1Q26 Mid Cap Commentary Podcast

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Transcript

Michael Kops: Hello, this is Michael Kops from Heartland Advisors. I'm joined by my teammates on the Mid Cap Value Strategy, Colin McWey and Troy McGlone.

Guys, it was a wild Q1 for the markets in general. How would you describe the landscape in mid-cap value land?

Colin McWey: Wild is a good way to frame what happened during the quarter, and it shows how much things can change shortly. And at the end of the day, what you need is a process to come back to, to kind of filter through the short-term noise and focus on what really matters over time. So in our case, it's the 10 Principles of Value Investing™ and the four price targets that we assign to all companies to account for a wide range of possible scenarios and outcomes. And then we look to make investment decisions based on what is most attractively valued in that framework, along with the qualitative part of our 10 Principles, the catalyst, the management teams, and the business strategies. Where do we see the clearest signs of that playing out or likely to play out going forward. 

Michael: And I know one of our differentiating factors is that we break the universe into two buckets, Quality Value and Deep Value.

How would you describe the behavior of those buckets for the quarter?

Troy McGlone: Yeah, hi, Mike. Generally speaking, the trend that we've experienced really over the last few years was consistent again in the first quarter where Deep Value significantly outperformed Quality Value.

So within the Russell Midcap® Value universe, Deep Value was up just under 6%, while Quality Value was up roughly 1.5%. 

Michael: And so we talked a bit, you commented, Colin, on the four price targets. In these moments of volatility, I know you've always referenced the fact that, you know, it's just kind of this grounding. You've done the work in advance for a range of potential outcomes. How was that put into practice for the quarter? 

Colin: Yeah. Well, if you look at what happened, just broadly speaking, in the market during the quarter, it really was a tale of two markets.

If we go to January and February, the observations of what happened are, number one, the market did begin broadening out from a narrow and myopic focus, AI winners at any price, into companies with attractive or reasonable valuations that were giving a fundamental reason to perform better on a relative basis.  That came with, obviously, a critical earnings season where companies reported year-end earnings. In that backdrop, we were very encouraged because we saw a good number of our most important positions, our 2% to 5% positions, provide the type of earnings reports that either allowed the companies to continue the improved relative performance that they had demonstrated late last year or established for the first time in a while, improved relative performance during the quarter with earnings reports. So it was a very good backdrop for just bottoms up, value investing, fundamentals, valuation, and then the qualitative part. Where there are signs of the catalyst playing out to allow these stocks to re-rate in a market that had shown signs of broadening out.

Obviously, I think we all know what happened at the end of February and into March. It was an exclusive exogenous shock created by geopolitics. And what we believe is while it's very important to assess what the implications of that will be, along with all of the other variables that impact business fundamental prospects going forward, the reality is it was a one-way geopolitical shock that created trading on headlines, guesses on what will happen next. And lo and behold, soon enough, we will be in another earning season and we'll see where fundamentals transpire from there.

So the point is, what will matter will broaden out from just purely geopolitical headlines. For us, what it comes back to, using the four price targets and accounting for a range of outcomes, in some cases, an exogenous shock like that, you bring it back to how you value companies. And in many cases, it takes companies that were fairly valued and brings them back to undervalued, when really nothing changed in the underlying fundamentals of the company. So it gave us, in some chances, the opportunity to add to positions that purely due to an exogenous shock just became much more attractive on risk versus reward.

Michael: Excellent. We got a bit of outperformance in Q1. What would you attribute it to?

Colin: Well, I think I mentioned that one of the things that was most encouraging to us is in terms of our largest positions. And in our case, our 2% to 5% positions, we usually have anywhere between, call it 15% to 20% of those positions in the portfolio. That oftentimes can comprise up to half of our overall portfolio assets. And so in our case, it was delivering the types of earnings reports where if it if a company's thesis was playing out back into late last year and in a backdrop where again some of the myopic focus on just playing the next AI winner started to take a back seat for a little bit that gave us a chance for these earnings reports to come through in the cases where the qualitative parts of our thesis were playing out we actually saw these stocks get recognition in terms of improved relative performance versus the Russell Midcap® Value and versus the respective sector that the company is classified in. So again, it was one of the most encouraging signs that we've seen in a long time in terms of just getting back to valuation, fundamentals, and the market broadening out and just really kind of a more of a stock picker's market.

Troy: Yeah, I mean, if you just step back, the primary driver was stock selection. And it is interesting when you break out our performance by Quality bucket and by sector, what you'll see is that we pretty much held serve in the Deep Value bucket, but within underneath it, underneath the hood, essentially. The biggest drag in Deep Value, which has been consistent, again, for the better part of a couple of years. Is in Information Technology, where we're seeing companies that inherently historically have generated low returns on invested capital, have destroyed economic value, are benefiting from the rising tide of AI infrastructure. And so that's an example where we're focused on our process dictates that we buy businesses that are benefiting from a self-help catalyst. And in the case of information technology, there's a lot of companies that are benefiting from the AI infrastructure build-out that it has nothing to do with what the management teams are doing to unlock value. Now, with that said, we were able to offset the drag in Information Technology with good stock selection in other areas. So, for example, in Financials, when the market sold off, you know, we're focused on our four price targets. And that's a scenario where it was our best contributor within Deep Value because in that moment, people started to care about balance sheets in the first quarter. And so it was kind of a tale of two stories where, although there was a lot of volatility, we still saw some of these AI beneficiaries, even though historically they're not great businesses, continue to outperform the broader market.

Michael: Excellent. How about since Deep Value has been such a driver for a while now and it was again in the first quarter, maybe some comments on a Deep Value holding that had an impact on the portfolio?

Colin: Sure. In our case, Exelon (EXC), which is a regulated utility, not the most exciting business in the world. And in the myopic focus of AI, it certainly hasn't been the most exciting area of Deep Value because, as Troy mentioned, Deep Value, the rising tide in a lot of Deep Value related to AI has been in areas like tech hardware and certain pockets of industrials in other industries.

However, if you take a step back and look at what's going on in the U.S., the data center build-out and the call on power demand and the call on more requirements from the grid to feed what's needed to do the build-out across the United States, Exelon plays a critical role in that. Exelon's footprint, it's a multi-state regulated utility primarily focused on transmission and distribution. A lot of Exelon's footprint is in a region called PJM. PJM, in our opinion, has a very flawed design in terms of its market structure. And when you have the data center build out that has driven the additional burden on the network, the reality is the independent power producers, with power prices going up, have been able to charge fairly egregious prices to provide the needed power generation across the footprint. That is what it is. But as a result of this flawed design, the next thing that's needed to meet the needs of this build-out is in the form of transmission. You need to connect all this back to the grid to have a grid that functions appropriately for the additional burdens being put on it. That's where Exelon comes right into play.

We had been of the view that Exelon had not been getting enough credit for the role that it has to play for the rest of this decade as the build-out happens. That had been our strong thesis. We had made Exelon a meaningful position in the portfolio as a Deep Value holding.
And lo and behold, our thesis showed the clearest signs yet of being validated with the company's year-end earnings update in February and the five-year rate-based growth plan that they provided to the market, which showed another step function higher in terms of the capital investment opportunities that they have and the earnings growth prospects that Exelon has.

Exelon has carried versus regulated utilities of comparable quality. So I'm excluding some of the weakest utility names in places like California that frankly have a lot of balance sheet questions. But versus peers of similar quality that have attractive rate-based growth characteristics, Exelon has carried a meaningful discount. And what we saw in the quarter is that discount finally started to close and it took the biggest step towards closing to what in our opinion is fair value. So this is a very encouraging development.

This is a long-tailed investment thesis. This is something that we believe will have legs far beyond this quarter or next quarter. 

Troy: And I think it's probably worth mentioning, too, why that discount existed in the first place. Because when we originally bought this position at Exelon years ago, it was when they also owned nuclear assets and the self-help catalyst that was originally identified, you know, by Colin, who covers Exelon for us, was the ability to recognize the value of that asset. And so Exelon spun that asset off into a separately traded entity. And that was before many people were paying attention to nuclear as a need in generating electricity in this country, before people were talking about artificial intelligence. And so that happened, and then the AI trade took off, and people have been allocating capital toward generation assets because of a view that we don't disagree with, that there's tightness in the supply of electricity generation. But when you step back, transmission, where Exelon, the RemainCo effectively is focused now, is still a very long-term need. Now it will play out over years, as Colin talked about, but it wasn't the immediate beneficiary of people gravitating toward generation because of the AI narrative that's been built in the marketplace. 

Colin: As we look past this year, one more thing to look out for for Exelon that people are not focused on right now: I mentioned the flawed market structure of PJM. In our view, one of the solutions that eventually has to happen to solve the generation problems associated with that market structure is you need to bring generation into the state-regulated base. That could provide even more opportunities for Exelon as we get past this year.

Michael: Excellent. Now, how about the Quality Value bucket? Is there a name there that you think would be interesting to share?

Colin: We think Murphy USA (MUSA) is worth mentioning. Again, this is not the most exciting business in terms of what the market has been chasing for the last several years. However, what Murphy is, is a very good advantaged operator in a very tough business. Murphy sells fuel. They sell fuel to mom and pop—you and I when we go to the pump to fill up for gasoline. You might pull into a Murphy USA store, especially if you're in the Southeast, and especially if you're someone who shops at Walmart in some of the more rural areas across the country.

The difference between Murphy and the other folks that operate in this very tough, in some ways unattractive business is Murphy has an incredible scale and cost advantage in terms of the way that they can procure fuel. And then what they do, especially when gasoline prices get more volatile or gasoline prices go up and people start price shopping to pinch pennies, is Murphy tends to pass through some of those procurement benefits to the average customer when they're really financially strapped. Murphy can do this and over time take share structurally in a very fragmented industry. Over 60% of this industry continues to be mom-and-pop, single-store type operators that are choking from the operating cost inflation that has hit them in the post-COVID environment. Think about insurance, real estate costs, labor inflation and availability. All of these things are squeezing mom and pop. In that backdrop, someone who is positioned like Murphy can flex their advantages even more.

The reality is, for the past three years until recently, there has been a notable lack of gasoline price volatility. That limits Murphy's ability to flex its muscle on its competitive advantages. Lo and behold, we took a position in Murphy a few months ago. We actually added to it early this year. Getting back to the four price targets: with no ability to call with any precision when gasoline prices will go higher or get more volatile, but following the four price targets and understanding the enduring advantages of Murphy, the stock actually traded back to what we viewed was a downside target type of scenario, creating a very attractive risk-reward setup with no near-term visibility earlier in Q1.

We added to Murphy, and with what's happened with the resumption of volatility for the first time in a few years, is leading indicators are pointing to Murphy accelerating its volume growth and taking another big chunk of market share away from the rest of this fragmented industry. And that has helped turbocharge Murphy's relative performance, and we feel that in the backdrop that has emerged, there could be a lot of legs where that came from.

Michael: Thank you for that, Colin. How about as you look out for Q2 here and the rest of the year, what's the outlook?

Colin: I think the right word to assume is that things will remain fluid. There are a lot of crosscurrents. You will not be well served, nor will we be well served, to make one assumption about how everything is going to play out and make investment decisions along those lines. You need to be prepared for a wide range of scenarios, variables, and outcomes. There are questions about the credit backdrop, the inflation backdrop, how it will impact companies from both a potential demand destruction standpoint as well as from a cost of goods sold standpoint and operating cost standpoint.

I think it's very important that we continue to focus on the process, the 10 Principles, the four price targets, and then the portfolio construction approach across value and Deep Value, and make decisions along those lines for what we think will be a very fluid backdrop. But one potential outcome of how this all plays out is the market's ability to price for perfection certain favored darlings that have been uniquely benefiting from the backdrop we've been in for the last couple of years. We would note that especially with some of the valuations that have built up across the marketplace, the rate of change in fundamentals will matter a lot from here. And what that means is it doesn't mean that business will have to get bad for some companies—it just means that in some cases, if businesses get less good, the market may increasingly focus on that wide range of outcomes that are always there. We think if we execute our playbook well, this plays right into our hands for how we do portfolio construction and bottom-up stock selection.

Troy: Said another way, ultimately, the return that an investor gets in the long term is a function of business fundamentals combined with what you paid for an asset. And there's no doubt that business fundamentals in a lot of the, you know I alluded to earlier, the beneficiaries in Deep Value and Information Technology, companies exposed to optical or memory, as a few examples. Their business fundamentals have been unbelievably good. And we don't deny that. But the question is, is there a margin of safety that will allow the returns from here to be as good as they've been in the past? And that's where I think investors should be paying a lot of attention, because no one can call exactly the way this is going to play out—but one can overpay for exposure to certain parts of the market. And so we're very focused, again as usual, on our four price targets.

Michael: Thank you, guys. An excellent recap of Q1. I appreciate the outlook. And thank you to everyone for joining us. 

Colin: Thanks, Mike.