This fund’s active management has worked well through a rough stock-market cycle

It is easy to invest in an index fund — they can have very low expenses and provide diversification. But there can also be some hidden risks you might not think about during good times for the broad stock market.

The $402 billion SPDR S&P 500 ETF Trust
which tracks the benchmark large-cap index, is highly concentrated, with five companies making up more than 24% of allocation and one, Apple Inc.
making up 7.4% of SPY. But if you diversify to small-cap stocks, an index-based approach may be dangerous because it is littered with unprofitable companies and “misfit toys,” according to Brad Evans of Heartland Advisors.

Evans co-manages the $431 million Heartland Value Plus Fund, which holds shares of 40 small companies, some of which fly well under the radar because they are not covered by any analysts at brokerage firms. Those are the analysts upon whose estimates forward price-to-earnings ratios are based. Evans told MarketWatch that high-quality companies can be overlooked by brokerage firms because “whether or not a stock is covered is entirely dependent on the investment-banking opportunity.” In other words, a smaller company that doesn’t need to raise money or hasn’t done so recently, may be orphaned by Wall Street.

Heartland Advisors is based in Milwaukee and has about $1.8 billion in assets under management. It describes its style as value-oriented, with a focus on dividends and limiting downside participation in the stock market. Evans has co-managed the Heartland Value Plus Fund since 2006.

The Heartland Value Plus Fund’s Institutional shares

are rated four stars (out of five) within Morningstar’s “Small Value” fund category. The fund’s Investor share class

has a three-star rating. Here’s how the two share classes have fared against the fund’s benchmark, the Russell 2000 Value Index
over the past five years:


The returns include reinvested dividends and for the fund are net of annual expenses, which are currently 1.01% of assets under management for the institutional shares and 1.22% for the investor share class.

The lower-cost institutional shares are available through investment advisers and through brokerage platforms, typically for a $50 fee when purchasing.

The five-year outperformance goes back to one of Heartland’s goals: limited downside capture. During 2022, when the Russell 2000 Value Index fell 14.5%, both classes of the Heartland Value Fund declined only 5%.

“The small-cap space is littered with companies that have weak balance sheets,” Evans said, describing the bottom-up process he and the fund’s co-manager Andrew Fleming use to select stocks.

In addition to looking for companies in sound financial condition, the fund’s managers “have a mandate to invest at least 70% in dividend-paying stocks,” Evans said.

And that doesn’t mean playing for high yields, but rather focusing on the potential for increasing free-cash flow so a company can increase its dividend payout over time.

Evans said that small-cap stocks with relatively modest dividend yields tend to outperform those with high yields over time because “the dynamic around high-yielders implies that dividends may be cut.”

He took the idea further, saying that a focus on growing dividends can act as a “governor” for capital allocation decisions. He said he believes management teams are less likely to make ill-informed decisions or over-leverage their balance sheets because of their desire to avoid being forced to cut dividends.

So far this year, the Russell 2000 Value Index has returned 1.2% while the Heartland Value Plus Fund’s institutional class is down 1.3% and the investor shares are down 1.4%. “This is the most paradoxical frustrating environment since I began doing this in 1995,” Evans said. In other words, during a period of rising interest rates, with signs of economic slowdown and uncertainty from Russia’s invasion of Ukraine, he would have expected a higher-quality approach to shine, relative to the index.

Getting back to the prevalence of low-quality in a stock index, Evans said that within the Russell 2000 Value benchmark there are many “zombies” that have survived in part because U.S. monetary policy was so loose for so long before the Federal Reserve began its tightening cycle in March 2022. Many of the weaker small-caps “have not grown to become midcap stocks and they have not been acquired, which means they are not good businesses or they have problems,” he said.

“We hold an attractive portfolio of 40 healthy companies. They have good management teams that are allocating capital wisely,” he said, describing a process that includes proprietary internal research to highlight “hidden gems” in the market, combined with “due diligence” that includes meeting with corporate management teams.

The bottom-up analysis has led the fund to be overweight in the materials, industrials, healthcare and consumer staples sectors, while underweight consumer discretionary and financial stocks, relative to the Russell 2000 Value Index, he said.

Two stock examples

One example of a stock held by the fund is Park Aerospace Corp.
which makes composite and carbon-fiber components for commercial and military aerospace applications. Evans said the company supplies components “tied to the Airbus 320/321 food chain” and Park Aerospace said in its most recent 10-K annual report that customers include “United States defense prime contractors and subcontractors.”

Park Aerospace’s market capitalization is $281 million and the company reported having over $100 million in cash as of Feb. 26, the end of its fiscal 2023, with no long-term debt and total liabilities of $43.4 million. That is a strong balance sheet. The company’s earnings before interest, taxes, depreciation and amortization (EBITDA) for fiscal 2023 came to $11.5 million. Evans said he believes that figure can climb to a range of $30 million to $40 million over the next three to five years.

“That would put the company at a very attractive multiple of 4 to 5 times enterprise value to EBITDA, he said. “We have seen multiples 10 to 15 times EBITDA in this sector. We think they would go to the higher end.”

Another fund holding Evans named was Dril-Quip Inc.
which makes equipment used for offshore oil drilling. This is an industry that floundered following the drop in oil prices from mid-2014 through early 2016, and has only been recovering over the past two years, as oil prices have stabilized. U.S. shale producers have been careful not to repeat their previous cycle of high investment and increasing output out of fear of another price crash.

Dril-Quip’s market cap was $831 million and the company reported having $254 million in cash and short-term investments as of March 31, with total liabilities of only $95 million.

Following an industry reset, with reduced head count and capacity, Evens believed Dril-Quip was primed for a resurgence in offshore drilling activity, to double its EBITDA and eventually begin paying a dividend. “This checks all the boxes,” he said.

Top holdings

Here are the 10 largest holdings of the Heartland Value Plus Fund s of April 30:




% of portfolio

TreeHouse Foods Inc.

Food: Specialty/ Candy


Powell Industries Inc.

Electrical Products


Haemonetics Corp.

Medical Specialties


Hanover Insurance Group Inc.

Property/ Casualty Insurance


Carter’s Inc.

Apparel/ Footwear Retail


PotlatchDeltic Corp.

Real-estate investment Trusts


Texas Capital Bancshares Inc.

Major Banks


Royal Gold Inc.

Precious Metals


Avanos Medical Inc.

Medical Specialties


Portland General Electric Co.

Electric Utilities


Sources: Morningstar, FactSet

Click on the tickers for more about each company, index or fund.

Click here for Tomi Kilgore’s detailed guide to the wealth of information available for free on the MarketWatch quote page.

Don’t miss: As tech companies take over the market again, don’t forget these bargain dividend stocks