Heartland Mid Cap Value Strategy 3Q18 Portfolio Manager Commentary

Executive Summary

  • On a year-to-date basis, the Strategy is outperforming its passive benchmark, the Russell Midcap® Value Index, returning 5.96%† versus 3.13%.
  • Stock selection was strong in a number of areas during the quarter as the Strategy beat its benchmark, returning 4.13%† versus 3.30%.
  • Strong employment figures and bullish consumer sentiment reignited a fear of missing out. 
  • The impact of recently enacted trade tariffs and budding inflation have yet to be fully felt.
  • The lack of consensus on how long robust growth will continue has created attractive valuations.

Third Quarter Market Discussion

Strong employment figures, robust manufacturing readings and bullish consumer sentiment reignited a fear of missing out on the part of investors. Yet while the economy remains hot by most measures, the long-term picture is less clear. 
 
The impact of recently enacted trade tariffs and budding inflation have yet to be fully felt. The lack of clarity translated into an absence of long-term conviction, leading investors to favor defensive pockets in the market and areas that have produced consistent growth in the recent past. 
 
Winners from this approach included some cyclical areas like the Industrials sector as well as less economically sensitive groups such as Health Care. 
 
Attribution Analysis
Stock selection was strong in a number of areas as the portfolio beat its passive Russell Midcap® Value benchmark. Materials stood out on a relative basis, along with the strategy’s Industrials and Financials holdings. The portfolio’s Consumer Staples names lagged, driven primarily by a single holding in the food products industry. 
 
Heartland Advisors Value Investing Materials Sector IconA Packaged Deal. The Materials sector was down in the broader index, but the portfolio’s names were up double digits and the group contained a top contributor. Bemis Company, Inc. (BMS), the largest manufacturer of food packaging in North America, was up sharply after it agreed to be acquired by one of its global competitors. 
 
Bemis is a long-time holding in the strategy, and last fall we increased our position meaningfully after shares weakened due to margin pressures and slowing sales as smaller players in the food packaging industry gained market share. In the most recent reporting period, the company made progress on improving its efficiency and increasing sales to middle market customers. 
 
Shares reacted favorably to the progress and jumped further when the acquisition was announced. We reduced our position on the news but continue to maintain a stake as we wait for the gap to close between the offering price and the current trading range.
 
Heartland Advisors Value Investing Industrials Sector IconBalancing Act. The strategy’s Industrials names enjoyed widespread strength. We remain overweight the group but have taken a balanced approach in the space by holding a mix of economically sensitive names as well as those with steady streams of recurring cash flow. 
 
Among the winners in the sector was Flowserve Corporation (FLS), a manufacturer and servicer of valves and pumps used in Energy production. The company is the only publically traded integrated business with the capability to manufacture seals. Because seals tend to fail at a relatively consistent pace, the capacity to make replacement parts provides Flowserve a competitive advantage among servicing peers and offers some consistency in cash flows.
 
Shares of the company were up after it reported results that significantly beat expectations for both top- and bottom-line growth. We were encouraged by the pace of organic growth of bookings including in its high-margin aftermarket business. Flowserve also showed progress operationally in its most challenged segment, the company’s Industrial Product Division, which manufactures standardized pumps.
 
We remain confident that management will be able to deliver on a plan to return margins to prior peak levels. Based on our expectations of improving sales and higher margins, we believe the company is trading at a significant discount to its Industrial peers.  
 
Trash to Treasure? Although the majority of the portfolio’s Industrials holdings were up for the period, the group did contain a key detractor, Stericycle, Inc. (SRCL). The company provides waste management services for medical refuse and offers secured destruction of confidential and personal information. Shares were down after management issued lower-than-expected guidance for the year due to weakness in its non-core businesses. 
 
We view the soft outlook as a temporary setback for a company that is trading at compelling valuations relative to long-term prospects. Stericycle faced a challenging pricing environment while renewing contracts in its medical waste business clients. Now that many of those contracts are in effect and are reflected in the bottom line, we expect to see sales once again grow on a period-over-period basis. Management also has ample opportunity to further improve efficiency and divest non-core units. These moves should increase margins in the quarters ahead.
 
Despite what we believe are achievable opportunities for improvement, Stericycle’s shares trade at just 13x earnings per share, well below the 20-40x its industrial waste peers.
 

Portfolio Activity

Market gyrations spurred by macro events continue to create opportunities for patient investors. 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. 
 
While the portfolio is less economically sensitive than in the recent past, we continue to follow our process where it leads us and have also added some high-quality cyclical names such as ManpowerGroup Inc. (MAN)
 
Manpower is a top-three global temporary staffing company with operations in 80 countries.  The company has outsized scale in industrial temp staffing under the Manpower brand and professional temp staffing—for information technology, engineering, and finance—under the Experis brand.  Manpower also has an outsized mix of revenue derived from Europe at 67% of total sales.
 
Manpower’s exposure to Europe, as shown below, has created an overhang for shares of the business as data has pointed to softening growth prospects in the region. Those concerns were amplified during the second quarter when the company reported slowing sales in Europe. 
 
Keeping a Good MAN Down?
Heartland Advisors Value Investing MAN vs. S&P 500 Chart
Source: Bloomberg L.P., Standard & Poor’s, and Heartland Advisors, Inc., 12/31/1998 to 6/29/2018, Quarterly
MAN Relative Performance vs. Equal Weight S&P 500 is represented by the ManpowerGroup Inc. stock price divided by the S&P 500 Equal Weight Index, both being set to a base value of 1 as of 12/31/1998 prior to the calculation (see last page for additional data). Eurozone Industrial Activity Ex Construction is represented by the Eurostat Industrial Production Eurozone Industry Excluding Construction (year-over-year, working day adjusted). All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future results.
 
Although it is possible Manpower could experience additional erosion in its growth rate, we see current valuations as offering an attractive risk/reward, particularly relative to industrial stocks with more direct domestic exposure.  
 
Longer term, we expect margins to expand as a result of management’s efforts to reduce costs through process automation and a heightened focus on exploiting cross-selling opportunities with existing customers, and we like management’s capital allocation strategy. Manpower’s balance sheet is strong, and the board has approved opportunistic share repurchases in the past. Higher margins with a lower share count should drive higher cycle-to-cycle earnings power. 
 
With shares trading at 6x 2019 earnings before interest, taxes, depreciation and amortization, Manpower is priced at a more than 40% discount to its domestic peers and a 25% discount to its historical median.
 

Outlook and Positioning

Heartland Advisors Value Investing Quote Image
The economy remains robust but is reaching levels that appear to leave little room for another leg up. 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. This conflicted backdrop, we believe, highlights the value of a bottom-up investment approach that focuses on the strengths and weaknesses of a company regardless of economic conditions.
 
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 quarters ahead. 
 
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 and Mid Cap Value Funds and their corresponding separately managed account strategies. He also is CEO of Heartland Funds. He has 18 years of industry experience, 14 at Heartland.

Composite Returns*

9/30/2018

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)11.7211.1511.0415.4713.205.964.13
Russell Midcap® Value10.7711.2910.7213.098.813.133.30

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.

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 9/30/2018, Bemis Company, Inc., Flowserve Corporation, ManpowerGroup Inc., and Stericycle, Inc., represented 1.90%, 2.95%, 1.96%, and 1.73% 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.

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.

Working Day Adjusted (WDA) data adjusted for nonseasonal effects related to the number of working or trading days in a given month or quarter (calendar variations). Since some months naturally have more working, or trading, days than others (due to the differing number of holidays or Sundays, Mondays, Tuesdays, etc.) this adjustment seeks to smooth out the working day differences between months. Working day adjustment is sometimes also referred to as trading day adjustment.

The Eurostat Industrial Production Eurozone Industry Ex Construction measures the output of industrial establishments in the following industries: mining and quarrying, manufacturing and public utilities (electricity, gas and water supply). Production is based on the volume of the output.

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

Supplemental information for chart:
Heartland Advisors Value Investing ManpowerGroup ChartHeartland Advisors Value Investing S&P 500 Chart
Source: Bloomberg L.P. and Standard & Poor’s, 12/31/1998 to 6/29/2018. All indices are unmanaged. It is not possible to invest directly in an index. 
Past performance does not guarantee future results.

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.

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