09 Nov 2011 Heartland Funds - Q3 2011 Commentary ( Portfolio )
Fears of another 2008 are fresh in many investors’ minds. The collapse of Lehman Brothers and the fallout that ensued led to one of the worst years in the market’s history. Replace Lehman with Greece and other peripheral European countries, and investors’ reflex to sell is understandable.

Today in Europe and the United States, we observe capital markets that are increasingly doubtful of repeated claims that western governments will maintain fiscal propriety. Credit default swaps, a form of insurance against a bond default, have become very expensive, particularly for European sovereign debt and for the larger European and US banks that are, to varying degrees, exposed to it. Closer to home, Standard & Poor’s downgraded US Treasury debt for the first time in American history. Simply put, markets seem to be concerned that global economic growth will be too weak to generate sufficient tax revenues to pay the bill on mounting government obligations. Amidst these concerns, the Russell 3000 Value Index posted its fifth worst quarter since its inception in 1979. The index returned a negative 16.63% which bested the Select Value Fund’s Investor Class shares which were down 18.84%.

The Fund’s underperformance in the quarter is partially the result of a flight to safety: i.e. investors seeking out the relative stability of larger capitalization stocks. The S&P 500, representing the largest US corporations, declined 13.87% in the quarter. The top decile of Russell 3000 Value stocks (those with market caps above $8.6 billion) declined 16%. In general, larger capitalization stocks performed better than smaller capitalization stocks. The Fund had a median market capitalization of $3.9 billion.

In a broadly declining equity market, cyclical stocks usually suffer greater losses. The Fund’s exposure to the Energy sector was the largest detractor to portfolio perfomance during the quarter. Perhaps not surprisingly, the top individual contributors to Fund performance were Utilities stocks. We highlight one of these below.

Black Hills Corporation (BKH) operates regulated electric and gas utilities in the Great Plains region as well as non-regulated natural gas, oil and coal production, and wholesale energy marketing businesses. BKH has recently traded slightly above its tangible book value, which is below the average for the Utility sector. The company has increased its dividend each year for 41 consecutive years, and eight insiders have purchased BKH stock since May. Our fundamental analysis has identified three distinct catalysts:

• Two gas fired generation plants are in the process of being completed and should enter the rate base in early 2012, which should drive earnings growth in 2012.
• A below market coal contract is scheduled to expire by the end of 2011. We expect profitability at the mine to normalize in the year ahead.
• BKH controls unexplored acreage and the company is in the process of drilling exploratory wells to determine its value. Exploration is expected to be completed by 2012 and the company will make a decision on how to monetize these assets.

Black Hills is an example of the type of investments we are seeking in this challenging, low growth environment. Companies demonstrating strong financial stewardship, trading near book value (note, the portfolio as a whole was valued at 1.1X book value as of September 30!) with identifiable catalysts for earnings growth.