Heartland Mid Cap Value Strategy 1Q18 Portfolio Manager Commentary

Executive Summary

  • Stock selection was strong with holdings in Real Estate, Health Care, and Utilities helping the Strategy beat its benchmark, the Russell Midcap® Value Index, returning -0.96%† 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.

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.

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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, Mid Cap Value, and Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 18 years of industry experience, 15 at Heartland.

Composite Returns*

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

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©2019 Heartland Advisors | 789 N. Water Street, Suite 500, Milwaukee, WI 53202 | Business Office: 414-347-7777 | Financial Professionals: 888-505-5180 | Individual Investors: 800-432-7856

†Composite returns are net of advisory fees.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 9/30/1996.

The U.S. dollar is the currency used to express performance.

Past performance does not guarantee future results.

The Mid Cap Value Strategy invests in mid–sized companies on a value basis. Mid-sized securities generally are more volatile and less liquid than those of larger companies.

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

Heartland Advisors, Inc. (the "Firm") claims compliance with the Global Investment Performance Standards (GIPS®). The Firm is a wholly owned subsidiary of Heartland Holdings, Inc., and is registered with the Securities and Exchange Commission. For a complete list and description of Heartland Advisors composites and/or a presentation that adheres to the GIPS® standards, contact the Institutional Sales Team at Heartland Advisors.

As of 3/31/2018, Avnet, Inc., Bemis Company, Inc., Jones Lang LaSalle Incorporated, and Harley-Davidson, Inc. represented 3.08%, 2.14%, 2.03%, and 1.03% of the Mid Cap Value Composite, respectively.

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

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