Heartland Mid Cap Value Strategy 2Q18 Portfolio Manager Commentary

Executive Summary

  • Stock selection was strong and the Strategy beat its Russell Midcap® Value benchmark for the quarter returning 2.73%† versus 2.41%.
  • Higher interest rates, a stronger dollar, talk of trade injected uncertainty into an economy that otherwise showed signs of continued strength.
  • New economic uncertainties have led to broad-based selling in many sectors, creating attractive valuations for individual companies.
  • Our bottom-up analysis has led to a portfolio that is less economically sensitive than in the recent past. 

Second Quarter Market Discussion

Higher interest rates, a stronger dollar, rising inflation data and concerns about the impact of a global trade war injected uncertainty into an economy that otherwise showed signs of continued strength. The result was an uptick in volatility and swings in sector leadership as investors tried to anticipate which areas of the market are best suited to lead in a more challenged market environment.
Some of the early winners of the debate included cyclical areas and businesses poised to benefit from an uptick in inflation. Conversely, some slow-growth, high-yielding industries continued to face challenges as interest rates continued to climb.
Attribution Analysis
Stock selection was strong and the portfolio beat its Russell Midcap® Value benchmark for the quarter. Industrials stood out on a relative basis, along with the strategy’s Consumer Staples holdings. Our Energy names were up on an absolute basis but lagged those in the benchmark. 
Heartland Advisors Value Investing Industrials Sector IconCleared for takeoff. Higher input costs and the threat of new tariffs sapped Industrials in the broader index. The strategy’s holdings in the space fared better and the group contained a strong contributor. Textron Inc. (TXT), an industrial conglomerate with aerospace, defense and finance operations, was up after announcing its backlog for business jet orders was continuing to grow. 
The company’s private jet division is a high-margin line and management has been investing heavily in a new aircraft line. The new offering could help further strengthen orders and we believe the group could help drive profits levels into the low double digits. We also view Textron’s bid for a large military contract for one of its jets as having the potential to be transformative. 
Heartland Advisors Value Investing Energy Sector IconPumped up. The nearly year-long disconnect between higher oil prices and shares of Energy companies began to fade this quarter and the group was up double digits in the broader market. The Mid Cap portfolio’s names in the space also showed strength and were led by National Oilwell Varco, Inc. (NOV). Shares of the leading global oilfield services company were up as investors grew more confident that firmer energy prices would lead to greater free cash flow generation for the company. 
We view NOV as a best-in-class business trading near the trough of its business cycle. The company has a history of strengthening its business line during downturns and, in our opinion, has done so again. Shares are trading at just 1x book value—near all-time lows. The company has historically generated 15-30% return on invested capital over a full cycle, and should do so next time around at even lower levels of activity with its lower cost structure.  
As the Energy space domestically and abroad continues to mend, we believe NOV’s products will make it a significant beneficiary. 
Heartland Advisors Consumer Discretionary Sector IconLooking for a recovery in discovery. The portfolio’s Consumer Discretionary names were up modestly but the group contained a key detractor. Qurate Retail Inc. (QRTEA), was down due to margin pressures and challenges related to its 2017 purchase of the remaining shares of HSN.
The company, which operates QVC, HSN and Zulily among other brands, is the third largest ecommerce retailer behind only Amazon and Walmart. Qurate has a significant presence in so-called “discovery-based retail” that focuses on attracting online shoppers who may be researching products and items without an initial intent to purchase. These shoppers tend to be younger and more tech savvy than QVC and HSN has traditionally targeted. 
Management is trying to reconfigure HSN’s sales to be less reliant on high-margin, lower-volume electronics and instead focus on beauty and fashion products. While the company expects the shift will produce more consistent sales, the process is putting near-term pressure on margins.
We believe the recent margin softness is temporary and expect management to reap significant cost synergies related to the HSN integration. Additionally, unlike many mall-based retailers, we view the company’s strategy and experience as a benefit in the continual march towards digital retailing. With shares offering more than 12% market cap/free cash flow yield, we believe more patience is warranted for Qurate.

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 for individual companies.  
The result of the activity is a portfolio that is less economically sensitive than in the recent past. For example, our bottom-up analysis has led us to scale back some of the strategy’s bank holdings. 
During the past 18 months, banks have benefited from relatively low percentage of loans going bad as well as expectations that rising rates will improve net interest margins. The group began to rally sharply and valuations have moved higher as a result. 
Higher rates could benefit lenders; however, we believe that loan performance is unlikely to improve further and could deteriorate as interest costs for borrowers head higher. While sentiment remains bullish on the group domestically, as shown, investors have been more cautious when viewing European institutions. In the coming quarters, we would not be surprised to see some of that same caution spilling over to shares of U.S.-based banks.  
A Warning From Overseas?
Heartland Advisors Value Investing Banks Chart
Source: FactSet Research Systems Inc. and Standard & Poor’s, 6/28/2013 to 6/29/2018
Past performance does not guarantee future results.

Outlook and Positioning

Heartland Advisors Value Investing Quote Image
The economy remains robust but valuations and profit margins for many businesses are near peak levels. Inflation has begun to make a ripple for some companies, and as interest rates rise, debt servicing costs could become a challenge for leveraged companies. 
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. We believe this disciplined application of our process will be key to navigating the months ahead. 
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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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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)11.6610.2811.409.838.101.752.73
Russell Midcap® Value10.7310.0611.278.807.60-0.162.41

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 6/30/2018, Amazon.com, Inc., National Oilwell Varco, Inc., Qurate Retail Inc., Textron Inc., and Walmart Inc. represented 0.00%, 4.17%, 1.22%, 1.75%, and 0.00% 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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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.

Euro STOXX Banks (Price) Index is a capitalization-weighted index which includes countries that are participating in the European Economic and Monetary Union (EMU) that are involved in the banking sector. The parent index is SXXE. The index was developed with a base value of 100 as of 12/31/1991.

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