Heartland Mid Cap Value Fund 2Q19 Portfolio Manager Commentary

Executive Summary

  • Stock selection was strong in a number of areas but the portfolio lagged its Russell Midcap® Value benchmark returning 3.01% versus 3.19%.
  • Volatility during the first half of the year has created opportunities for investors willing to look beyond daily headlines or the latest earnings releases.
  • Domestic-focused companies and those insulated from the effects of tariffs fared better than businesses with international exposure.

Second Quarter Market Discussion

As trade tensions flared and economic data continued to point to slowing growth, investors honed in on mitigating perceived risks. As a result, domestic-focused companies and those insulated from the effects of tariffs fared better than businesses with international exposure. Similarly, names with a demonstrated history of producing growth were favored over those that typically reach a positive inflection point after a slowdown.
 
While shares of growth companies benefited against the backdrop, so too did some richly valued defensive plays as the market searched for yield and low volatility in an unsettled market.
 
The skittish tone was also reflected in a spike in volatility during the period, as shown. The performance swings of the broad indices provided opportunities for active managers to exploit pricing inefficiencies that resulted from emotional responses driven by a short-term outlook.
 
Uncertain Times
Heartland Advisors Value Investing CBOE Volatility Index Chart
Source: Bloomberg L.P., 3/29/2019 to 6/28/2019
Chicago Board Options Exchange Market Volatility Index (CBOE VIX)
Economic predictions are based on estimates and are subject to change.
Past performance does not guarantee future results.
 
Attribution Analysis
Stock selection was strong in several areas, but the portfolio lagged its Russell Midcap® Value benchmark for the quarter. Health Care stood out on an absolute and relative basis, along with the strategy’s Consumer Staples. Real Estate holdings also fared well. The portfolio’s Financial names were up on absolute terms but lagged the average for the benchmark. 
 
Heartland Advisors Value Investing Health Care Sector IconNice checkup. Health care equipment holdings helped boost results in the broader sector and the group contained a top contributor, Dentsply Sirona Inc. (XRAY), a manufacturer of health care technology and supplies with an emphasis on dental products. 
 
We initiated a position in Dentsply in the first quarter of this year. We became interested after the company’s sales growth softened and margins eroded due to a lack of management focus. A new CEO was brought in at the time, and we believed fresh management could instill a renewed sense of urgency to the business. Since then, the company has undertaken cost-cutting initiatives and established plans to divest lower-margin units. Management expects these changes will result in up to $225 million in annual savings by 2021. 
 
As the company continues to make progress on reducing costs and streamlining its business units, we expect margins to increase and the stock to trade more in line with medical device peers.
 
Heartland Advisors Value Investing Real Estate Sector IconWelcome home. While the Real Estate group has become expensive over the last several years, we have been selective in seeking opportunities that offer unique advantages or where prices appear to underestimate the long-term potential of businesses. For example, American Homes 4 Rent (AMH) a real estate investment trust (REIT) that focuses on renting single family homes, offers exposure to a supply-constrained portion of the real estate market. 
 
We purchased AMH last year when the market was concerned about the impact of rising interest rates on the sector. At the time, we were drawn to the company’s strong balance sheet and capable management team. Throughout 2018, AMH’s portfolio proved resilient against rising rates as tenants continued to rent rather than buy, given higher costs for home purchases. The dynamic led to lower turnover in its properties and greater pricing power for rents. As a result, cash flow growth, which was stagnant in the first half of 2018, accelerated to more than 12% in the first quarter of this year. 
 
Improved results for AMH caught investor’s attention, and shares have risen since our initial purchase. During the quarter, we harvested gains in the name and have reduced our exposure as valuations have escalated.
 
Heartland Advisors Value Investing Information Technology Sector IconUpon further analysis. Heightened trade tensions with China weighed on Information Technology stocks and the portfolio’s holding lagged those in the benchmark. Much of the weakness came from software holdings, including Teradata Corporation (TDC), a database management company and the market leader for complex data analytics.
 
Teradata is in the process of transitioning from a legacy model focused on hardware and perpetual license sales to a more flexible approach that emphasizes software and subscription services. This move should result in more predictable revenue streams. While management has made impressive strides in evolving its business model, investors were spooked this quarter when the company reported that its legacy business was shrinking faster than analysts had initially anticipated.
 
We took the resulting weakness in shares as a buying opportunity. Although the runoff of Teradata’s legacy business may temporarily impact sales, we were impressed by management’s guidance of 11%-12% growth in recurring annual revenues. We anticipate that as the company continues to make progress in transitioning its go-to-market strategy, free cash flow generation could more than double to a range of $4-$5 per share in fiscal year 2021, translating to a free cash flow/enterprise value yield of 11%-14%.
 

Portfolio Activity

Volatility during the first half of the year has created opportunities for investors willing to look beyond daily headlines or the latest earnings releases. During this period, we’ve sought to maintain a balanced approach rooted in valuations while also taking a clear view of the risk/reward profile of each business. 
 
For example, we remain overweight to the Health Care sector, but our exposure to pharmaceutical benefit providers has dropped as we believe valuations don’t adequately compensate investors for risks posed by the headwinds the group faces in the form of restrictive legislation and pricing pressure.
 
Despite the challenges facing benefit providers, we continue to find opportunities within the health care space. For example, we recently added Humana Inc. (HUM), a leading managed care benefit provider that specializes in Medicare Advantage HMO plans.
 
Shares have been under pressure this year as many of the candidates running for the 2020 presidential nomination have voiced support for a single-payer health system that would displace private sector benefit providers. We believe a move to a so-called “Medicare for all” system is unlikely, regardless of who wins the White House in the coming election, and instead we are focused on Humana’s sales growth and solid profit margins.
 
The company is expected to continue to produce high single-digit compounded annual growth as the marketplace continues to shift to Medicare Advantage coverage. Despite having what we view as superior earnings growth prospects compared to the S&P 500, shares of Humana trade at just 13.5x forward earnings per share vs. nearly 17x for the broader index.
 
Beyond health care, we continue to scour both economically sensitive and defensive areas for opportunities but are following our fundamental analysis to where it leads. While each investment decision is made on a stock-by-stock basis, the cumulative effect of our efforts is a portfolio that is less economically sensitive than in the recent past.
 

Outlook and Positioning

Softening economic data and uncertainty about when or how ongoing trade disagreements will be resolved, highlight the need for a patient, disciplined investment approach. As such, we aren’t making market calls, but instead are focusing on capitalizing on the opportunities presented. We believe it’s important to avoid jumping into positions that have only recently come under pressure, even if their valuations have improved. In our view, the prudent course is to get past a fear of missing out on upside potential and stay focused on company-specific factors. 
 
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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 17 years of industry experience, 10 at Heartland.

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Select Value, Mid Cap Value, and Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 19 years of industry experience, 15 at Heartland.

Fund Returns

6/30/2019

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Since Inception (%)20-Year (%)15-Year (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD* (%)QTD* (%)
Mid Cap Value
Investor Class
7.49----10.964.9516.623.01
Mid Cap Value
Institutional Class
7.76----11.245.1916.703.00
Russell Midcap® Value7.06----8.953.6818.023.19
*Not annualized

The inception date for the Mid Cap Value Fund is 10/31/2014 for the investor and institutional class.

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In the prospectus (pdf) dated 5/1/2019, 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 5/1/2020, 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 2.37% for the investor class shares and 2.28% 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 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 6/30/2019, American Homes 4 Rent, Dentsply Sirona Inc., Humana Inc., and Teradata Corporation represented 1.62%, 1.46%, 2.05%, and 2.79% 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 are sourced from GICS®.The Global Industry Classification Standard (GICS®) is the exclusive intellectual property of MSCI Inc. (MSCI) and S&P Global Market Intelligence (“S&P”).  Neither MSCI, S&P, their affiliates, nor any of their third party providers (“GICS Parties”) makes any representations or warranties, express or implied, with respect to GICS or the results to be obtained by the use thereof, and expressly disclaim all warranties, including warranties of accuracy, completeness, merchantability and fitness for a particular purpose.  The GICS Parties shall not have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of such damages.

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.

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

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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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