3Q26 Mid Cap Commentary Podcast

Submit Questions Here

Transcript

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

Guys, thank you for joining me. It was a volatile quarter in Q3 for mid-caps. How would you describe the universe in Q3?

Colin McWey: Well, it certainly was choppy. I think you had interest rate volatility, oil price volatility, and I think one of the things that was very interesting was seeing a lot of the crowding that had happened exclusively in the AI trade in Q2, there were still pockets of that that went on. However, you saw a lot of the extreme momentum unwind and actually go into other pockets of the market.

In some cases, we consider this a healthy thing of excessive valuations getting called into question, in some instances. That is a good thing. The other thing you did see, however, is violent short covering rally. And a lot of that money flowed into some of the most heavily shorted stocks in the universe. And at the end of the day, we aren't investing behind a short covering rally. We're looking for durable competitive advantages and attractive attributes to take the long view.

Troy McGlone: Yeah, I think it's worth highlighting that we spoke after the second quarter about how much the benchmark constituents changed, specifically in the Information Technology sector. So, some of the darlings in the infrastructure build-out, specifically in the semiconductor industry, were removed from the Index in late June.

And they were replaced by a large chunk of what would be characterized as potential AI losers, for example, in the software industry. So, there was a furious rally in the third quarter of a lot of these businesses that we've done work on and have decided in most instances that they weren't worth investing in.

Michael: So, what kind of action were you taking in the face of this market backdrop? 

Colin: We still think that valuation disparities are as wide as we can ever recall, especially when you make any adjustment for the long-term quality and mid-cycle kind of normalized earnings and cash flow generation potential of various companies.

We think these disparities are not only wide across different sectors, they're also wide within the two buckets. So, within the Quality Value bucket of the universe, we see those extremes. We also see that in Deep Value, even though the Deep Value opportunity set is not as fertile as it's been sometimes in the past. But, thematically, we call out three different categories that we think are very interesting right now in the landscape. Number one is companies that have been completely orphaned in this AI euphoria landscape. In these cases, you don't need to take the other side of some sort of AI disruption bear case. These companies have just been flat out ignored because they are not the flavor of the day.

We also think that there are very good opportunities to apply our process and invest behind companies that will capture the long-term, durable, lasting benefits of what we call AI implementation in the real world. A classic example of that are advantage consolidators in fragmented industries with scale and technology advantages.

And then also, very selectively, in areas where there's been some sort of top-down negative industry narrative that have compressed the multiples of an entire industry or group. There's the opportunity to do fundamental research, roll up your shirt sleeves, and be selective and play in those areas where you think there's some sort of moat and competitive advantage that will last over time.

Michael: It already feels like these disparities have gone on longer than what seems rational or reasonable, but that doesn't mean it can't continue.

What are your guys' thoughts on how long this can go on? 

Troy: Yeah, from our perspective, the obvious answer is it's unknowable, but there are observations that we could point out. In particular, how the artificial intelligence investment or infrastructure cycle is being funded. And so again, we've talked in length before, that we have not said that we don't believe in the technology of artificial intelligence, but the reality is looking back at prior technological changes and infrastructure investment cycles, it's very common where the capital cycle, gets in front of the economic cycle, even if the technology is totally real and the bull case plays out.

And we think we're in that phase and it's evidenced by the fact that. Some of the biggest funders of this capital cycle, including the top 10 public companies, are spending about a trillion dollars of CapEx. This is consensus estimates for this year. The market's expecting that to go to a trillion three in 2027, which would be a large boost to the economy, just that alone. That doesn't count all these private companies as well. We think the losses are being absorbed by the private companies.

But so that that was the first few years of the cycle these public companies like the large tech companies weren't funding most of the spending via their operating cash flow from their core legacy businesses. And for the most part there are still several companies that generate significant free cash flow but most of them are now burning free they've negative free cash flow essentially. And so what that means is they're dependent upon the capital markets to raise money including some of the strongest financial balance sheet companies in the world, like Amazon, Google, Meta, for example. So they need to raise debt and equity in order to fund incremental capital. So at the end of the day, we can't know when the capital cycle ends, but increasingly it's dependent upon the kindness of the capital markets remaining open for those investors.

Michael: Excellent. Thank you. For the quarter, we lagged a bit. What would you attribute it to?

Colin: You actually can narrow it down to Information Technology and Health Care. And if you look within those two sectors, some of the biggest short covering beneficiaries came in those sectors. So it wasn't so much a function of our Tech holdings or our Health Care holdings, you know, having some sort of bad fundamental news. In a lot of cases, we had names that were appreciating in those sectors throughout the quarter. But, you know, if you have a name that's going up and there's a short covering rally and stocks are doubling, you may not keep up. To be fair, Moderna had the mRNA vaccine update that came through and that stock was a moonshot. So that falls in the Russell Midcap® Value in Health Care.

At the end of the day, for us, it's not about playing for a short-term short covering rally. It's about how are businesses priced, what is the opportunity set in front of us, and how we're making a decision based on a one to three year forward looking horizon and looking to invest behind something that we think is more lasting than technical short covering.

Troy: Yeah, the third quarter is really a microcosm. If you look at the data from our perspective, a microcosm of what's happened in the last year, which is we've underperformed because of negative stock selection, but the story is more about what we don't own than what we do own. So, to Colin's point, we don't have a handful of companies that have bad fundamentals and we're making all these internal mistakes in the portfolio. We are not owning some of the businesses that are rising as fast as the portfolio.

Michael: Excellent. So maybe you could share with us an example of an idea that doesn't fall into any of these buckets that have been driving the market, but you believe over the long term is a good opportunity.

Colin: We think in the Quality Value bucket, a great example is Bentley Systems (BSY). We referenced, you know, one of the opportunities for us is actually looking where a top-down industry narrative has compressed the multiples of everyone indiscriminately.

Bentley is an infrastructure software provider to generally the engineering industry. If you think about either the owners of critical assets around the world in the public workspace or in transportation, or if you think about the engineers that are doing the projects related to these assets. Bentley provides the foundational software, that these customers rely on. Their reliance on it has grown for over four consecutive decades. It's very high quality. It's vertical software. 

To be clear in the software space, we believe that AI disruption prospects are real. If you think about a lot of point solution software products or administrative software, we believe that notwithstanding the opportunities for short covering rallies, there are very viable business disruption cases there. We don't believe that's the case at all with Bentley because you are talking about a deeply embedded solution with customers that has been built over decades, and it's a classic case of very low cost of ownership, very high cost of failure. So, the value proposition and the ability to replicate the offering is extremely difficult. 

We think the prospects for Bentley from here will actually improve with AI as customers use AI-driven workloads, and we believe that it will show up in the key metrics, meaning annual recurring revenue acceleration and free cash flow acceleration.

Troy: For reference, roughly the cost per person, an engineer who uses their software is roughly five basis points on a project cost. So you can imagine some of these large infrastructure projects, it might be something like a highway, for example, the cost could be in the hundreds of millions to billions of dollars. And if there's a mistake in the engineering portion of that project. The person or the state who owns that project at the end of it won't even know there's a mistake until it's too late. And the cost will be astronomical to taxpayers or the asset owner. And so that's an example of it's an entrenched software in a specific end market that is a very low cost relative to the value it has for its clients.

Michael: Excellent. Sounds like a great example of exactly what we're talking about.

So how about the outlook for the rest of the year?

Colin: We're actually optimistic. We, you know, Troy mentioned, we don't know when some of the extremes come to an end, the extreme valuation and the AI euphoria, but we see that the seeds are being sown. And there's a lot of companies in the universe where the rate of change will matter enough. It's not that business has to go flatline from very good. In some cases, businesses can go from very good to less good. And if you just look at the valuations, you can see the excess is priced in and that may not take much to change that. 

I come back to the three general categories that we highlighted at the outset. The type of orphaned businesses that have been completely ignored in this backdrop that are, on a relative basis, extremely attractively valued. The long-term winners of AI deployment in the real world. And then selectively, the example like Bentley, where you can step in where a top-down narrative has kind of created a dislocation when you look at the underlying attributes of the companies. These continue to be the widest valuation disparities that we can recall when you make reasonable assumptions in our opinion, and we believe that remains very exploitable.

Michael: Okay, great. Thanks, guys.