Heartland Mid Cap Value Strategy 2Q17 Portfolio Manager Commentary

Executive Summary

  • Security selection was mixed and weakness in IT, Industrials, and Utilities caused the Strategy to lag its benchmark, the Russell Midcap® Value Index, returning -0.33%† versus 1.37%.
  • Investors stayed with familiar themes, as momentum, growth, and perceived safe havens continued to lead the market higher.
  • Companies that have enjoyed strong runs over the past few months may face reduced upside as they struggle to meet heightened bottom-line expectations.

Second Quarter Market Discussion

Investors stayed with the familiar for much of the quarter as momentum, growth, and perceived safe havens continued to propel the major indices to new heights. We believe this market action reflects a balancing act between a murky economic outlook and political turmoil on one side and, on the other, fears of being left out of the ongoing equity market surge. 
Investors’ emphasis on top-line expansion and less cyclical areas has dominated market performance since January—and has been in play for much of the past few years. However, the weight of expectations could be becoming too much for some of the largest Information Technology (IT) companies such as Apple (APPL), Alphabet (GOOG), and Netflix (NFLX). Shares of these businesses began to sink early in June as doubts emerged that they could meet growth projections in the quarters ahead.
While it is too early to determine whether the sell-off for the tech giants is a sign that attractively valued companies will resume the position of leadership they held to close out 2016, we are encouraged by recent movements. As shown, history suggests that value cycles like the one that began to emerge late last year tend to endure for far longer than just a few months.
Setting Up for a Value Run?
Russell 3000® Value Index Less Russell 3000® Growth Index

Heartland Mid Cap Value Strategy Portfolio Manager Commentary Value Less Growth Chart

Source: Furey Research Partners and Russell®, 12/31/1978 to 6/30/2017, annualized return over rolling 10-year periods. Additional information for indexes shown at end of commentary. All indexes are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Attribution Analysis
Security selection was mixed, and weakness in our IT, Industrials, and Utilities names caused the Strategy to lag its benchmark, the Russell Midcap® Value Index. Allocation decisions contributed mildly to relative results. Real Estate holdings led on the upside. The price of oil slumped, and Energy was the worst performing group in the Index. The portfolio’s names in the sector were down but performed in line on a relative basis. 

Heartland Advisors portfolio manager commentary health care sector iconA healthy showing. An overweight to and stock selection in Health Care boosted performance and the group contained a top contributor. AmerisourceBergen Corporation (ABC), a pharmaceutical distributor, was up after posting results that beat consensus estimates. The report eased concerns about the company’s ability to withstand fallout from drug pricing pressures that have been a headwind for the industry.
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 8.5x enterprise value/earnings before interest, taxes, depreciation, and amortization.
Heartland Advisors portfolio manager commentary financials sector iconRising over the banks. The Strategy’s Financials names were up on an absolute basis and outperformed the broader benchmark. As valuations for banks began to escalate late last year, we sought more attractively priced opportunities in the sector that were less influenced by interest rate movements. For example, we added CNA Financial Corporation (CNA) in the third quarter of 2016.
This diversified insurance provider was a top contributor after reporting better than expected earnings. Investors anticipate continued earnings growth and have bid up shares of the company. 
We remain constructive on CNA’s leadership and ongoing cost-cutting opportunities. However, valuations have risen and we are monitoring ongoing progress of efforts to boost margins. 
Heartland Advisors value investing portfolio manager commentary information technology sector iconA tech letdown. IT was a point of weakness for the portfolio, with a single name accounting for the majority of the underperformance. Avnet, Inc. (AVT), a leading electronics distributor, was down after announcing that 2018 results are likely to come in well below expectations. The anticipated shortfall reflects greater than expected pressure on contract pricing and more aggressive loss of customers due to merger activity in the semiconductor industry.
The announcement was disappointing, but we believe the expected shortfall is a temporary setback as opposed to a permanent impairment of the company’s operations. Avnet has made significant strides through the divestiture of its weak performing tech solutions business and has ample opportunity to continue to evolve its business to focus on more profitable client groups such as smaller semiconductor manufacturers.

Portfolio Activity

After the strong run for cyclical and attractively valued companies at the close of 2016, we began to harvest winners as multiples expanded and we believed some of the names no longer offered adequate upside potential to compensate for downside risk. This process led to a reduction in some of the portfolio’s larger sector-level overweights and resulted in changes to industry-level exposures. 
For example, we reduced our overweight in Energy in recent quarters and have pivoted away from domestic onshore drillers to global players that have exposure to off-shore oil deposits that have traditionally enjoyed higher margins than onshore producers during a full energy cycle. Current depressed valuations have allowed us to take positions in technologically advanced businesses that we believe are well run and more differentiated than land-focused producers.
While overweights have been reduced during the past six months, we remain committed to our fundamental process and have refused to pay up for lower volatility or perceived safety. In areas such as Real Estate and Utilities, we remain underweight but continue to scour the sectors for attractive opportunities in current market conditions. 
One example is Consumer Discretionary holding Brunswick Corporation (BC), a leading manufacturer of marine engines under the Mercury Marine name, and boats under the Sea Ray, Bayliner, and Boston Whaler brands. Additionally, it markets fitness equipment through its Life Fitness brand.
Current management has reshaped Brunswick’s portfolio, improved operations, and repaid debt since the financial crisis. With an underleveraged balance sheet, leadership has accelerated product investments and executed bolt-on acquisitions with the goal of bolstering the company’s leading market share in the marine engine and fitness segments. These businesses have leading market share, generate above average margins due to higher competitive barriers, and are less cyclical than the legacy boat business. Subscale boat brands have been sold and manufacturing plants have been consolidated into flexible facilities. This restructuring should allow the company to achieve profitability on lower sales volume than in prior cycles.
Shares trade at 14.7x estimated 2017 earnings compared to 16x for peers, yet Brunswick enjoys higher profit margins and has a stronger balance sheet than its competitors.

Outlook and Positioning

The economic outlook is clouded, but expansion could endure for several quarters to come. Stock performance during the past six months has made valuations of defensive and growth areas less compelling. Companies that have enjoyed strong runs over the past few months may face reduced upside as they struggle to meet heightened bottom-line expectations. 
In response, we continue to comb through all sectors and industries looking for opportunities where we believe risk is mispriced. As always, balance sheets are a key focus in our analysis. Companies with favorable liquidity and strong, consistent free cash flow should be in a healthy position to succeed. Additionally, companies that can drive earnings growth—whether through cost savings or increased sales—should be well positioned to keep pace with heightened investor expectations. 
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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 15 years of industry experience, 8 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 17 years of industry experience, 14 at Heartland.

Composite Returns*

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

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©2018 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.

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 6/30/2017, Apple Inc., Alphabet Inc., Netflix, Inc., AmerisourceBergen Corporation, CNA Financial Corporation, Avnet, Inc., and Brunswick Corporation represented 0.0%, 0.0%, 0.0%, 3.9%, 3.7%, 2,5%, and 2.2% of the Mid Cap Value Composite, respectively.

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

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.

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®.

Growth and value investing each have unique risks and potential for rewards and may not be suitable for all investors. A growth investing strategy emphasizes capital appreciation and typically carries a higher risk of loss and potential reward than a value investing strategy; a value investing strategy emphasizes investments in companies believed to be undervalued.

Because of ongoing market volatility, performance may be subject to substantial short-term changes.

Additional Information for Indexes in Chart (calendar year returns %):

19881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013201420152016YTD 2017*
Russell 3000® Growth Index
Russell 3000® Value Index

*Not annualized as of 6/30/2017
Source: FactSet Research Systems Inc. and Russell®

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

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

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.