Heartland Mid Cap Value Fund 3Q17 Portfolio Manager Commentary

Executive Summary

  • Allocation decisions boosted results, but weakness in our Consumer Discretionary and Information Technology names caused the Fund to lag its benchmark, the Russell Midcap® Value Index returning -0.66% versus 2.14%.
  • On several metrics, the portfolio is trading at a material discount to its benchmark.
  • Uncertainty was the driving story for much of the quarter, until a late quarter surge in economic optimism.
  • We believe as data confirms the economy is self-sustaining, investors will rediscover the importance of valuations.

Third Quarter Market Discussion

A sober outlook reigned for most of the quarter as markets dealt with uncertainty on several fronts. Prospects for pro-growth legislation out of Washington appear to be on hold and tax reform remains a question mark. Adding to the mix were heightened tensions with North Korea and yet-to-be-determined effects from several major hurricanes.  
As investors grappled with each new piece of news, they stuck with the familiar—momentum, growth, and perceived safe havens. The lukewarm optimism, also affected the bond market, as shown, where yields on the 10-year treasury fell as investors poured money into fixed income. A resurgence of optimism in September reversed the flow of assets and yields moved higher.
Fading Optimism?
10-Year Treasury Yield
Heartland Mid Cap Value Fund Portfolio Manager Commentary 10-Year Treasury Chart
Source: Bloomberg L.P., 9/30/2016 to 9/29/2017 
Past performance does not guarantee future results.
While uncertainty was the driving story for much of the quarter, there were signs during the last few weeks that some of the macro concerns may be overdone and that synchronization of the world’s leading economies could lead to a broadening of growth across industries. We view the development as constructive and believe if it continues it will significantly benefit shares of attractively valued businesses.

Attribution Analysis

Allocation decisions boosted results, but weakness in our Consumer Discretionary and Information Technology names caused the Strategy to lag its benchmark, the Russell Midcap® Value Index. Industrials holdings led on the upside. The portfolio’s Financials were down modestly.

Heartland Advisors portfolio manager commentary materials sector icon

Package for pickup. Materials names contributed on an absolute basis. We believe holdings in the sector continue to offer upside potential. For example, Bemis Company, Inc. (BMS), the largest manufacturer of food packaging in North America, has multiple catalysts to propel shares higher.

Company revenue was soft this spring due to a changing sales environment among food distributors with smaller players gaining market share. Bemis had traditionally focused on large customers and so the shift was a blow to its top and bottom line. In our view, the weakness presented an opportunity to add to our position in an industry leader that has significant opportunity to increase margins and bolster earnings. The company is focused on increasing sales to fast-growing, smaller industry players. The new structure could lead to an expansion of its regional customer base, which currently represents about 30% of sales.

Heartland Advisors portfolio manager commentary energy sector icon

Positive energy. The portfolio’s Energy holdings had a strong showing and contained a significant contributor. Cabot Oil & Gas Corporation (COG) was up after reporting strong earnings and solid production from its low-cost assets in the Marcellus basin. Additionally, a pipeline project that will provide Cabot with additional delivery capacity received necessary approval to proceed.

The news was a welcome development, and we expect more projects will follow. The additional delivery capacity provided will allow Cabot to increase its output and should result in better pricing power as the pipelines provide access to other geographic regions. The company’s ability to generate free cash flow while also increasing production is rare in the Energy sector and should result in its revenue growing more quickly than its peers.

Heartland Advisors value investing portfolio manager commentary consumer discretionary sector icon

Clipped wings. The portfolio’s Consumer Discretionary names lagged, with more than half of the shortfall coming from a single holding. Spirit Airlines, Inc. (SAVE) reported earnings that beat consensus estimates, but guidance for the remainder of the year was weaker than expected. Management noted that recent price cuts by United Airlines (UAL), a key competitor, are expected to take a toll on sales and could slow Spirit’s expansion into larger markets. While painful, we view the reduced fares as a short-term brush back from the competitor. As the lower fares start to take a toll on competitors’ margins, we expect pricing to creep back up. Additionally, airlines have begun to pare back capacity projections for the second half of the year, which should result in firm pricing for the group.

Longer-term, Spirit’s cost advantage and industry trends should help the airline thrive. The company’s costs per mile flown are 30% to 50% lower than those of its competitors.

With shares trading at just 8x estimated 2018 earnings, we believe the market is fixating on the effects of what should be a temporary pricing setback and overlooking Spirit’s unique cost advantage.

Portfolio Activity

As macro events continue to drive investor behavior, the gap has widened between fundamentally attractive businesses and those with momentum, growth, or safe-haven status working in their favor. The reemergence of that disparity is reflected in valuation metrics for the strategy, with the portfolio trading at a material discount to its benchmark on a price/earnings, price/sales and enterprise value/earnings before interest, taxes, depreciation, and amortization basis.  
While the continuation of a run up for momentum and growth has been frustrating for value investors over the past several months, these market dynamics have also provided the team an opportunity to initiate positions in excellent franchises trading at compelling prices.
One example is AMERCO (UHAL), a leading provider of moving equipment and storage facilities under the U-Haul brand. Through decades of expansion and focus, AMERCO has built a dominant distribution network that is more than three times the size of its two largest competitors combined. 
The company has been focused on adding to its strength by expanding its truck fleet and storage facility footprint. The investment required for these efforts has put pressure on earnings and share prices have suffered. 
Based on management’s history of being fiscally conservative, we view the upfront costs as a prudent use of revenue that will result in earnings acceleration. Additionally, we’ve been impressed with new initiatives including U-Haul 24-7 which should lead to higher utilization rates of its trucks, and expect storage occupancy in new units will reach levels in-line with AMERCO’s established locations.

Outlook and Positioning

Heartland Mid Cap Value Fund Portfolio Manager Commentary QuoteWhile no one can predict when the current pattern of a macro-driven market will end, we do have some thoughts on what may lead to a change. If data confirms the economy is self-sustaining, or valuations for momentum, growth, and defensive stocks become too bloated to ignore, we believe investors will rediscover the importance of valuations.
Given the near decade-long length of the growth-over-value cycle, we would expect when the tide turns the change will be quick and strong. Investors may have gotten a glimpse of the power of a focus on fundamentals during the last few months of 2016 when economic confidence surged and attractively valued stocks followed.
As value investors, Heartland will welcome the change and believe we are well positioned for it.
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 16 years of industry experience, 9 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 18 years of industry experience, 14 at Heartland.

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In the prospectus (pdf) dated 5/1/2018, 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 2.50% for the investor class shares and 2.45% 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 9/30/2017, AMERCO, Bemis Company, Inc., Cabot Oil & Gas Corporation, Spirit Airlines, Inc., and United Airlines represented 1.28%, 1.68%, 2.36%, 1.80% and 0.00% 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.

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

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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.

Separately managed accounts and related investment advisory services are provided by Heartland Advisors, Inc., a federally registered investment advisor. ALPS Distributors, Inc., is not affiliated with Heartland Advisors, Inc.

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

The Heartland Funds are distributed by ALPS Distributors, Inc.