Heartland Advisors

2Q25 Mid Cap Commentary Podcast

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.

Troy, the mood of the market shifted once again, didn't it?

Troy McGlone: It certainly did. Market sentiment has been volatile really for a significant amount of time now, and ultimately the past three months were no exception.

We entered the quarter, it seemed like investors were paralyzed by concerns about a trade war escalation. And ultimately, there's been some de-escalation in real time. We're seeing country by country negotiation headlines hit the news. And now it appears that really there's been 180 degree turn in sentiment. And what was a large degree of acute fears have really rotated into a V-shaped recovery being discounted by the market. 

Mike: And do you think that tariff concerns are overblown? 

Troy: We really still think that the jury's out for deliberation on that point.

To subscribe to the idea, you do really have to believe that ultimately companies' management teams will move forward with their investment projects, given the uncertainty that was created by tariff headlines and also uncertainty around tax policy, which has ultimately been concluded. But also there are derivative implications to consumer purchasing patterns. So as companies raise prices to offset tariffs in some degree. There is some elasticity. And we also believe it's possible and probable that there was some pull forward in purchasing activity that took place as people made purchases. We saw that in the auto industry, for example, where used car sales spiked significantly in the quarter, which is a clear sign that there are certain buyers that maybe were on the sidelines and decided to pull the trigger because of pending tariff price increases.

Mike: Colin, is that what you're hearing on the ground? 

Colin McWey: Well, actually, what we have heard from several business managers is that it's quite difficult to commit to large investments without knowing what the rules of the world will be, as those rules have direct implications on the potential demand from their customers and ultimately the returns on those investments.

If you think one step further, it's really impossible to know what portion of near-term demand reflects a pull forward from customers looking to get ahead of price increases. But ultimately, if it's a pull forward, that could reduce the demand run rate once panic buying subsides. And actually, oddly enough, in late July, we have heard some early indicators on earnings calls that there was some pull forward in instances. And if you want to complicate matters a little bit further, traditional economic indicators are sending those decision makers mixed signals about which way the economy may be headed.

If you look at leading versus coincident economic indicators, they've generally moved in tandem with each other over time, with the latter confirming the former. However, currently the gap between the two is the widest it's been in recent history. And I think this really reflects the difficulties faced by company executives, consumers, and investors.

Mike: The Mid Cap Value portfolio lost two basis points in the quarter, trailing the Russell Midcap® Value Index, which was up 5.35%. What drove the results?

Troy: Yeah, stock selection was a key driver of underperformance. It accounted for about 80% of our underperformance, and the lags were really concentrated in the Industrial and Consumer Discretionary sectors.

Really it was similar to what we experienced in 2024 where it was a combination of stocks that we both owned and didn't own within the benchmark that created headwinds. So if we take Industrials as an example where we also liked last year. Over time we preferred to where we found value and Industrials would be defined a combination of companies that are under-earning. Industrials generally tend to be a cyclical group of companies and we can find businesses that are under-earning that are trading at attractive valuations. And ultimately, the market has really gravitated towards really paying almost any price for earnings growth, regardless of where a company seems to be in the cycle.

So normally, what we would see is that as profits approach mid to late cycle levels, that the valuation multiples come in and fall as the market anticipates peak earnings. And we're really not seeing that. And so it's become a headwind where we own companies and the staffing and transportation industries and examples that we believe we're highly confident are earning below their potential, but ultimately the market continues to discount that, through lower valuations as opposed to the securities that are in the benchmark.

Mike: Colin, what would you say about performance for the quarter?

Colin: Yeah, I mean, beyond that, there was a little bit of a, well, there was a significant impact in terms of us not owning some really high-octane names. And it shows up in terms of an underweight to beta momentum and growth. But what we've observed, in terms of traditional beta, if you think about companies that are economically sensitive, we actually, we think and we observe day-to-day that we're relatively balanced between those types of companies that have some economic sensitivity, versus those that are defensive. So we think of that in terms of traditional beta as a value investor would use their process to pick stocks. 

But the type of beta momentum and growth we're talking about that's in the Russell Midcap® Value universe includes a drag from not owning some pretty speculative or growthy business models that are in our benchmark. Most of these are either plays on some common themes out there like cryptocurrencies or artificial intelligence. So think about the likes of Robinhood, Coinbase, MicroStrategy.

And in terms of playing artificial intelligence in mid-cap value land, a lot of names in pipelines, engineering and construction, independent power producers, electrical components, etc. These businesses got bid up very strongly with the theme trading in the quarter, and we were hurt simply by not owning them. 

The strategy was also hurt by not owning some very high-octane names in cyclical parts of the market, such as Technology, Industrials, and Consumer Discretionary, that were some of the best-performing sectors in the benchmark during the quarter.

But to be fair, we also had a few companies that provided tepid earnings updates that will keep their valuations depressed for the time being. But in these cases, we think patience is very much warranted due to valuation under what we consider a reasonable range of scenarios and outcomes in the future.

Becton Dickinson (BDX) is a perfect example of this. The stock sold off nearly 20% after the company lowered its annual guidance to reflect recent NIH funding cuts and a $0.25 earnings impact from tariffs.

However, Becton has a mission-critical position across the healthcare landscape that is durable, and it trades at 12 times earnings on an enterprise-valued EBITDA basis, its discount is near a two-decade high at 15%. This compares to what typically happens where Becton carries a healthy premium multiple versus the broader mid-cap universe.

A major reason why they have warranted a premium valuation over time is the inherent stability of their margins and cash flows under almost any economic scenario. Even if growth remains stuck in a low single-digit range, which is the guide for this year, we consider the multiple compression way overblown for a company that has little risk of an earnings cliff event that we can easily envision an earnings cliff event for many businesses that carry much more expensive valuations.

Mike: Great. I know you've owned the stock for a while, so thank you for the update.

What about any new names added in the quarter?

Troy: Yeah, we added a new Deep Value self-help idea in the Financial sector.

So just as a reminder, for the Deep Value or lower return businesses that we add, we do look to find a self-help catalyst so that essentially the value is unlocked by something that's change-aided, basically driven internally.

So, one of the names that we bought was Everest Group (EG). They operate in the global property casualty reinsurance business, which inherently is a commodity business. The economic returns are largely dictated by supply and demand. And so ultimately, as capital enters the space, returns are competed away.

And that business, because the returns are more cyclical and volatile in the public markets, typically what you'll see is a much more valuation ascribed to property reinsurance relative to maybe specialty property casualty companies. And so the prior management team had somewhat of a rational strategy, which was, let's try to diversify away from that low multiple business. And what they did was essentially diversified away by adding a lot of casualty risk, which comes with much longer duration liabilities. And essentially what this does is protect policyholders from some sort of accident or death. 

And what we've seen is that business has been underpriced across the entire industry. And so last year, Evers Group had to take a very large reserve charge. There was a new CEO put in place. And what we're attracted to is what we think is really an example of a shrink-to-grow strategy. So, because this business was mispriced, really what they're doing is either raising prices or walking away from existing lines of business. And in insurance, when you write less business, what that does is it frees up capital. And so what they're able to do is use that capital rather than grow the top line is simply to buy back shares and the stock's trading right around tangible book value over long term they've been able to grow their book value per share at a double digit compound management growth rate so we don't think there's a heroic set of outcomes that need to take place in order to get a nice return here if they could just simply grow book value per share buy back shares at an attractive price we think we can get a nice return and ultimately the strategy is fully within in maintenance control.

Mike: Excellent. Any other new names you'd like to mention? 

Troy: Yeah, we took a new position in a company called Hubbell and Industrials (HUBB).

It's an electrical equipment supplier. This is a company we've been following actually for several years. They make basically components that you'll find on utility grid infrastructure. So if you drive past on a freeway, you see highline poles. Basically all the components on the poles would be products that at Hubbell Manufacturers. And they also sell electrical infrastructure components to just broad industrial end markets.

Ultimately, this is a company, it's a very good business, and it's a Quality Value and a combination of both self-help and duration call catalyst. At the end of the day, we think this is a mid-single digital organic roar, but post-COVID in the supply chain bottlenecks, what happened was utility customers actually overordered product and started to build inventory to ensure that they had supply of Hubbell's products.

And the market got really excited about the growth potential of Hubbell and it was exactly when the whole AI growth narrative took off. And so people were ascribing very high valuations to Hubbell. And it got caught up in that whole AI infrastructure play.

Up until earlier this year, when there was some air taken out of that story, it was when the deep seek news hit the public markets and ultimately anything tied to artificial intelligence got hit materially. And this is a business we've been paying attention to, and it fell to the point where we were confident in the valuation that we were paying.

And on the duration call side, this is a business that has better margins, better returns on invested capital, better balance sheet than industrial peers we were able to buy to the sector like multiple.

And on the self-help side, they are in one of their businesses, their electrical solutions business, which sells the components to just the broad industrial end markets. They're effectuating what is a self-help strategy through 80-20 initiatives, so they're rationalizing SKUs. If they can't sell enough of the product, they're going to raise prices. And they're also consolidating about 15% of their manufacturing footprint through 2027. And the executive that was put in charge of that is the same individual who made the change in their other segment over years and enhanced profitability. So they used to have their plants oriented toward and market applications. So you might make a similar product that serves, say, oil and gas or mining, which is deeply cyclical, and it would also serve the commercial construction business and market. And so what the  company ended up with was too much capacity with similar component manufacturing capabilities. What they're doing is streamlining their manufacturing to center excellence around product type. And so that's allowing them to shrink their manufacturing footprint and flex their production capacity relative to end markets that are growing. And that's driving margins higher over time. So it's a combination of buying a better than average business and an average price with internal self-help change agents at play.

Mike: Excellent. Thank you, Troy. I know our listeners enjoy getting color on individual security, so it's really helpful.

More broadly, Colin, how would you describe your approach in this market?

Colin: The opportunity set is very bifurcated and that's really driven by valuation extremes and disparities that are as wide as we can recall. It's a sign of the times that factors like momentum and earnings revisions are outperforming foundational value attributes like free cash flow yield in really historic fashion over the past several quarters, if you go back to the start of 2024.

Over the long term, the story is quite the opposite. History has shown time and again that the opposite is true, and valuation attributes provide efficacy to returns, along with good fundamental forecasting.

We believe that fundamental factors such as strong free cash flow and attractive valuations are always important, but that is doubly true at a time when speculation exceeds risk aversion, which is generally what we observe today.

We remain focused on using our two-bucket approach to invest in select Quality Value and Deep Value companies that are attractively priced under a reasonably wide range of scenarios. And we are even more attracted to those with a plausible self-help playbook that is largely within their control, regardless of where the fluid macroeconomic backdrop goes from here.

Mike: Excellent. Guys, thank you so much. It's been really helpful. I know our listeners will appreciate it. Thank you again for the time. 

Troy: Thanks, Mike.

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Author

Heartland Advisors Value Investing Relationship Manager Michael Kops

Michael Kops

Vice President and Partner

Heartland Advisors Value Investing Portfolio Manager Colin McWey

Colin McWey

Vice President and Portfolio Manager

Heartland Advisors Value Investing Portfolio Manager Troy McGlone

Troy McGlone

Vice President and Portfolio Manager

 

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