Heartland Mid Cap Value Strategy 3Q16 Portfolio Manager Commentary

Executive Summary

  • Stock selection in Financials was strong and helped the Strategy outperform its benchmark, the Russell Midcap® Value Index, returning 6.11%† versus 4.45%.
  • Improving economic sentiment helped lead cyclical sectors higher.
  • Our generally optimistic outlook is tempered, and we are focused on financial strength in the names we own.

Third Quarter Market Discussion

Investor confidence in the U.S. economy played out in equities and fixed income markets alike. Bond proxies lagged and economically levered areas fared best. The move higher for cyclicals reflected a combination of optimism and a search for attractive multiples. While generally optimistic, investors focused on valuations as they sought to protect against unexpected difficulties.

On the fixed income side, the yield curve steepened, and, as the chart shows, the markets began to price in an increased likelihood of a second rate hike before year’s end. Meanwhile, U.S. and global credit spreads have tightened over the past nine months, pointing to greater confidence and growing comfort toward risk.

Expectations of a Fed Rate Hike by Year End

Heartland Mid Cap Value Strategy Portfolio Manager Commentary Rate Hike Chart

Source: Bloomberg L.P., July, August, and September represent dates of calculation on 7/1/2016, 8/26/2016, and 9/21/2016, respectively. Each month shows the probability of a rate hike using Fed Funds Futures Contracts on 12/14/2016.

Attribution Analysis

Strength of economically sensitive stocks was welcome news for valuation conscious investors. Over the past 18 months, we have found compelling multiples among these areas and our commitment was rewarded this quarter as the Strategy outperformed its Russell Midcap® Value benchmark.

Security selection in Financials was a key source of strength. Our Consumer Discretionary holdings also boosted results. A company specific issue detracted from performance in Materials.

Banking on improved margins. The majority of the portfolio’s strength in Financials came from our Bank holdings. Zions Bancorporation (ZION) was a standout as its book of loans with Energy exposure performed better than expected. The regional bank has also made faster–than–expected progress on improving efficiency and is pursuing fee generating opportunities.

The company trades at 1x tangible book value despite its premium core deposit base. The discount, in our view, doesn’t fully reflect greater revenue opportunities and the cost cutting efforts underway. These efforts should result in a greater efficiency ratio and an improved return on equity.

Well-oiled machine. Our Industrial names were up on an absolute basis led by a top contributor in the Machinery space.

Oshkosh Corporation (OSK) rose after it announced earnings that beat Street estimates and raised full year guidance. The majority of its business lines posted double–digit revenue growth and strong margin expansion. The company trades at 16x estimated 2017 earnings versus a median of 19x for peers. Price appreciation has nudged valuations higher, but we expect earnings will continue to improve. An upturn in deliveries of mine resistant defense vehicles should provide revenue growth for the coming year, followed in 2018 by increased sales of light joint tactical vehicles. The company’s lift equipment unit has been under pressure, but we believe sales have troughed and inventory management will offset some of the softness.

Power of the consumer. Holdings in Consumer Discretionary boosted returns on an absolute and relative basis and contained a top contributor.

Garmin Ltd. (GRMN), a manufacturer of navigation and communication equipment, was rewarded after reporting better than expected earnings and raising guidance for the full year. Believing Wall Street was focusing too heavily on declining sales in personal navigation devices (PND) for autos and overlooking growth potential for its other products, we initiated a position in Garmin in late spring. Our thesis was validated this quarter as sales of outdoor and fitness products more than offset a small decline in the PND business.

We expect the navigation market will continue to shrink, but view the fitness line as an underappreciated source of sales. Dollar strength has been a headwind for the company and should subside in the near term. These factors make the stock’s 2.7x enterprise value to sales compelling in our view. We trimmed our position as shares jumped into the mid $50s and valuations got too rich. The stock has pulled back modestly and valuations are once again attractive.

A material issue. Materials holding Olin Corporation (OLN), the world’s largest chlor–alkali producer, drove the majority of underperformance in the space. Shares were down sharply after it preannounced lower than expected earnings and management reduced earnings expectations for the full year. We were disappointed by the announcement, yet our view of the company remains constructive.

No power surge. Our Utilities holdings were up, but contained a key detractor. FirstEnergy Corp. (FE), a partially unregulated electric company, was down over skepticism that Ohio authorities would approve a proposed rate increase. Investors also grew concerned that the company would need to raise capital through an equity offering to maintain its investment grade bond rating.

At 13x earnings per share and 1.2x book value, we think the company could reach valuations inline with fully regulated utilities.  Approval of rate hikes in Ohio, which should come this fall, will be important to our investment case.  

Portfolio Activity

The portfolio continues to hold high quality holdings as measured by balance sheet strength, free cash flow yield, and the ability to weather a full market cycle. Given companies with stronger credit ratings will likely have greater flexibility when pursuing growth, we are focused on credit market dynamics and how they affect the rates companies needing to raise capital pay.

Economically sensitive names that tend to fare well in the later stages of expansion have caught our attention. Our bottom–up research continues to uncover compelling opportunities, and we are focused on striking an appropriate balance between great companies at moderate discounts and average names at deep discounts. Our efforts have resulted in a portfolio that trades at a discount based on every valuation multiple we track versus its benchmark, the Russell Midcap® Value Index.

Outlook and Positioning

We continue to believe the most likely scenario for the economy in the near term is modest inflation and economic growth. As such, our focus remains on idiosyncratic factors that provide our businesses with the greatest opportunity to succeed. Balance sheets will continue to matter and companies with favorable liquidity and strong, consistent free cash flow should be in a healthy position to succeed regardless of the macro environment. Additionally, valuations will remain important, and we believe paying up for traditionally defensive sectors heightens downside risk. While it is too early to make a call that consumer spending will increase, recent weakness in the group has resulted in more names hitting our watch list.

Our outlook is tempered. We are being conservative when projecting earnings and are focused on financial strength that can be drawn upon to either expand in an environment of economic growth or to withstand unexpected bumps.

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 15 years of industry experience, 8 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 17 years of industry experience, 13 at Heartland.

Composite Returns*

9/30/2016

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)11.589.9815.609.6520.2115.186.11
Russell Midcap® Value10.747.8917.3810.4917.2613.724.45

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 9/30/2016, FirstEnergy Corp., Garmin Ltd., Olin Corporation, Oshkosh Corporation, and Zions Bancorporation, represented 2.7%, 1.4%, 3.5%, 2.6%, and 2.7% of the Mid Cap Value 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, 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®.

Fed Funds Futures are contracts with payouts at maturity based on the average effective federal funds rate during the month of expiration.

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Separately managed accounts and related investment advisory services are provided by Heartland Advisors, Inc., a federally registered investment advisor. ALPS Distributors, Inc., is not affiliated with Heartland Advisors, Inc.

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