Heartland Mid Cap Value Strategy 1Q22 Portfolio Manager Commentary

Executive Summary 

  • Security selection was strong on a relative basis and the portfolio outpaced its Russell Mid Cap® Value Index benchmark for the period.
  • Russia’s invasion of Ukraine could lead to a prolonged uptick in production costs for businesses.
  • Excessive pessimism has created opportunities to upgrade the quality of the portfolio’s holdings in hard hit industries.

First Quarter Market Discussion

Equities began the year on a sour note as budding economic concerns from late 2021 began to take root. While the somber tone was consistent throughout much of the period, the causes for the caution evolved as did relative winners and losers. 

Valuation-conscious investors could take comfort in the fact that the market showed a renewed focus on price paid for opportunities. Likewise, richly valued businesses that were previously riding high on the prospect of future growth lost much of the luster they’ve enjoyed for the past few quarters. 

Companies that were positioned to benefit from rising interest rates got off to a fast start in January as investors anticipated the Federal Reserve would be aggressive in raising borrowing costs to rein in inflationary pressure. The dynamic changed as the surge in COVID-19 cases tied to the Omicron variant subsided in late January, and geopolitical tensions ruptured into the headlines when Russia invaded Ukraine in late February. The move caused a spike in the price of commodities, most notably oil, and could lead to a prolonged uptick in production costs for businesses. 

The possibility that inflation could prove more stubborn than anticipated comes at a time when consumer savings rates, as shown below, point to the corrosive effects of rising costs on household finances. The challenges Main Street is facing in setting aside cash for a rainy day could be a harbinger of a slowing economy in the quarters ahead.

Deflated Cushion

Heartland Advisors Value Investing Personal Income vs. Retail Sales Chart
Source: U.S. Bureau of Economic Analysis and U.S. Census Bureau, retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/. The data in this chart displays personal saving as a percentage of disposable personal income (DPI), frequently referred to as "the personal saving rate," is calculated as the ratio of personal saving to DPI on a monthly basis from 1/1/2005 to 1/1/2022. Past performance does not guarantee future results.

Attribution Analysis

Security selection was strong on a relative basis with holdings in Communication Services and Health Care boosting returns and the portfolio outpaced its Russell Mid Cap® Value Index benchmark for the period. Names in Materials detracted on an absolute and relative basis.

Heartland Advisors Value Investing Materials Sector IconA television star. Holdings in Communication Services were up on an absolute basis and trounced the sector average for the benchmark. The group also contained a top performer, Nexstar Media Group, Inc. (NXST).

Nexstar is the largest local television broadcaster in the United States covering just under 70% of all TV households. The company was assembled through decades of careful mergers and acquisitions by its founder and CEO, Perry Sook. 

We took a stake in Nexstar in early autumn of 2020 after it had already come under pressure as part of the COVID-19 selloff that started the year. The company had closed on the acquisition of a competitor’s broadcasting and media assets shortly before the pandemic hit. The purchase was 100% financed with loans, and investors became wary of Nexstar’s debt load when the COVID recession hit. 

In addition to the above headwinds, broadcasting businesses have faced challenges in recent years as viewers transition away from cable subscriptions—a portion of revenue of broadcasters is derived from the number of consumers who buy cable. As consumers have shifted their TV consumption toward streaming, investors have assigned lower valuations to broadcasters over time despite the business remaining highly profitable for companies like Nexstar.

While we acknowledge recent challenges for the company, the team believes investors are undervaluing the durability of Nexstar’s significant profit stream from the existing cable subscription market as well the negotiating leverage the company enjoys from its large viewer base. Shares of Nexstar are currently trading at a roughly 25% discount relative to its peers based on enterprise value/earnings before interest, taxes, depreciation, and amortization.

Heartland Advisors Value Investing Financial Sector IconHealth check. Staffing and supply chain issues continued to hamper companies in the Health Care space during the period, and the sector was a laggard for the broad indices. The portfolio’s holdings in the sector were down but outperformed the benchmark average for the group and contained a top contributor, AmerisourceBergen Corp (ABC).

AmerisourceBergen Corp. (ABC) is a leading national pharmaceutical distributor with deep relationships with hospitals and retail pharmacies. The company has been quietly bolstering its business model during the past few years to include animal health products for the European market and an expanded line of higher-margin, value-added services that reach beyond drug distribution. During these efforts, valuations for the company were under pressure due to liability issues stemming from opioid litigation as well as concerns about increased scrutiny of drug prices by politicians. 

Our team has been following these developments and have been impressed by the strides management has made on the business side. The opioid litigation has largely been resolved, and the company continues to bolster its global reach and portfolio of services offered. While investors have begun to take notice of the strides AmerisourceBergen has made, shares remain attractive, in our view, trading at 13X estimated 2023 earnings per share. 

Heartland Advisors Value Investing Health Care Sector IconCollateral damage. Last period we wrote about the resiliency the Materials sector had shown in the face of rising inflation thanks to many in the industry being well positioned to pass cost increases on to customers. While the advantage continued for some businesses in the group, the hostilities in Ukraine created new challenges for others in the sector including portfolio holding PPG Industries Inc. (PPG).

PPG is the second-largest coatings supplier in the world and boasts the top market share in the industrial space, including auto refinishing and original equipment manufacturing (OEM), aerospace, and general industrial. The company is second only to Sherwin-Williams in the architectural coatings market. 

PPG was able to weather inflation pressures late last year by aggressively raising per-unit pricing including a 6% price increase in the fourth quarter. Shares of the business responded favorably at the time as signs pointed to cost pressures peaking. That momentum was lost, however, as inflation has persisted due to a spike in commodity prices spurred by Russia’s invasion of Ukraine. The conflict in Europe has also exacerbated bottlenecks for auto component manufacturers, putting pressure on PPG’s near-term sales.

The challenges PPG is facing may persist in the near-term, however, we view shares as compelling given current valuation and management’s recent decision to buy back stock at what we believe is a discount to intrinsic value. In the long run, PPG should thrive as a provider of key components for its customers and benefit from its unique position to participate in the shift toward electric vehicles (EVs). 

Portfolio Activity  

The broad pullback in equities to start the year has created short-term pain for some investors but has helped rein in historically high valuations in some pockets and has created opportunities where pessimism may be overdone when viewed against historical normalized earnings. 

Economically sensitive areas of the market such as Industrials, Materials, and Consumer Discretionary are among the sectors where we have been finding attractive businesses at valuations that have caught our attention. BWX Technologies, Inc. (BWXT), is one such example.

The company is a manufacturer of nuclear power and fuel components for the Department of Defense and Department of Energy. BWXT also services existing nuclear power facilities in North America, and produces radioisotopes used in medical imaging and diagnostics. 

Shares of BWXT Technologies sold off in the second half of 2021 as growth in the company’s defense business showed signs of slowing. The softening of growth, in our view, is tied to customer ordering patterns that will likely impact growth over the next few years. Over the longer term, there are clear growth drivers that should benefit BWXT’s defense end markets. The company’s margins are also facing pressure as it has ramped up investments in the development of a key component used in radioisotope production. Currently, there is no domestic supply of the component, and the global supply is limited. 

Earlier this year when shares were trading at just 14X earnings projections for the next 12 months, we took a stake in the business. The team believes revenue growth from BWXT’s defense business will return to high single digits in the next few years. Additionally, we anticipate the company will gain clarity into the success of its investments in its medical business line that will result in either a boost in high-margin sales or a winding down of associated spending. 

Following our initial purchase, the stock moved higher in late February as money poured into defense stocks on optimism that military spending would grow after Russia invaded Ukraine. While the team does not view the conflict as boosting near-term results for BWXT, we believe the war could support growth in defense budgets in coming years after recently plateauing. 

Outlook and Positioning

The hostilities taking place in Ukraine add to the string of unpredictable developments that have buffeted the economy and markets over the past two-plus years and serve as a reminder that sound investing, in our view, requires the discipline to maintain a long-term focus and a disciplined approach to evaluating opportunities. Our work against this backdrop has led us to opportunities to upgrade the quality of the portfolio’s holdings in industries where we believe investors have become too pessimistic. 

Recent elevated volatility is likely to persist during the coming months, in our view, and the team believes the best path forward starts with our commitment to finding business with attractive valuations, balance sheet strength, and catalysts that can result in a change in perception by investors. This approach should result in a favorable risk-reward profile in the quarters and years ahead. 

Thank you for your continued trust and confidence.

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Portfolio Management Team

Colin McWey

Vice President and Portfolio Manager

Will Nasgovitz

CEO and Portfolio Manager

Troy McGlone

Vice President and Portfolio Manager

Composite Returns*

3/31/2022

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)11.8812.5811.4316.0012.021.011.01
Russell Midcap® Value10.7612.019.9913.6711.45-1.82-1.82

Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.
*Performance data is preliminary. Yearly and quarterly returns are not annualized. The Strategy's inception date is 9/30/1996. 

The US Dollar is the currency used to express performance. Returns are presented net of advisory fees and net of bundled fees and include the reinvestment of all income. 

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©2022 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

†Composite returns are net of advisory fees.

Past performance does not guarantee future results.

The Mid Cap Value Strategy seeks long-term capital appreciation by investing in mid-size companies as defined by the market capitalization range of the Russell Midcap® Index. This focused portfolio seeks companies with strong underlying business franchises priced at a discount to their intrinsic worth that have temporarily fallen out of favor.

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, Inc. at the address listed below.

GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

As of 3/31/2022, AmerisourceBergen Corp (ABC), BWX Technologies, Inc. (BWXT), Nexstar Media Group, Inc. (NXST), PPG Industries Inc. (PPG), represented 2.34%, 1.67%, 1.85%, and 2.56% of the Mid Cap Value Composite’s net assets, respectively. Sherwin-Williams Co (SHW) was unowned.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.

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.

GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

The statements and opinions expressed in this article are those of the presenter(s). 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.

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. There is no assurance that dividend-paying stocks will mitigate volatility. 

CFA® is a registered trademark owned by the CFA Institute.

Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indices. Russell® is a trademark of the Frank Russell Investment Group.

Data sourced from FactSet: Copyright 2022 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

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

Absolute Value is a business valuation method that uses discounted cash flow analysis to determine a company's financial worth. Absolute value models try to determine a company's intrinsic worth based on its projected cash flows. Earnings Per Share is the portion of a company’s profit allocated to each outstanding share of common stock. Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA) Ratio is a financial indicator used to determine the value of a company and is calculated by dividing the entire economic value of the company (enterprise value) by its earnings before interest, taxes, depreciation, and amortization (EBITDA). Inflation Risk is the possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency. Intrinsic Value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.  Momentum investing is an investment strategy that aims to capitalize on the continuance of existing trends in the market. To participate in momentum investing, a trader takes a long position in an asset that has shown an upward trending price, or the trader short-sells a security that has been in a downtrend. The basic idea is that once a trend is established, it is more likely to continue in that direction than to move against the trend. Normalized Earnings are earnings adjusted for cyclical ups and downs in the economy.  Original Equipment Manufacturer (OEM) is a company whose goods are used as components in the products of another company, which then sells the finished item to users. Relative Value is a method of determining an asset's value that takes into account the value of similar assets. Calculations that are used to measure the relative value of stocks include the enterprise ratio and price-to-earnings ratio. Russell Midcap® Value Index measures the performance of those Russell Midcap® Index companies with lower price/book ratios and lower forecasted growth characteristics. All indices are unmanaged. It is not possible to invest directly in an index. Volatility is a statistical measure of the dispersion of returns for a given security or market index which can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.

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