Heartland Mid Cap Value Strategy 1Q16 Portfolio Manager Commentary

 Executive Summary

  • Despite strong stock selection in Health Care and Information Technology, the Strategy lagged its benchmark, the Russell Midcap® Value Index, returning 2.18%† versus 3.92%.
  • Mixed economic news and a heightened focus on the credit cycle resulted in a volatile start to the year.
  • Balance sheets and cash flow management will continue to be a priority in this slow growth environment.
  • Given the fluid credit landscape, we believe it is more prudent to take on economic exposure than balance sheet risk.

Market Discussion

Mixed economic news and a heightened focus on the credit cycle led to a volatile start for the major indices. Positive returns for the Russell Mid Cap® Value Index masked significant moves during the quarter. Heavy selling during the first six weeks led nine of ten sectors in the Index down with only the most defensive areas weathering the pessimism.

The sell-off ebbed in mid-February after data failed to support the extreme weakness priced into equities. Although the readings were tepid, they were reassuring on two fronts: The numbers signaled the economy had not slipped into recession, and, in turn, was not strong enough for central banks to take actions to slow growth. A willingness to reward “less bad” news benefited cyclical areas. However, defensive pockets remained solid as investors hedged against continued softness in the economy.

Attribution Analysis

While security selection was mixed, our names in Health Care and Information Technology (IT) provided strength. Holdings in Industrials underperformed on a relative basis with a company specific issue causing more than one-third of the shortfall. Allocation decisions detracted with a material underweight to Utilities accounting for the majority of weakness. Power companies benefited from an active Mergers & Acquisitions (M&A) climate. Our holdings kept pace with the group, but valuations prevented us from taking on greater exposure.

Healthy balance sheets. Health Care was a key source of strength. Our holdings showed improved results and outperformed those in the benchmark. We have been committed to owning companies in the space with low or manageable debt and the ability to generate consistent, organic growth. In our view, those characteristics are essential in a slow or no growth macro environment. As a result, we’ve avoided Biotech, Pharmaceuticals, and Hospitals. During the past several years, many businesses in these areas have used debt for aggressive M&A activity. As investors have turned their attention to balance sheets and reassessed fundamental prospects, companies in these industries have sold off and our lack of exposure has boosted returns.

Financially sound. An underweight to Financials was additive. While performance on an absolute basis was modestly negative, relative strength was derived from holdings in Real Estate Investment Trusts (REITs).

Labeled a winner. Our Industrials names detracted compared to the benchmark, but contained a solid contributor. Brady Corp. (BRC) boosted results after reporting better than expected earnings on higher margins and improved guidance. The maker of safety labels and security products has been using free cash flow to pay down debt and benefited from cost cutting measures instituted in 2015.

Although management raised full-year guidance, there appears to be additional room for improvement. The consolidation and cost cutting undertaken last year should help the company continue to grow earnings even if sales are flat or slightly soft. Given its 3% dividend yield, 4% free cash flow yield, and that it is trading at 9x estimated 2017 earnings before interest, taxes, depreciation, and amortization (EBITDA), Brady is attractively valued in our view. We believe it should continue to perform even if the economy softens.

A glitch in technology. An overweight to Information Technology dampened results and the group contained a key detractor. Diebold, Inc. (DBD) was down after it announced an acquisition of one of its largest competitors. Investors reacted negatively to the timing of deal in light of the uncertain macro-economic backdrop as well as the meaningful debt financing. While the issues raised are warranted, we remain confident in the long-term prospects for the company.

Diebold is led by a management team that has success in improving operations and product and service offerings. These efforts have translated to higher margins and greater market share for the banking technology solutions company. We believe the company is well positioned to capitalize on the early stage shift to smaller, less people-intensive branch networks in the banking industry.

Under-utilized. Our holdings in Utilities kept pace with the Index, but a material underweight to the sector hurt relative results. FirstEnergy Corp. (FE), a partially unregulated electric company, was a top contributor after it reached a preliminary agreement with officials in Ohio to provide power through a long-term purchase agreement. The deal is expected to result in stable returns for three of its largest merchant operations.

Once finalized, the agreement should result in a premium for its shares as investors view the company as more closely reflecting a fully-regulated power producer.

Portfolio Activity

We have taken recent volatility as an opportunity to upgrade the quality of our holdings. Facing a tighter lending environment, we continue to evaluate debt levels on an absolute basis and relative to free cash flow. We are also focused on credit market dynamics and how they affect the rates companies needing to raise capital will pay as those with stronger credit ratings will have greater flexibility when pursuing growth due to lower cost of capital.

We have been finding opportunities in late-stage cyclicals. While our weighting to Industrials is mostly unchanged, valuations in the group, as shown, are at lows last seen during the Great Recession. We believe a worst case scenario is already priced in, and, as a result, downside risk has been reduced. We will act opportunistically in the sector and the Portfolio’s exposure may increase over the near-term.

Priced for the Worst?
Industrials Enterprise Value/Sales (trailing 12 months)
S&P Composite 1500 Industrials Sector Relative to S&P Composite 1500 Index

Heartland Mid Cap Value Strategy Portfolio Manager Commentary Industrials Chart

Source: FactSet Research Systems Inc. and Standard & Poor’s, 3/15/1995 to 3/31/2016

We’ve increased our exposure to Energy and Utilities and the Portfolio’s weighting in Consumer Discretionary is down.

Outlook and Positioning

We believe continued tepid growth calls for caution. Balance sheets will matter in the months ahead and companies with favorable liquidity and strong, consistent free cash flow should be in a strong position to succeed regardless of the macro environment.

Questions remain about the ability of global economies to expand without the aid of monetary and fiscal policy. As investors, however, those concerns do not represent all aspects of total risk. Valuations will continue to matter and we believe paying up for traditionally defensive sectors heightens downside risk.

Against this backdrop, we are being conservative when analyzing projected earnings and are focused on financial strength that can be drawn upon should the economy falter. Put simply, we believe it is more prudent to take on economic risk than balance-sheet risk given the evolving credit landscape.

Thank you for the opportunity to manage your capital.

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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Colin McWey

Colin McWey

McWey, CFA, is Vice President and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He has 14 years of industry experience, 7 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 16 years of industry experience, 13 at Heartland.

Composite Returns*

3/31/2016

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)11.208.747.019.22-7.362.102.10
Russell Midcap® Value10.517.2310.529.88-3.393.923.92

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

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†Composite returns are net of advisory fees.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 9/30/1996.

Past performance does not guarantee future results. Performance represents past performance, and current returns may differ.

The Mid Cap Value Strategy invests in mid–sized companies on a value basis. Mid-sized 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.

The U.S. dollar is the currency used to express performance.

As of 3/31/2016, Brady Corp., Diebold, Inc., and FirstEnergy Corp. represented 1.5%, 2.4%, and 3.6% of the Mid Cap Composite, respectively.

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 above, 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 as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems, Inc. or the Global Industry Classification Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

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®.

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