At the Heartland Value Plus Fund (HRVIX), where Rodney Hathaway and co-managers William Nasgovitz and Eric Miller are always looking for stocks trading below their intrinsic value, they pay particular attention to those not covered by Wall Street analysts or the subject of sell recommendations. And to lessen the risks of unpopular stocks, the team also searches for outfits that pay dividends, since they are likely to be stable. Most of the holdings in the Value Plus fund, in fact, pay dividends.
Hathaway's search for promising, out-of-favor sectors has led the fund to the basic materials sector. Recent cutbacks in excess capacity have boosted pricing power for several basic materials companies, he says.
The fund's focus on stable, unpopular companies has paid off recently, as well as over the long term. For the one-year period through last month, the portfolio rose 37.3%, vs. a 30.8% gain for its small-cap value peers. For the three-year period through May, the fund was up 20.5%, on average, vs. a 10.3% gain for its peers.
Despite the fund's focus on out-of-favor stocks, Value Plus is slightly less volatile than most of its peers. The fund's three-year
standard deviation of 18.0% is a little lower than the peer group average of 18.2%.
Based on risk and return characteristics during the last three years, Standard & Poor's gives the fund its highest overall rank of 5 Stars. Bill Gerdes of S&P's Fund Advisor spoke recently with Hathaway about his strategy. Edited excerpts from their conversation follow:
Q: Heartland Funds has several value offerings. How does Heartland approach value investing?
A: We buy stocks trading below their intrinsic values. We focus on stocks with low price-to-earnings ratios, low price-to-cash flow ratios, and low price-to-sales ratios. We also look for companies with strong balance sheets and low debt.
Q: How does Heartland Value Plus differ from other Heartland offerings?
A: Value Plus focuses on dividend-paying stocks. Most of the fund's holdings pay a dividend. If a company pays a dividend, that implies it's stable and has good cash flows. Dividends also generally lower a stock's volatility.
Q: What are your stock-selection criteria?
A: We use a proprietary 10-point grid to evaluate our investments. The first point on the grid is, a potential holding should have a catalyst. We look for catalysts in potential investments to avoid value traps. Catalysts we like include new managements, new regulations affecting the company, or anything that opens up value for investors. The final item on our 10-point grid is technical analysis. We like stocks that are out of favor with Wall Street. Many of our holdings aren't covered by Wall Street or only have sell recommendations. We do a lot of our own investment research.
Q: Do any market areas currently look attractive or undervalued?
A: Over the last few months, we've beefed up our holdings in basic materials. We have a few paper, steel, and fertilizer companies. Many companies in these industries were severely depressed for several years. As a result, several basic materials companies cut excess capacity, boosting their price power.
On the other hand, we're focusing less on finance, a big area in the small-cap universe. We believe earnings growth is likely to be better in other sectors. Also, rising interest rates generally aren't good for finance stocks.
Q: Have there been any broad trends in the catalysts you've been focusing on recently?
A: There have been mergers and acquisitions in health care, as large pharmaceutical companies with sparse new-product pipelines have purchased biotech companies. We have a couple of biotech holdings, which we think are good acquisition targets, including Orthovita (VITA).
Q: What are the fund's largest sectors?
A: Technology and health care are the two largest sectors, each making up about 17% of the fund. In technology, we look for low
beta companies with good balance sheets.
Q: What is the fund's median market cap?
A: It was $998 million at the end of March. Our median market cap tends to be larger than many of our peers because we look for a little more stability.
Q: What are the fund's largest holdings?
A: At the end of March, they included Ikon Office Solutions (IKN), NICOR (GAS), Lubrizol (LZ), and Imation (IMN).
Q: Do you have any favorite holdings?
A: Imation has cash reserves of about $11 per share and no debt. They make blank CDs and DVDs, which are likely to gain from higher consumer spending.
Q: What's your outlook for the small-cap value market?
A: Valuations for small-cap stocks are close to parity with the broad market, but earnings for small-cap companies will outpace earnings growth in the overall market this year.