3Q25 Mid Cap Commentary Podcast

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Transcript

Michael Kops: Hello, I'm Michael Kops, Vice President at Heartland Advisors. I'm here with Troy McGlone and Colin McWey, co-managers for the Heartland Mid Cap Value Strategy.

Colin, how would you describe the mood of the markets?

Colin McWey: Well, Michael, we saw a continuation of trends that began accelerating in Q2. Growing optimism surrounding the AI boom and the corresponding surge in electricity demand helped power large and mid-cap growth stocks to new highs, regardless of business model quality or valuation. Investors also continued chasing speculative bets on cryptocurrencies, where a business model isn't required and where leverage is treated like vegetables. The more you have, the better it is.

Mike: Troy, how would you describe the combination of quality versus valuations in
the current environment?

Troy McGlone: There are periods in the market when paying attention to valuation can be penalizing, and the third quarter was one of those times.

Not owning the highest octane cyclicals put our strategy at a disadvantage during the quarter, as lower multiple and defensive parts of the market underperformed. 

Mike: And how did that play out more broadly for value investors? 

Troy: Even in the mid-value universe of stocks, returns for momentum in the Russell Midcap® Value Index outperformed value factors such as free cash flow to enterprise value by more than 14% over the last 12 months. The dramatic outperformance of momentum over free cash flow yield continued during the quarter and coincided with extreme outperformance of high versus low volatility stocks.

Mike: And how much of this do you think ties back to the broader economy?

Colin: Well, despite observing market speculation, there are pockets of economic weakness that persist. This includes the residential housing market, where several industry participants recently called out deteriorating demand in new construction and remodeling activity. Even areas that are historically very resilient, like replacing an air conditioning unit when it fails, are exhibiting abnormal demand weakness.

This tells you that affordability in some of these pockets is a persistent issue. More recently, a few cracks seem to have emerged in business development companies, private credit, and auto lending. 

Mike: And it seems there's some concerns about the job market.

Colin: Yes. Several negative economic data points on the job market came through in September. This included disappointing job creation in August, coupled with a large downward revision to non-farm payrolls for the prior year. This dropped employment estimates by almost 1 million jobs. Changes in the trajectory of the job market, as evidenced by initial jobless claims, tend to persist for some time.

Mike: So what does all this mean when it comes to managing the strategy?

Troy: Yeah, we believe this is the type of market where paying attention to the quality of what you own and the price paid to own it is crucial for us. Analyzing businesses that we do and do not own along with what we pay are foundational components of our 10 Principles of Value Investing™ process. We believe this is also an environment where it makes sense to consider what valuations are pricing in on the continuum of probable outcomes.

Mike: So how does that play out in practice? 

Colin: Well, we rely on a four-price target approach that respects a range of outcomes, valuation discipline, and downside risk. We remain unwilling to chase many companies in our universe that we consider either speculative or price for perfection. 

In a generally expensive broad market, we do observe valuation disparities across companies that are as wide as we can ever recall. We think this can be exploited with the right process and the right time horizon. And we're actually encouraged recently by insider buying in several of our holdings where we already found attractive valuations.

Mike: The Mid Cap Value Strategy gained 1.77% in the third quarter, trailing the Russell Midcap® Value Index, which was up 6.18%. What accounted for the performance?

Troy: Our stock picking has made life harder in a generationally euphoric backdrop that challenges our style to begin with. Stock selection was responsible for most of our underperformance, as the selection effect was negative in seven sectors, including Health Care, Financials, Consumer Discretionary, Energy, Industrials, Real Estate, and Materials. 

Mike: And what about the two buckets?

Colin: Well, at all times, we aim to hold high-quality mid-cap companies trading at relative bargains. This is the Quality Value bucket. And then also the other bucket, deeply discounted businesses that have produced poor economic returns over time, but that have a self-help catalyst to unlock value. That's our Deep Value sleeve of the portfolio. Within value, each of these styles tend to take turns outperforming, similar to how periods of growth and value outperformance tend to alternate over time.

During the quarter, the returns from the Deep Value bucket began outperforming Quality Value at the same time that growth was beating value. This is a significant departure from the past two decades, where the outperformance of growth tended to coincide with Quality Value's relative advantage over Deep Value. We surmise that the speculative backdrop may have had something to do with this, and time will tell. 

Mike: The best performer for the quarter came from the deep value bucket. Can you provide a little color?

Troy: Yes, it was D.R. Horton (DHI). It's the largest home builder in the country. The company enjoys roughly a 10% market share with scale advantages in a highly fragmented industry.

The company has a particularly strong position in entry-level homes. To produce affordable housing, Horton runs the business with a speculative inventory model. I know speculative inventory has a negative connotation, but this allows the company to have an advantage in running the business like a manufacturer, where they're able to reduce unit costs and the savings are mostly passed on to the home buyer in the form of lower prices. To accommodate this business model, the company's balance sheet is noticeably strong, allowing for maximum flexibility in capital allocation.

Mike: I know you like to tread lightly in the Deep Value bucket and you have a mandate that essentially a firm needs to own its future or have a self-help Catalyst. How would you describe that for D.R. Horton?

Troy: Management has been pivoting the company's balance sheet away from owning large swaths of undeveloped land, preferring instead to use less capital-intensive methods to source buildable lots. This self-help strategy has reduced the capital commitment to the business and increased returns on invested capital. 

Mike: And when did you add the stock?

Troy: Well, Horton sold off in late 2024 and earlier this year along with the entire home building industry because of weak demand and rising discounts across the industry. We used the sell-off to establish a position marking, I believe, the fourth time we owned the company. We further increased our position during the broader market sell-off at the end of the first quarter and in early Q2. Shares of DR Horton rose sharply this quarter on earnings that beat analysts' expectations on both home deliveries and gross margins. In addition, orders, which were flat year-over-year, exceeded consensus expectations by more than four percentage points. Management accelerated its share repurchases, buying back more than 3% of the company in the third quarter alone. That fact, plus falling long-term interest rates and a 13F filing by Berkshire Hathaway detailed a new stake in D.R. Horton. We believe all these factors propelled shares.

Mike: And what about quality value? Is there a stock you can show a little color there?

Colin: There is. On the standout side for quality value, LAM Research (LRCX) was a strong performer during the quarter. LAM is a supplier of semiconductor capital equipment with the leading market position in technology integral to the production of the chip industry's most advanced circuits. A cyclical downturn and market volatility earlier this year gave us a chance to buy shares at a compelling valuation. A new upcycle and clear market share gains demonstrated in recent quarters helped drive strong recent performance in the shares.

Mike: And what's the broader case for LAM? 

Colin: It's bigger picture. Over the past decade, the semi-cap industry has consolidated. Five companies control roughly three quarters of the entire market. LAM is dominant in the etch process. That's a process by which chips are created by removing materials from the wafer to transfer patterns. Industry consolidation and improved customer profitability help create a structurally more profitable semi-cap industry over time.

LAM's leadership position, if you look back over history, in particular was with memory customers. This has proved quite fortuitous, as many of the key applications used by those memory customers became mission-critical for manufacturers producing today's leading-edge chips, even outside of the memory industry. This leaves the company uniquely positioned to gain share in an industry that already benefits from structurally higher customer capital intensity and a growing base of recurring revenues.

Mike: And how about some details around a holding that didn't work last quarter?

Troy: Well, Centene (CNC) was our worst-performing holding in the quarter. Shares of the managed care company suffered from a policy-induced risk pool shift in the ACA healthcare exchanges that negatively impacted profit margins and caused a pre-announced earnings cut nearly a month ahead of the scheduled earnings release date.

Frankly, we were evaluating a position size reduction given the policy changes, but were surprised by the announcement's timing. Recognizing the short-tailed nature of the liabilities in managed care, meaning that they can adjust for rising losses faster than other forms of insurance, we waited for management to formally articulate their plans to address the issue in late July. We came away encouraged by aggressive price actions meant to reflect recent developments and restore margins.

Mike: And you chose to hold the stock?

Troy: Yes. In September, the company provided a positive update on the action plan that helped shares begin to recover from July's sharp sell-off. Meanwhile, political pressures have been touched by both sides of the aisle to address the looming health insurance affordability crisis. Any policy improvement would further supplement the actions taken by Centene, which assume no relief.

Mike: Excellent. Any final thoughts? 

Colin: Well, last quarter, the markets punished those who weren't all in on the AI and cryptocurrency booms. However, as long-term-minded investors, we consider this basic table stakes for being active managers. It's our job to consider as wide a range of outcomes as possible when constructing the portfolio to allocate capital based on the best risk-reward scenarios.

Mike: Colin and Troy, thank you so much for your time. 

Troy: Thanks, Mike.