Heartland Mid Cap Value Strategy 3Q20 Portfolio Manager Commentary

Executive Summary

Stock selection was positive on an absolute basis with Materials and Consumer Staples leading on the upside.
The gap between top and bottom performers reached levels not seen since the “Dotcom” era.
Buying activity highlighted differing views on timing of the recovery among sectors and industries.

Third Quarter Market Discussion

Equities spent much of the period building on strength that began in late Spring as investors seemed to conclude the worst of the COVID-19 recession was over. The optimism reflected the view that a combination of an accommodating Federal Reserve and government stimulus would propel earnings to pre-pandemic levels.

While the tone was generally upbeat, buying activity highlighted differing views on timing of the recovery among sectors and industries.

Large growth companies were among the top beneficiaries, as investors seemed to continue to chase yesterday’s winners. While performance among Financials and Real Estate was more subdued, the dynamic led to the gap between top and bottom performers reaching levels not seen since the “Dotcom” era, as shown below.

The Haves and The Have Nots

Source: Furey Research Partners, FactSet and Standard & Poor’s. 1/1/1990 to 9/30/2020. This chart shows the difference in returns, as a percentage, for the best and worst performing sectors in the S&P 500.
Past performance does not guarantee future results.

Attribution Analysis

The portfolio’s holdings in Materials and Consumer Staples outperformed on a relative basis but could not overcome weakness in Consumer Discretionary and Utilities and the strategy lagged its Russell Midcap® Value benchmark for the quarter.

A room with a view. As stocks sold off earlier this year in response to the global pandemic, the Team acted opportunistically by adding industry-leading businesses that were trading at significant discounts relative to their intrinsic value. Hilton Worldwide Holdings Inc. (HLT) is an example of this approach.

Hilton, a global hospitality franchise and property manager with roughly one million hotel rooms under the company’s operational umbrella, owns popular hotel brands including the namesake Hilton franchise, DoubleTree, Hampton Inn, and Embassy Suites. Hotel owners enter into multi-year franchise agreements with Hilton in return for access to Hilton’s property management expertise, booking software, and Hilton Honors loyalty members.

Shares of the company sold off earlier this year as travel restrictions in response to COVID-19 led to a dramatic downturn in room bookings. Hilton was particularly impacted because of the company’s focus on the mid and upper- price point and business travel customers. We viewed the slump in share price as an overreaction to a temporary setback for demand and initiated a position in early summer. Since then, revenue per available room night, an industry metric that measures room rate and occupancy, has improved meaningfully and shares rose double-digits for the period.

We believe Hilton should be a direct beneficiary of rising travel demand going forward, and that the company is in the early innings of a global expansion that could serve as a catalyst for growth in the coming years.

Narrowing the spectrum. While investors spent much of the period bidding up businesses based on sales growth expectations, the portfolio reaped the benefits of some holdings that were driving an improved outlook through self-help measures. Spectrum Brands Holdings (SPB), a household products company, is one such example.

Spectrum sells a variety of home goods through its market-leading brands including Kwikset, Black and Decker, Pfister and Remington. Of the company’s $3.8 billion in annual sales, roughly 80% are driven by its top 15 brands. During the past 18 months, management has undertaken an initiative to exit non-core business lines such as auto care and batteries, reduce debt and improve efficiency. These efforts have begun to produce results and sales figures have exceeded expectations during the COVID downturn.

We believe Spectrum is in the early innings of its transformation and should also see continued organic sales growth as it invests proceeds form divestitures into its business. Despite recent improvements in its share price, the company still trades at meaningful discount to its peers on an enterprise value/earnings before interest, taxes, depreciation and amortization basis.

Returning to power? The portfolio’s Utility names lagged on a relative basis with the shortfall stemming from a stock-specific issue in the group. FirstEnergy (FE) is a business we’ve owned in the past and sold out of after shares had appreciated following its successful transition to a pure regulated utility through the divestiture of its merchant power unit.

We initiated a new stake in FirstEnergy in March after shares sold off due to concerns that the recession would have an outsized impact on the company’s industrial-oriented client base. Similar to our successful experience in the past, we felt that the company was attractive given its meaningful discount to its peers.

Subsequent to our investment, FirstEnergy was named in an investigation related to $60 million of payments made by the merchant power entity to Ohio politicians. Our initial reaction when news broke was to reduce our exposure to the company, however, we continued our due diligence on the matter and believe that market reaction overestimated the likely fallout from the investigation.

As shares fell in price, we added to our position in the belief that as the matter proceeds, some of the clouds casting a shadow on the business will subside.

A bad haircut. The portfolio’s holding in Consumer Discretionary were up modestly on an absolute basis but lagged the sector average for the benchmark. Most of the weakness came from a single name, Mohawk Industries, Inc. (MHK), a building products company and the dominant U.S. player in flooring. Shares sold off after details from a class action lawsuit filed against the company were disclosed. The lawsuit alleges that management manipulated sales figures for one of its products through questionable accounting practices.

After digging deeper into the allegations, we chose to significantly reduce our exposure to the name and continue to monitor the situation.

Portfolio Activity

While we continue to monitor macro events that will impact the global economy, our focus remains on finding businesses where we believe valuations reflect a misunderstanding of risk and those businesses that are poised to succeed against a variety of backdrops. Rich valuations across broad swaths of the equities market has left little room for error for businesses striving to meet what we view as overly optimistic earnings estimates. As a result, we have sought to own overlooked businesses where even incremental improvement should result in meaningful upside in share price. 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.

Outlook and Positioning

With the expectation that rates will remain near historically low levels for the foreseeable future, many investors have embraced businesses based on rosy forecasts for earnings expansion despite elevated valuations. The dynamic has been a headwind for Value investors like ourselves.

The current challenging environment, should, in our view, give way to a market where businesses fail or succeed based on idiosyncratic factors and where fundamental analysis shines.

As we sort through the companies that hit our radar, we will not change our philosophy or process. The team continues to focus on 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 the opportunity to manage your capital.

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Portfolio Management Team

Colin McWey

McWey, CFA, is Vice President and Portfolio Manager for the Opportunistic Value Equity Strategy, as well as the Mid Cap Value Fund and it’s corresponding Mid Cap Value Strategy. He has 18 years of industry experience, 11 at Heartland.

Will Nasgovitz

Nasgovitz is CEO and Portfolio Manager of the Opportunistic Value Equity Strategy, as well as the Mid Cap Value Fund, the Value Fund, and their corresponding Mid Cap Value and Small Cap Value Strategies. He also is President and Director of Heartland Funds. He has 20 years of industry experience, 17 at Heartland.

Troy McGlone

McGlone, CFA, is Vice President and Portfolio Manager for the Opportunistic Value Equity Strategy, as well as the Mid Cap Value Fund and it’s corresponding Mid Cap Value Strategy. He has 12 years of industry experience, 6 at Heartland.

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Composite Returns*

9/30/2020

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	Since Inception (%)	10-Year (%)	5-Year (%)	3-Year (%)	1-Year (%)	YTD (%)	QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)	10.40	8.72	7.64	2.05	-6.68	-13.56	3.16
Russell Midcap® Value	9.55	9.71	6.38	0.82	-7.30	-12.84	6.40

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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†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.

As of 9/30/2020, FirstEnergy Corp., Hilton Worldwide Holdings, Inc., Mohawk Industries, Inc., and Spectrum Brands Holdings, Inc. represented 3.13%, 2.25%, 0.69%, and 3.77% 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.

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.

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.

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.

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

Bear Market occurs when the price of a group of securities is falling or is expected to fall. Cyclical Stocks cover Basic Materials, Capital Goods, Communications, Consumer Cyclical, Energy, Financial, Technology, and Transportation which tend to react to a variety of market conditions that can send them up or down and often relate to business cycles. Free Cash Flow is the amount of cash a company has after expenses, debt service, capital expenditures, and dividends. The higher the free cash flow, the stronger the company’s balance sheet. Real Estate Investment Trust (REIT) is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. Return on Equity is a measure of the net income after taxes that a firm is able to earn as a percent of stockholders equity. 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. Yield is the income return on an investment.