Heartland Mid Cap Value Fund 1Q18 Portfolio Manager Commentary

Executive Summary

  • Stock selection was strong with holdings in Real Estate, Health Care, and Utilities helping the Fund beat its benchmark, the Russell Midcap® Value Index returning -1.08% versus -2.50%.
  • Tax-cut euphoria pushed the markets higher to start the year but then gave way to questions about what will sustain elevated multiples going forward.
  • New trade tariffs, a sixth rate-hike from the Federal Reserve, and budding inflation left investors searching for opportunities that have the potential to thrive in a less accommodative world.
  • Budding economic uncertainties have led to broad-based selling in many sectors, creating attractive valuations.

First Quarter Market Discussion

Tax-cut euphoria pushed the markets higher to start the year but then gave way to questions about what will sustain elevated multiples going forward. 
 
Employment numbers, corporate earnings, and manufacturing data reflected the strength of the business climate. Yet, a nagging sense emerged that macro factors may have peaked and that broad tailwinds are less certain in the quarters ahead. 
 
New trade tariffs, a sixth rate-hike from the Federal Reserve, and budding inflation left investors searching for opportunities that have the potential to thrive in a less accommodative world. As a result, investors stuck with past winners and companies with a clear path to growing revenue in a less-benign economic environment.
 
All told, sentiment remained mostly upbeat—but conviction softened and volatility reemerged.
 
Attribution Analysis
Stock selection in several areas led the portfolio to beat its Russell Midcap® Value benchmark for the quarter. Real Estate stood out, along with the Strategy’s Utilities holdings. Allocation decisions also contributed positively. The portfolio’s Information Technology (IT) names were up on an absolute basis but lagged those in the benchmark. 
 
The consensus that rates will continue to climb has stoked selling pressure in bond proxies such as Real Estate and Utilities. Both groups have traditionally been viewed as defensive, but as the chart shows, profitability of Real Estate Investment Trusts has been more cyclical and may be softening once again. Utilities, however, could have more sustainable earnings growth given the rate base growth allowed by regulators.
 
Weak on Defense?
Heartland Advisors Value Investing Historical Forward Chart
Source: KeyBanc Capital Markets, Thomson Reuters, and FactSet Research Systems Inc., 2/29/2004 to 2/28/2018
Real Estate Investment Trusts (REIT), Next Twelve Months (NTM), Funds From Operations (FFO), Earnings Per Share (EPS).
REIT data is based on all REITs included in KeyBanc Capital's database of coverage.
Past performance does not guarantee future results.
 
Heartland Advisors Value Investing Real Estate Sector IconNice house, tough neighborhood. While Real Estate names as a whole were weak, the portfolio’s holdings performed well and the group contained a key contributor. Jones Lang LaSalle Incorporated (JLL), a top global real estate consultant and brokerage, was up after posting better than expected earnings and an improving balance sheet.
 
As earnings have improved and management streamlines the company’s cost structure, shares have taken off and valuations are approaching our estimates of fair value. In response, we’ve trimmed our exposure to mitigate risk. We will continue to monitor valuations and act accordingly. 
 
Heartland Advisors Value Investing Information Technology Sector IconTechnological breakthrough. The portfolio’s IT holdings were up on an absolute basis and contained a key contributor, Avnet, Inc. (AVT). Shares advanced as investors took note of improvements in day-to-day operations. 
 
This leading electronics distributor has accelerated cost cutting to offset the loss of three client contracts in 2017. We believe the contract terminations were isolated incidents and do not represent a trend. Additionally, Avnet has made significant strides through the divestiture of its weak-performing tech solutions business and has ample opportunity to continue to evolve to focus on more profitable client groups such as smaller semiconductor manufacturers. As the company attracts more early stage semi-conductor designers, Avnet can enjoy long-lived relationships that mature into higher-margin projects. 
 
Despite its improvements and a strong balance sheet with less than 10% net debt/capital, the company trades at less than book value and remains, in our view, a compelling bargain.
 
Heartland Advisors Value Investing Materials Sector IconPackaged for success? The portfolio’s Materials names were down for the quarter, but we believe the sector continues to offer attractive opportunities. For example, Bemis Company, Inc. (BMS), the largest manufacturer of food packaging in North America, has multiple catalysts that could propel shares higher. 
 
We have been long-term owners of the company but increased our position meaningfully last fall after shares came under pressure due to margin pressures and slowing sales as smaller players in the food packaging industry gained market share. Bemis had traditionally focused on large customers and so the shift was a blow to its top and bottom line. 
 
Bemis has revised its sales incentives with a focus on increasing sales to smaller industry players. The new structure could lead to an expansion of its regional customer base, which currently represents about 30% of sales.
 
We expect Bemis’ focus on improving results will lead to accelerating working capital velocity and boost profit margins materially. 
 
Heartland Advisors Value Investing Consumer Discretionary Sector IconNo Easy Rider. The portfolio’s Consumer Discretionary holdings performed mostly in line with those in the benchmark but the group also contained a key detractor. Harley-Davidson, Inc. (HOG), the world’s largest motorcycle manufacturer with approximately 50% market share in the U.S., was off on soft sales and a weaker-than-expected outlook for the year. As fears of a trade war began to heat up, shares faced additional selling pressure.
 
While headwinds have proven challenging, the company’s brand strength is second-to-none and cannot be easily replicated by competitors. Additionally, the new product development window has shrunk from 5+ years to just over 3 years. The improved pace should generate additional interest from buyers and may attract younger riders in the future.
 
Despite its status as a global icon and its dominant domestic market share, HOG trades at just 12x this year’s earnings and offers a 3.5% dividend yield.
 

Portfolio Activity

Recent volatility has created opportunities for patient investors. New economic uncertainties have led to broad-based selling in many sectors, creating attractive valuations.  Against this backdrop, we have trimmed some winners and added to existing investments and initiated new positions. 
 
The result of the activity is a portfolio that holds roughly two-thirds of its assets in more traditional value opportunities characterized by good companies experiencing a temporary overhang that has resulted in depressed valuations. The remaining third is held in less-distinguished businesses trading at significant discounts. 
 
As always, each buy and sell decision is based on the underlying fundamentals of the company; this work has resulted in increased exposure in the Utilities and Financials sectors. We have also pared our commitment to Information Technology in light of opportunities available elsewhere.
 

Outlook and Positioning

Heartland Advisors Value Investing Quote ImageThe economy remains robust but cross-currents are emerging. Valuations appear elevated, and higher interest rates, inflation, and overseas tariffs could put pressure on margins. 
 
While we are monitoring these developments, the results will not change our philosophy or process. The team continues to seek attractively valued companies across all sectors. We remain focused on balance sheet strength and on identifying catalysts that can result in a change in perception by investors. With economic tailwinds already priced into many companies’ share prices, we believe the disciplined application of our process will be key to navigating the months ahead. 
 
Thank you for the opportunity to manage your capital.
 
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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Colin McWey

Colin McWey

McWey, CFA, is Vice President and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He has 15 years of industry experience, 8 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 17 years of industry experience, 14 at Heartland.

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In the prospectus (pdf) dated 5/1/2017, the Net Fund Operating Expenses for the investor and institutional classes of the Mid Cap Value Fund are 1.25% and 0.99%, respectively. The Advisor has contractually agreed to waive its management fees and/or reimburse expenses of the Fund to ensure that Net Fund Operating Expenses for the Fund do not exceed 1.25% of the Fund’s average net assets for the investor class shares and 0.99% for the institutional class shares, through at least 5/1/2019, and subject thereafter to annual reapproval of the agreement by the Board of Directors. Without such waiver and/or reimbursements, the Gross Fund Operating Expenses would be 3.22% for the investor class shares and 3.46% for the institutional class shares.

Past performance does not guarantee future results. Performance represents past performance; current returns may be lower or higher. Performance information for institutional class shares of Funds that existed prior to their initial public offering is based on the performance of investor class shares. The investment return and principal value will fluctuate so that an investor's shares, when redeemed may be worth more or less than the original cost. All returns reflect reinvested dividends and capital gains distributions, but do not reflect the deduction of taxes that an investor would pay on distributions or redemptions. Subject to certain exceptions, shares of a Fund redeemed or exchanged within 10 days (90 days for the International Value Fund) of purchase are subject to a 2% redemption fee. Performance does not reflect this fee, which if deducted would reduce an individual's return.

An investor should consider the Funds’ investment objectives, risks, and charges and expenses carefully before investing or sending money. This and other important information may be found in the prospectus (pdf). To obtain a print prospectus, call 800-432-7856. Please read the prospectus carefully before investing.

As of 3/31/2018, Avnet, Inc., Bemis Company, Inc., Jones Lang LaSalle Incorporated, and Harley-Davidson, Inc. represented 3.05%, 2.24%, 2.01%, and 1.02% of the Mid Cap Value Fund’s net assets, respectively.

Portfolio holdings are subject to change without notice. Current and future portfolio holdings are subject to risk.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. The specific securities discussed, which are intended to illustrate the advisor’s investment style, do not represent all of the securities purchased, sold, or recommended by the advisor for client accounts, and the reader should not assume that an investment in these securities was or would be profitable in the future. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true.

Economic predictions are based on estimates and are subject to change.

There is no guarantee that a particular investment strategy will be successful.

Sector and industry classifications as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems Inc.

Heartland Advisors defines market cap ranges by the following indices: micro-cap by the Russell Microcap®, small-cap by the Russell 2000®, mid-cap by the Russell Midcap®, large-cap by the Russell Top 200®.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.

Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.

Heartland’s investing glossary provides definitions for several terms used on this page.

The above individuals are registered representatives of ALPS Distributors, Inc.

The Heartland Funds are distributed by ALPS Distributors, Inc.

CFA® is a registered trademark owned by the CFA Institute.

The Mid Cap Value Fund invests in a smaller number of stocks (generally 30 to 60) than the average mutual fund. The performance of these holdings generally will increase the volatility of the Fund’s returns. The Fund also invests in mid–sized companies on a value basis. Mid-sized securities generally are more volatile and less liquid than those of larger companies. There can be no assurance that the Fund will grow to or maintain an economically viable size, in which case the Board of Directors may determine to liquidate the Fund.

There is no assurance that dividend-paying stocks will mitigate volatility.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

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