Heartland Mid Cap Value Fund 2Q20 Portfolio Manager Commentary

Executive Summary

  • Stock selection was strong, and the portfolio outperformed its Russell Midcap® Value benchmark.
  • Buyers appeared to be motivated by a fear of missing out more so than fundamentals.
  • Companies, in our view, will need to show bottom-line growth to differentiate themselves going forward.
     

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.

Second Quarter Market Discussion

Aggressive action by the Federal Reserve as well as economic data and earnings reports that were less bad than expected, enticed investors back to equities.

The risk-on sentiment was in stark contrast to much of the first quarter when doomsday scenarios related to COVID-19 roiled the markets. The speed and strength of the rebound gave way to a pause late in the period as investors digested the long-term ramifications of the spring global economic shutdown.

While the move higher for the quarter was a welcome relief for battered portfolios, buyers appeared to be motivated by a fear of missing out more so than fundamentals. For example, as shown below, shares of companies with low returns on equity, as a whole, materially outperformed their higher quality counterparts. Lower quality names often lead in rallies following selloffs, but the magnitude of the bounce back was noteworthy.

A FOMO Rally?
Heartland Advisors High Beta/Low Volatility


Source: FactSet; FTSE Russell; Jefferies. This chart shows companies held in the Russell 2000 Index. The 2020 bear market is representing data gathered during 1/16/2020 to 3/18/2020. The average bear market data is calculated based on bear markets taking place during 12/31/1985 to 6/18/2020. Bottom was on 3/18/2020. The average 3-month after bear market data is calculated based on 3 months following each bear market taking place during 12/31/1985 to 6/18/2020. Return on equity (ROE) measures the net income after taxes a firm is able to earn as a percentage of shareholders’ equity. A bear market occurs when the price of a group of securities is falling or is expected to fall.

Attribution Analysis
Stock selection was strong in several areas, and the portfolio outperformed its Russell Midcap® Value benchmark for the quarter. Consumer Discretionary holdings stood out on an absolute and relative basis, along with the strategy’s Materials names. The portfolio’s holdings in Financials lagged. 
 
Performance parts. Strength among the portfolio’s Consumer Discretionary names was widespread and included a name we highlighted during the first quarter, Advance Auto Parts, Inc. (AAP). The company is a dominant player in the fragmented auto parts industry and differentiates itself from peers through its client mix. 

We took a stake in the business after it experienced what we viewed as a temporary lull in its self-help efforts. Despite the setback, we’ve been impressed with management’s ability to stabilize gross profit margin, improve free cash flow, and deleverage the balance sheet.  We continue to see ample opportunity for achievable operating improvements and believe management is on the right path. 

As the U.S. economy has begun to reopen from the COVID-19 shutdown, Advance Auto Parts has enjoyed a surge in sales. The jump has caught the attention of investors’ attention and shares are up double-digits for the quarter.
 
Follow the money. Financials posted solid gains for the period with strength coming from a broad range of industries. Our holdings in the space were up soundly led by Raymond James Financial Inc. (RJF), a diversified financial services company offering wealth advisory, asset management, investment banking, and banking services to retail and institutional clients.

Shares of Raymond James began falling in February of this year as the market started pricing in the potential impact of COVID-19 on company profits.  Raymond James earns advisory and management fees based upon client asset levels, interest income from lending activity, and banking fees based upon capital markets activity.  As equity and credit markets continued to deteriorate and as interest rates fell throughout the first quarter, the stock fell more than 40% from its peak.

Despite the near-term headwinds for the company, we are attracted to Raymond James due to its impressive history of growing market share and the opportunity it has to penetrate new markets outside of its stronghold of the Southeast. The potential for growth coupled with the company’s ability to generate returns on equity that far outpace peers should serve investors well in the years to come. Despite its strong position, shares are trading at just 1.7x tangible book value vs. a long-term median of more than 2x
 

Portfolio Activity

The run up in equity prices during the period has narrowed the pool of attractively-valued businesses. Signs of a speculative bubble in pockets of the market have begun to emerge, however, we continue to focus on finding and owning companies that are poised to succeed against a variety of backdrops or those that are priced at significant discounts to peers regardless of the sector or industry. For example, we recently took a stake in PS Business Parks, Inc. (PSB). 

PS Business Parks operates in the industrial, warehouse, and “flex” (combination of industrial & office) real estate segment. Unlike competitors who often lease tens of thousands of square feet to single tenants, many of PS Business’ clients rent less than 5,000 feet at a given location. The business also offers shorter leases—usually 1 to 3 years—than many of its peers. This differentiated approach results in fewer competitors and less pricing pressure when seeking to attract tenants. 

While PSB’s business model can result in the company being more sensitive to changes in the economic climate, management has demonstrated a knack for efficient use of capital all while maintain a strong balance sheet. Management’s focus on highly efficient capital deployment is evidenced by the company’s trailing 10-year free cash flow to invested capital yield of ~9% vs.  an industrial real estate investment trust (REIT) peer median of 2%. The yield is impressive in our view, given the company has grown its inventory of square footage by 10% compounding annualized growth rate over the past two decades.

Public REITS have lagged the broader market through the first half of this year due to investor concerns about rising vacancies and tenant rent deferrals resulting from the recession caused by COVID-19. While PSB has been a strong performer over the long term, it came under what we believe was excessive selling pressure over the past six months because of the its exposure to shorter duration leases and small tenants, two characteristics investor fear in the face of a weakening economy. 

The selling pressure was overdone, in our view, and failed to recognize the competitive advantage PSB enjoys due to its strong management team and balance sheet strength. Should the recession drag on, we expect the company will be able to expand their portfolio of property at attractive prices as they have in past cycles, which will drive higher cycle-over-cycle earnings power.
 

Outlook and Positioning

Investors have been heartened by recent data that shows a more resilient economy than initially expected at the beginning of the pandemic. However, the fallout from COVID-19 is far from over and we have no doubt that unforeseen effects from the coronavirus will ripple through the economy and equity markets for quarters to come. In the face of this ever-changing backdrop, we believe “less bad” news will no longer drive positive performance. Instead, companies will need to show bottom-line growth to differentiate themselves.
 
Balance sheet strength and catalysts that can result in a change in perception by investors remain a priority. We also believe businesses with pricing power will have an advantage in an economy that is likely to see excess supply and weakened consumer demand in the near-term. 

Against this backdrop, the team continues to focus on valuations, balance sheet strength, and catalysts that can result in a change in perception by investors. We believe this disciplined application of our process will be key to navigating the quarters ahead and positions the portfolio to succeed against a number of economic scenarios. 

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Portfolio Management Team

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 18 years of industry experience, 11 at Heartland.

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 President and Director of Heartland Funds. He has 20 years of industry experience, 16 at Heartland.

Fund Returns

6/30/2020

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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
3.93---4.190.15-11.16-17.3220.91
Mid Cap Value
Institutional Class
4.19---4.440.37-10.98-17.2820.98
Russell Midcap® Value3.46---3.32-0.54-11.81-18.0919.95
*Not annualized

Source: FactSet Research Systems Inc., Russell®, and Heartland Advisors, Inc.

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

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©2020 Heartland Advisors | 790 N. Water Street, Suite 1200, Milwaukee, WI 53202 | Business Office: 414-347-7777 | Financial Professionals: 888-505-5180 | Individual Investors: 800-432-7856

In the prospectus (pdf) dated 5/1/2020, the Net Fund Operating Expenses for the investor and institutional classes of the Mid Cap Value Fund are 1.10% and 0.85%, 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 1.10% of the Fund’s average net assets for the investor class shares and 0.85% for the institutional class shares, through at least 5/1/2022, 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 1.36% for the investor class shares and 1.07% 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 6/30/2020, Advanced Auto Parts, Inc., PS Business Parks, Inc., and Raymond James Financial Inc. represented 3.08%, 2.00%, and 2.99% of the Mid Cap Value Fund’s net assets, respectively.

Statements regarding securities are not recommendations to buy or sell.

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

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.

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

The Mid Cap Value Fund seeks long–term capital appreciation and modest current income.

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

The Heartland Funds are distributed by ALPS Distributors, Inc.

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.

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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.

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Data sourced from FactSet: Copyright 2020 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

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