following. We agree. 

Our willingness to steer clear of the path toward speculation by staying true to Heartland’s 10 Principles of Value Investing™ has helped us outperform the Russell 2000 Value® Index so far in 2024 and over the past 1, 3, and 5 years. The Heartland Value Fund has also outpaced a majority of its small value peers — including active and passive strategies — during these time periods, according to Morningstar, by focusing on well-managed, undervalued businesses with resilient balance sheets and sound business strategies.

Such attributes may lack flash in an era marked by the speculative frenzy surrounding artificial intelligence, yet these are precisely the types of businesses being targeted for acquisition. Canadian Western Bank, which we initially purchased in 2021 at a cost of around $22 (USD) a share, agreed to be bought last month by National Bank of Canada and was trading at more than $30 a share at the end of June. At around the same time, Poland Spring owner BlueTriton agreed to merge with Primo Water, another portfolio member.

With the typical stock in our Fund trading at just 10.5 times 2025 estimated earnings per share, versus 19.9 for the S&P 500 Index, we wouldn’t be surprised if there were more take outs to come. Even if that does not come to pass, we are confident a portfolio constructed on the merits of low price to earnings and low debt with strong earnings and revenue prospects makes sense in all markets.

What gives us this conviction? For starters, we have implemented guardrails to make sure that performance is driven by security selection, and not because we are overweight or underweight an industry relative to the index. Even if those allocations are the result of bottoms-up stock picking, and not a top-down sector bet, they could end up being more responsible for the Strategy’s results than our selection effect. To prevent this, sector exposures (with exceptions for small sectors) must be no less than 50% and not more than 150% of the benchmark’s. Our goal is to win in each area of the market so we can deliver consistent outperformance. 

Another comforting factor is that when it comes to security analysis, we seek confirmation through old-fashioned “boots on the ground” examination. For more than 40 years, Heartland has engaged in active, in-person fundamental research to gain first-hand knowledge about a company’s operations and strategy. We want to see, with our own eyes, how its products stack up versus the competition’s. This is accomplished, in part, through meetings with management and customers, such as founder Bill Nasgovitz’s recent visit to the Charles LeMoyne Cancer Center, a customer of a long-term holding, Accuray Inc. (ARAY). Through his visit, Bill gathered insight into Radixact, an Accuray product, manufactured in Madison, Wisconsin, being installed in the Montreal hospital to radiate cancers (see photo below). 

Visiting a company to ascertain its suitability for a portfolio seems to be becoming a lost art. In an era of passive investing, where investors feel comfortable buying an index fund or ETF without understanding what they own, we believe this on-the-ground research sets us apart from the crowd.

Attribution Analysis & Portfolio Activity

For the quarter, the Heartland Value Fund was down 3.21%, outpacing the 3.64% loss for the Russell 2000® Value Index. Stock selection was mixed during this brief period, with the Strategy outperforming the benchmark in Consumer Staples, Financials, Industrials, Information Technology, Materials, and Real Estate, while lagging in other areas including Consumer Discretionary, Energy, Health Care, and Utilities. Security selection, however, was the primary reason the Fund has beaten the index so far this year, up 3.29% versus the loss of 0.85% for the benchmark.

While opportunities aren’t necessarily plentiful, we try to take advantage of them when they arise. A good example is Hexcel Corp. (HXL), a new position added during the quarter. We didn’t have any holdings in the aerospace & defense portion of the Industrials sector entering the period. Admittedly, this is not a huge sub-industry group; in fact, it only makes up a little more than 1% of the Russell 2000 Value Index. But we are mindful that deviating from our benchmark’s weightings detracts from our stock picking and potentially adds risk and volatility to our Strategy.

The good news for us was the shares took a hit in early April, after the market reacted negatively to the announced appointment of Tom Gentile as Chief Executive Officer. Gentile formerly served as CEO of Spirit AeroSystems, a major aerospace supplier that ran into production challenges and quality issues on parts produced for Boeing. Investors clearly did not like the hire, but we felt the reaction was excessive. Gentile inherited bad contracts at Spirit, and the HXL Board of Directors has significant experience in the aerospace & defense space, so we feel confident they understand the implications of their decision.

Hexcel seems to be in the 3rd inning of a long-term recovery. The company is diversifying into new defense production, where its composites are critical for stealth platforms. The sweet spot for the business, however, is in wide-body aircrafts (such as the Airbus A350 or Boeing 787) that help airlines lower their unit costs. This segment has yet to bounce back from the global pandemic, so there is still runway for HXL’s rebound. Yet the shares are attractively priced relative to cash flow, trading below prior aerospace M&A multiples. Management seems to agree, as there has been a healthy dose of insider buying activity lately, including on the part of its outgoing CEO, who recently purchased nearly $1 million in company stock.  

Another area where we are underweight is banks, but we don’t just want to add holdings in that industry to check a box. The goal is to find well-run institutions in good regions with solid population growth. Enter Seacoast Banking Corp. of Florida (SBCF)

SBCF, which provides commercial and consumer banking, wealth management, and mortgage services across Florida, has been on our watch list for some time. Investors, concerned about Seacoast’s profitability, have pushed the share price down more than 17% year to date. But we believe the bank’s net interest margin is poised to rebound in the second half of this year. Meanwhile, management has been aggressively reducing costs by closing redundant branches at the same time it has been adding bankers. If loan demand picks up even modestly, the combination should result in decent operating leverage. 

An added benefit: Seacoast could be a takeout target, as it is one of the few remaining pure-play regional banks in Florida, one of the highest growth regions for financial services. Yet the stock trades at just 1.5 times tangible book value, which is one standard deviation below its 10-year average multiple.

In this volatile market, we also understand that promising long-term opportunities may already reside in our portfolio; our job is to have the discipline to stick with them, even amid short-term challenges. An example of this is Century Communities (CCS), a homebuilder based in Denver.

The stock slumped more than 15% in the second quarter along with other homebuilders as mortgage rates rose. While weakness in real estate could persist for the next few quarters, this is a case where the story is about the future. Simply put, there is a massive shortage of homes in America after building rates fell below the 50-year average following the global financial crisis. Since 2012, 7.2 million more households have been formed than single-family homes constructed. 

As the median sales price on new homes sold rose to $433,500 in April, housing affordability sank to record lows, putting a strain on the lower end of the market just as millennials are forming new households. Less than 52% of millennials currently own homes, compared with 78% for Baby Boomers and 70% for Gen X. This is creating an attractive supply-demand dynamic for CCS, as approximately 94% of the homebuilder’s sales are made to entry-level buyers. 

We believe Century’s management team, which has guided the company to more than 20 consecutive years of profitability, should be able to navigate the housing slowdown while taking advantage of this gap. Yet the stock trades at just under 1X book value versus 1.7X book for homebuilders and 4.3X for the S&P 500.

Outlook

We agree with Howard Marks: It doesn’t make sense to passively follow the herd like index funds. Given how richly priced the broad market is today, we are fine going in a different direction to build in a margin of safety. The fact that mega-cap tech stocks continue to outperform in the face of historically frothy prices, in our view, only makes the case for small value stronger. As value investors, our job is to be disciplined enough to avoid what the crowd is buying today while being patient enough to pounce on opportunities, which is guided by our 10 Principles of Value Investing™.  

Fundamentally and patiently yours,
The Heartland Investment Team

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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

CEO and Portfolio Manager

Heartland Advisors Value Investing Portfolio Manager Bill Nasgovitz

Bill Nasgovitz

Chairman and Portfolio Manager

Fund Returns

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*Not annualized

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

The inception date for the Value Fund is 12/28/1984 for the investor class and 5/1/2008 for the institutional class.

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©2024 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

In the prospectus dated 5/1/2024, the Gross Fund Operating Expenses for the investor and institutional classes of the Value Fund are 1.07% and 0.89%, respectively.

Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance for institutional class shares prior to their initial offering is based on the performance of investor class shares. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. All returns reflect reinvested dividends and capital gains distributions, but do not reflect the deduction of taxes that an investor would pay on distributions or redemptions. Subject to certain exceptions, shares of a Fund redeemed or exchanged within 10 days of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual's return. To obtain performance through the most recent month end, call 800-432-7856 or visit heartlandadvisors.com.

An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the Funds' prospectus. To obtain a prospectus, please call 800-432-7856 or visit heartlandadvisors.com. Please read the prospectus carefully before investing.

As of 6/30/2024, Accuray, Inc. (ARAY), Century Communities, Inc. (CCS), Canadian Western Bank (CWB CN), Hexcel Corporation (HXL), Primo Water Corporation (PRMW), and Seacoast Banking Corporation of Florida (SBCF), represented 0.52%, 1.73%, 2.69%, 0.97%, 2.01%, and 1.00% of the Value Fund’s net assets, respectively.  National Bank of Canada (NA.TO) is unowned by the Value Fund.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.

The Value Fund invests primarily 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.

The Value Fund seeks long-term capital appreciation through investing in small companies.

Information about Morningstar Ratings™ are ©2024 Morningstar, Inc. All rights reserved. The information contained herein is (1) proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed, and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

The Morningstar RatingTM for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.

As of 6/30/24, the Value Fund Investor Class was rated against 450, 424, 332, and 450 U.S.-domiciled Small Value funds over the 3-, 5-, 10-year, and overall periods, respectively and has Morningstar’s 4-star rating for the 3-year, 4-star rating for the 5-year, 2-star rating for the 10-year, and 3-star rating for the overall periods. As of 6/30/24, the Value Fund Investor Class was rated against 450, 424, 332, and 450 U.S.-domiciled Small Value funds over the 3-, 5-, 10-year, and overall periods, respectively and has Morningstar’s 4-star rating for the 3-year, 4-star rating for the 5-year, 2-star rating for the 10-year, and 3-star rating for the overall periods. 

The above individuals are registered representatives of ALPS Distributors, Inc.

The Heartland Funds are distributed by ALPS Distributors, Inc.

The statements and opinions expressed in this article are those of the presenter(s). 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.

There is no assurance that dividend-paying stocks will mitigate volatility.

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 2024 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

Buyback is the repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. 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 Per Share is the portion of a company’s profit allocated to each outstanding share of common stock. Earnings Yield is the reciprocal of the price to earnings ratio.  Free Cash Flow is the amount of cash a company has after expenses, debt service, capital expenditures, and dividends. The higher the free cash flow, the stronger the company’s balance sheet. Insider Buying is the purchase of a company's stock by individual directors, executives or other employees. Margin of Safety is a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. 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.  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 Russell Investment Group. Russell 2000® Index includes the 2000 firms from the Russell 3000® Index with the smallest market capitalizations. All indices are unmanaged. It is not possible to invest directly in an index. 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. S&P 600 Index is a group of 600 U.S. stocks chosen for their market size, liquidity and industry group representation. All indices are unmanaged. It is not possible to invest directly in an index. 10 Principles of Value Investing™ consist of the following criteria for selecting securities: (1) catalyst for recognition; (2) low price in relation to earnings; (3) low price in relation to cash flow; (4) low price in relation to book value; (5) financial soundness; (6) positive earnings dynamics; (7) sound business strategy; (8) capable management and insider ownership; (9) value of company; and (10) positive technical analysis.

Heartland’s investing glossary provides definitions for several terms used on this page.

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