Heartland Mid Cap Value Strategy 1Q19 Portfolio Manager Commentary

Executive Summary

  • Stock selection was strong in a number of areas but the portfolio lagged its Russell Midcap® Value benchmark returning 13.28%* versus 14.37%.
  • Oversold conditions at the end of 2018 led to a burst of buying activity to start the year.
  • Market gyrations over the past six months have created opportunities for patient investors.
  • In response to rampant corporate debt, we remain keenly focused on balance sheet strength.

First Quarter Market Discussion

Oversold conditions at the end of 2018 led to a burst of buying activity to start the year, and the equity markets rebounded sharply.
 
Many of the areas that were hardest hit during the previous period—cyclicals, growth stocks and inflation-sensitive names—led on the upside. 
 
The snap back reflected a stark change in mood from the pessimism that closed out 2018, yet the fundamental narrative for companies was largely unchanged. Earnings growth projections remained muted, and global trade tensions persisted. Data began to confirm earlier forecasts of a slowing economy, as shown in the Citi Economic Surprise Index. Even the Federal Reserve’s decision during the period to suspend its program of raising rates, which was cheered by investors, had been widely anticipated for months.
 
Decelerating Data
Heartland Advisors Value Investing Index Value Chart
Source: Bloomberg L.P., 3/29/2018 to 3/29/2019
The Citigroup Economic Surprise Indices measure data surprises relative to market expectations.  A positive reading means that data releases have been stronger than expected; a negative reading means data releases have been worse than expected.
 
While investors pivoted to an optimistic stance, they showed signs of caution for some highly levered industries. The skepticism played out in Consumer Staples, where shares of companies with significant debt and undifferentiated products lagged the broader market.
 
Attribution Analysis
Stock selection was strong in a number of areas but the portfolio lagged its Russell Midcap® Value benchmark for the quarter. Consumer Staples stood out on a relative basis, along with the strategy’s Materials holdings. The portfolio’s Financial names lagged. 
 
Heartland Advisors Consumer Staples Sector IconSomething to cluck about. The recent tone for Consumer Staples has been weak. However, we have found opportunities in companies with strong balance sheets and those that have already weathered a downturn. Sanderson Farms, Inc. (SAFM), the third largest producer of fresh chicken in the U.S., is a prime example of this approach. 
 
A few years ago, Sanderson was riding high as chicken prices in mid-2017 were nearly double the five-year average. As profits gapped higher, many producers added capacity to keep up with demand. However, the resulting surge in supply put pressure on pricing, and shares of Sanderson and its peers weakened.
 
In response to soft pricing, Sanderson has focused on growing its business as a producer and wholesaler and improving its already impressive efficiency level. The company’s rock-solid balance sheet and expertise as a low-cost producer gives it a competitive advantage, in our view. As chicken prices rebound, we believe investors will take note of the company’s attractive return on equity profile and shares should rise.  
 
Heartland Advisors Value Investing Industrials Sector IconHard at work. Economically sensitive areas such as Industrials had a strong showing during the period, and the portfolio’s holdings in the space contained a top contributor, ManpowerGroup Inc. (MAN). 
 
The global staffing firm features a mix of industrial and IT staffing services and is the third-largest agency of its type in the world. Shares were under pressure in late 2018 due to a slowing European economy, where the company generates two-thirds of its revenue. As economic sentiment improved to start the year, shares retraced losses from the previous quarter and were up double-digits for the period.
 
While we anticipate revenue to decline in the short term, we see the shares as offering an attractive risk/reward profile, particularly relative to industrial stocks with a greater mix of domestic exposure. 
 
Longer term, we expect margins to expand as a result of management’s strategy of reducing costs and leveraging its scale to gain share in the high-margin recruitment outsourcing industry. Manpower’s balance sheet is strong, and the board has approved opportunistic share repurchases in the past; these have resulted in 4% fewer shares outstanding in 2018 relative to 2017. Higher margins with a lower share count should drive greater cycle-to-cycle earnings power. 
 
With Manpower trading at less than 6.5x 2019 earnings before interest, taxes, depreciation, and amortization, versus a peer group average of over 8x, we believe valuations are overstating the bear case for the stock. Additionally, relative to U.S. industrials, Manpower’s stock is trading at the low end of its 20-year historical average across several valuation metrics.
 
Heartland Advisors Value Investing Health Care IconA healthy opportunity? The portfolio’s Health Care names were up on an absolute basis but lagged those in its benchmark. AmerisourceBergen Corporation (ABC), a pharmaceutical distributor, performed inline with its peers despite reporting better-than-expected earnings and sales in its most recent quarter. Investors have grown cautious toward the industry as politicians have ratcheted up scrutiny of drug prices, creating uncertainty about profit margins in the future. 
 
We trimmed our exposure to the AmerisourceBergen in late fall of 2018 as part of an effort to mitigate some risk the company could face related to the political backdrop. However, we continue to believe shares are attractive. 
 
While we remain mindful of legislative headwinds related to drug prices, we believe ABC operates with a unique competitive advantage. The Pennsylvania-based business, along with two competitors, controls 90% of the drug distribution market. Its partnership with Walgreens has helped the company gain economies of scale, which has allowed it to be more aggressive in pursuing additional clients. Despite its attractive balance sheet, shares trade at approximately 11.5x earnings per share and offer an 8% yield of free cash flow/enterprise value.
 

Portfolio Activity

Market gyrations over the past six months have created opportunities for patient investors. During this period, we’ve trimmed winners when valuations have become stretched and redeployed assets into current holdings or new opportunities where prices, in our view, don’t accurately reflect the risk/reward profile of the business. The lack of consensus on how long the business cycle will continue its robust growth has led to attractive valuations in both economically sensitive and defensive areas. 
 
We continue to scour both economically sensitive and defensive areas for opportunities but are following our fundamental analysis to where it leads. We recently added First Horizon National Corporation (FHN), a Tennessee-based bank that ranks among the top-50 in the country based on assets. The company has significant market share in its home state and a solid foothold in fast-growing North Carolina, South Carolina, and Florida. 
 
Shares have been under pressure recently as First Horizon continues to make progress toward integrating its 2017 acquisition of Capital Bank Financial. As part of those efforts, First Horizon sold riskier loans from Capital Financial’s book of business. The sales had a negative impact on loan growth numbers and played into investors’ fears that lending was slowing industrywide. 
 
We believe investors are missing that First Horizon is a “self-help story” and well-positioned for the future. Cost cuts related to the Capital Financial merger should fall to the bottom line in 2019. Additionally, management has worked to neutralize the company’s exposure to interest rates and should be able to eliminate high-cost deposits it inherited through the acquisition, which could provide a tailwind to interest income. Lastly, recent bank mergers in its footprint should allow First Horizon to take market share from competitors. 
 
With the company trading 9.7x 2019 estimated earnings compared to a historical average of over 14X, we believe the current slump in share price offers a compelling opportunity to own a successful regional player with meaningful upside potential in the years ahead.
 

Outlook and Positioning

Heartland Advisors Value Investing Quote Image
While broad indices may continue their bumpy ride for the next several quarters, we believe eventually perceptions and fundamentals will converge. As such, we are avoiding making market calls and instead focusing on capitalizing on the opportunities presented. Given the significant runup in corporate debt over the past several years, we believe balance sheet strength should be a key differentiator that will separate successful investments from losing bets. 
 
As we examine the companies that hit our radar, we will continue to adhere to our philosophy and process. We believe this disciplined application of our process is key to sound investing. 
 
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, 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*

12/31/2018

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)10.8612.265.728.50-8.26-8.26-13.42
Russell Midcap® Value9.8413.035.446.06-12.29-12.29-14.95

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 3/31/2019, AmerisourceBergen Corporation, First Horizon National Corporation, ManpowerGroup Inc., and Sanderson Farms, Inc. represented 1.17%, 1.79%, 3.73%, and 2.33% of the Mid Cap Value Composite, 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 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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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.

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