2Q26 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, thanks for joining us. Could you maybe give us a little bit, your take on the mid-cap value universe for Q2?

Colin McWey: Yeah, thanks, Mike. I think it was an environment where for much of the quarter we saw the buildup of AI euphoria reach what you could really call as a fever pitch. And where that fever pitch is most emphasized is the data center build out. The beneficiaries of all the capital spending related to that build out, and then how to play it in the most obvious high octane front door way. So we're all familiar seeing the behavior of tech hardware, semiconductor stocks, a lot of folks within places like Industrials looking for ways to just play that build out. And it wasn't about a focus on valuation much of the time. It was just, how can I get more juice to that theme?

It really, in that euphoric pitch, what's interesting to us, it became even more so an environment where the valuation disparities, when you look at companies on a durable basis, what type of business model competitive advantages do they have and how are they valued today versus those attributes? The valuation disparities are about as wide as we can ever recall. 

And I think what is interesting when the herd's all going one way is, it looked like a one-way freight train for much of the quarter until all of a sudden in the very last week, all this crowding showed signs of unwinding and it actually happened rather fast. And what's interesting on that front is a factor like momentum outperformed a value attribute like free cash flow yield by about a thousand basis points for much of the quarter. And then all of a sudden, in just over a week, you saw a lot of that unwind right at the end of the quarter. So we just think it's a sign of the times, but with the right process and the right time horizon, this is something that can be exploited. 

Troy McGlone: It's possible that that momentum unwind had something to do with the Russell rebalance. So the Russell rebalanced late in the quarter in late June. And it's plausible if you look at the returns of the Russell Midcap® Value Index by sector. The Tech sector which is where there's a lot of this AI infrastructure exposure that people are excited about, was up over 55% and the benchmark was up about 13.4%. And, there was a significant change in the benchmark at the end of the quarter and so it's logical to think that people were maintaining exposure to exciting areas so that they didn't underperform, and then, but they knew right. And if you're an active manager, a lot of people probably knew that these businesses were fairly valued, if not more than fairly valued. And all of a sudden, when that rebalance happened, we've seen a significant shift in what Colin described.

Michael: So how are you operating in an environment like this?

Colin: I think we like to bring it back to our process, the two buckets and the four price targets, the quantitative analysis, namely valuation and balance sheet quality, as well as, the qualitative, where you're looking for management teams, catalysts, and business strategies that can change perception. And then most importantly, we still care about what price you pay for those attributes. And it's really about blending those type of things. And we believe that over time, there's a wide swath of opportunities because of the valuation disparities. It doesn't require making a call on how to participate in AI. In many cases, it also doesn't require taking the other side of an acute AI bear case. We believe that AI will fundamentally change the economic landscape and the investment landscape in a lot of ways. However, there are multi-year implications to how this all plays out that people are not necessarily trading on day-to-day. We try to focus on the more durable, lasting implications.

What we think is really interesting in many cases is you can take a rather AI-agnostic approach to just look at traditional value-oriented companies in both buckets and exploit the opportunities there. In some cases, there are duration call opportunities where an AI bear case might be overly manifested in a company. But on the flip side, we actually think our process allows us to invest behind companies that will capture durable benefits from AI, just not in the way that the market's trading right now. We believe that there are opportunities to find companies with the industry structure, the competitive advantages, and the business strategies to capture long-lasting durable benefits beyond the way that people are trying to play AI today.

Troy: This really manifests itself in the strategy section of the 10 Principles for us. So we haven't changed anything about how we, you know, our process and how we think about investing in businesses. But there's no doubt that the market's sentiment right now has changed. But if you just look at past technological revolutions, which to Colin's point, I think it's fair to say that AI is that, that will change the way many people work and live their lives.

But, there's been a lot of other technological revolutions over, over many centuries and the common thread there we could go through them whether it be the internet, the semiconductor chip, the railroad, the printing press, the reality is just because you identify a theme doesn't mean you get attractive long-term investment returns and that's because people get excited they allocate capital, to the point where the returns become poor and so for us we look at the common thread of all these technological breakthroughs and they tend to be who wins is, the consumer wins, the people who use the technology win because the costs come down over time. And so rather than go try to chase an infrastructure play that has is performing well right now, the reality is it's really difficult if not impossible to identify how durable that, that moat or trend is if they even have a moat And so for us, it's thinking about, you know, how past cycles perhaps rhyme with this cycle and how we can use that to our advantage and think long term with our existing process in place. 

Michael: Great. So, there's no doubt the AI and tech conversation is kind of sucking the air out of the room. Whether it's a good day or a bad day, it is the topic for discussion. Maybe we could just step outside of that because our process lends itself to not making these big bets on sectors, or overcrowding to areas, or taking full contrarian views and completely avoiding things. It's a much more balanced approach. And so maybe you could just give us a stock example that's out of the fray.

Troy: Yeah, I think out of the fray might be, I think walking through this example is a good idea to show where we think the company is generally AI agnostic in the long term. But right now there's some macro-overhangs tied to AI, in our opinion. And that's a company, MarketAxess, that we initiated in recent quarters. And they are the world's leading bond trading platform. So publicly traded bonds trade over the counter or OTC. So this is a trading platform because it's OTC. There's not actually an exchange. And so they pioneered the electronification of trading, of bond trading effectively. And they built this business over several decades, had a huge advantage versus the competition. And to be frank, the prior management team rested on their laurels and didn't adopt or adapt to changing technological protocols. So there were some other companies that came up with different trading protocols and MarketAxess the prior management kind of viewed it as, oh, these are temporary phenomenons. These are not durable things. So we're just going to wait for the macro environment to benefit us, which is they do very well. They offer the depth of market when you trade a single bond. And the reality is credit spreads are very tight. And so there's other protocols that have come along that allows you to trade entire portfolios. Maybe you don't get the best price on any individual bond, but as an entire portfolio, you'll get good pricing. It's kind of a good enough solution, right?

Well, there's a new CEO who was brought in from another company in the exchange industry. And he, from his perspective, MarketAxess should be investing in various technologies to maintain their leadership. And they've been doing that. And it has caused their margins to come under pressure because they're investing. This is a high fixed cost business, but the incremental margins are very attractive because you build the network. And once you have the volume, the incremental margins are very high. And so they've been through that. And we believe that they're at the precipice of showing some positive inflections there.

But the reality is in the debt capital markets right now, credit spreads remain, very, very tight near cycle lows. In addition, all this debt that's being raised to fund AI. So you think about the private companies, the public companies are raising hundreds of billions of dollars in debt. Well, that transaction doesn't occur on a trading platform, right? That's called a new issue. And so bond investors are focused on these new issues and they're not focused on trying to make money in the secondary market where MarketAxess plays.

And so that's the example of we think MarketAxess is AI agnostic in the long run. But right now there's a macro-overhang created by all the debt that is being raised to fund the AI infrastructure buildup. 

Michael: Mmm

Troy: And so meanwhile, this is a company, they have a net cash position on their balance sheet, significant free cash flow, high margins, despite the fact that they've been through an investment cycle. And right now it's trading at almost a 9% free cash flow yield on enterprise value. 

So for us, time is on our side, and we think it's a matter of time before the debt capital markets normalize. Inevitably, it's cyclical, and that will be to the advantage of a company like MarketAxess. 

Michael: Excellent.

Colin, stock you'd maybe like to comment on? 

Colin: Yeah, I think MarketAxess is a Quality Value duration call opportunity that has self-help attributes. If we flip over to the Deep Value bucket, and again, I would call this a relatively AI agnostic opportunity. This is about an internal playbook to improve a company's lot in life, which is what we look for in Deep Value. IFF, International Flavors and Fragrances, as their name implies, they develop flavors and fragrances that are sold across a host of consumer applications, including food, beverage, personal care, household products. Interestingly, this is a company that we historically have been very familiar with, even though we have been unwilling to invest in IFF. And the reason for that is we were very aware that this is a company that had an acquisition-laden strategy, putting a lot of debt on the balance sheet. And we had observed over time that IFF was making itself bigger, not necessarily better.

A significant improvement to the C-suite happened about two and a half years ago. Typically, when there's a management change and they have a well-intentioned playbook, that does not mean that it's time to invest behind the company. Sometimes you need to track progress steps that a company makes when they have a heavy lift in front of them. 

IFF, to our way of thinking as we tracked it over time, finally made enough progress, and namely significant operational streamlining and portfolio streamlining. They completed 11 divestitures, taking in about $6 billion of proceeds. They significantly reduced the debt on their balance sheet. They had too much leverage. They have appropriate leverage today, a very clean balance sheet. That also enabled IFF to put in its first material share or purchase program in over six years. So they're able to finally shrink the share count.

On top of that, though, I mentioned operational streamlining. This company has done a ton with its cost structure. To basically eliminate overhead and invest in R&D and commercial efforts to become a market share gainer again. We had also seen adequate progress on the operational streamlining, and this is evidenced by improved margins and free cash flow generation.

So today, IFF has three segments where it has a right to win, a leading position, its operations are humming along much better, it has the right portfolio and the right focus. We actually believe that going forward, IFF, once again, like it once did, is starting to look like the premier flavor and fragrance player in the industry named Givaudan, who trades at a much higher valuation.

So we think the stage is set now with the blocking and tackling from here after the real heavy lifting of refocusing this company. We think that that valuation gap versus the darling can close materially overtime. So that's a classic self-help Deep Value opportunity that we look for.

Michael: Excellent. So our clients know us for a handful of things. One, of course, is our two buckets, the Deep Value bucket and the Quality bucket, our rules and tools that are designed to help us identify what could potentially be unintended bets in the portfolio to increase our opportunity for consistency, and of course, our 10 Principles of Value Investing™ for our stock analysis.

As you guys look out to the rest of the year with those things in mind, what are you thinking?

Colin: One observation is that we mentioned the wide valuation disparities. What's interesting to us is that these valuation disparities aren't isolated to just a couple sectors or a couple industries or just a couple pockets of the market. They are not isolated. We talked about it. It's not isolated exclusively to companies that are on the wrong side of some sort of secular AI disruption narrative.

This getting back to the two buckets and across a broad range of companies and industries, the valuation disparities are there that we believe are exploitable. And they are exploitable in a broad swath of ways. It's not all about how do I participate in AI or take the other side of a disruption narrative. It's traditional value investing available across the two buckets and across different types of companies, which fits well into our sector bands.

So we think this is an exploitable opportunity that is relatively broad. And we think the one-way freight train environment that we've seen with the AI euphoria, that will come and go. And ultimately, it's the price you pay versus the long-term fundamental attributes of the company. 

Troy: Yeah, I might just add that on the Deep Value side.

We learned a lesson years ago with regard to buying what we kind of call a duration call catalyst for a Deep Value business, meaning we're just betting that the durational cash flows are longer than the marketplace. And, you know, we use that lesson to focus on self-help catalysts to unlock value. Colin alluded to one with IFF. You know, this is a catalyst that is internal only and the company can, the management team can execute to unlock value. And the reality is if we do a post-mortem on what's happened in the Deep Value bucket over the last several years. The place that's really hurt us is just the rising tide that's benefited any company that had exposure to infrastructure assets that were needed to build out the AI infrastructure.

Michael: No self-help necessary. 

Troy: In our opinion, that's not self-help, right? I mean, some people might call that today self-help, but the reality is they were in the right place at the right time, a lot of these companies. So that that has been a headwind. But the reality is, we think in the long run, the self-help catalyst is meant to unlock value under a range of outcomes, not just a scenario where there's a big macro tailwind. And so that is a big difference, differentiation for us. In our opinion, we're going to continue to stick with that with that strategy.

Michael: Excellent. Thank you, guys, so much.