Heartland Mid Cap Value Strategy 4Q16 Portfolio Manager Commentary

Executive Summary

  • Stock selection in Consumer Staples and Financials was noteworthy and helped the Strategy outperform its benchmark, the Russell Midcap® Value Index, returning 11.35%† versus 5.52%.
  • Strength for attractively valued companies continued its year-long trend.
  • We are focused on striking a balance between great companies at moderate discounts and average businesses at deep discounts.

Fourth Quarter Market Discussion

Investor confidence surged following the presidential election and drove the major indexes to new highs. Economic optimism pushed yields up as investors abandoned Treasuries in favor of equities. Meanwhile, U.S. and global credit spreads tightened, underscoring greater confidence and growing comfort toward risk.

An agreement among the Organization of the Petroleum Exporting Countries (OPEC) to cut production also contributed to strength. Investors viewed the supply constraints as a necessary element in a lasting recovery for the Energy sector.

The bullish tone benefited economically sensitive sectors such as Financials, Materials and Industrials the most while defensive areas and so-called bond proxies like Utilities lagged. Across sector lines, attractively valued companies demonstrated strength, as shown, continuing a trend in place for much of the year.

Value Continues to Shine
Russell 3000® Value Index Less Russell 3000® Growth Index

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

Source: Bloomberg L.P. and Russell®, 12/31/2015 to 12/30/2016
Additional information for indexes shown at end of commentary.
All indices are unmanaged. It is not possible to invest in an index.
Past performance does not guarantee future results.

Attribution Analysis

Security selection in the majority of sectors was positive, and the Strategy outperformed its Russell Midcap® Value benchmark.

Holdings in Consumer Staples and Financials were noteworthy on both an absolute and relative basis. Allocation decisions were mostly positive, with a significant underweight to Real Estate serving as a key contributor.

Heartland Mid Cap Value Strategy Portfolio Manager Commentary financials iconBeyond the banks. Our Financials holdings outpaced the benchmark and were driven by the Strategy’s Insurance names.

CNA Financial Corporation (CNA), a diversified insurance provider, was up after it reported better than expected earnings and continued progress toward winding down or exiting less profitable business lines.

The company brought in an industry executive who is well suited to lead its transformation, and we expect the business will improve its level of return on equity. New leadership is likely to bring experienced producers from a top competitor on board. We also believe leadership will cut expenses where appropriate.

Despite CNA’s improved underwriting and strong leadership, shares are trading at just 90% of book value. The company’s low dividend payout ratio provides room for dividend growth and/or a one-time special dividend in the future. We believe the multiple doesn’t accurately reflect significant upside potential.

Heartland Mid Cap Value Strategy Portfolio Manager Commentary materials iconGood chemistry. The Strategy’s Materials holdings outpaced the benchmark with Olin Corporation (OLN), the world’s largest chlor-alkali producer, driving the majority of outperformance in the space. The company announced solid earnings and progress on raising prices to consumers. Shares also benefited from expectations for increasing demand and decreasing capacity both domestically and in the European Union. Olin continues to make strides in optimizing its asset base and logistics footprint.

Heartland Mid Cap Value Strategy Portfolio Manager Commentary IT iconTechnology glitch. The portfolio’s Information Technology (IT) holdings were up, but the group contained a key detractor.

Top 10 holding CA, Inc. (CA) was down after reporting solid earnings but softer-than-expected new sales in its enterprise solutions business. Shares also faced pressure as investors turned away from slow-growth, cash-producing IT names in favor of economically sensitive areas.

Given CA’s free cash flow to enterprise value yield of almost 8% and a 3.3% dividend yield, we believe investors are overlooking the company’s growth in software as a service (SAAS) sales that are independent of mainframe renewals. The traction in the SAAS business should lead to top-line and earnings growth in the coming quarters.

Portfolio Activity

The Strategy continues to hold high-quality companies as measured by balance sheet strength, free cash flow generating capabilities and returns on capital. Given that much of the recent run up in stocks was driven by expanding valuation multiples, earnings growth going forward will be key to supporting current market prices. However, businesses that offer modest growth can still make for profitable investments if they are trading at a significant discount to their historic levels.

Heartland Mid Cap Value Strategy Portfolio Manager Commentary consumer discretionary iconDiamond in the rough. Recent addition Signet Jewelers Limited (SIG) should see strong bottom-line growth from a combination of increased revenue and greater efficiencies as it digests a recent acquisition.

The company operates under the Jared, Kay, and Zales brands. As the largest jeweler in the U.S., Signet controls approximately 15% of the market compared to 1% or less for peers. This advantage in scale has allowed the company to gain share from small mom-and-pop stores and provides opportunities to reduce costs and improve results. For example, management is focused on increasing sales at its Zales stores by focusing on higher-ticket bridal sets.

Signet is completing a review of its in-store financing business. The analysis could lead the company to divest the business or result in the loans being packaged and sold as securities. In either case, we view the potential move as a positive development.

Outlook and Positioning

Our outlook has tempered. The markets appear to have entered a transition phase. As economic sentiment has improved, cyclical areas have been rewarded and valuations have expanded. Some of the froth has been removed from more defensive areas, but multiples remain elevated in most cases.

Against this backdrop, we are focused on striking a balance between great companies at moderate discounts and average businesses at deep discounts. Our efforts have resulted in a portfolio with compelling upside that trades at a discount based on valuation multiples we track versus its benchmark, the Russell Midcap® Value Index.

We continue to seek idiosyncratic factors that provide our businesses with the greatest opportunity to succeed. 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. Performance represents past performance, and current returns may differ.

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.

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

As of 12/31/2016, CA, Inc., CNA Financial Corporation, Olin Corporation, and Signet Jewelers Limited represented 3.9%, 3.1%, 3.0%, and 1.1% 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 as determined by Heartland Advisors may reference data from sources such as FactSet Research Systems Inc. or the Global Industry Classification Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

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 typically carries a higher risk of loss and potential reward than a value investing strategy. A growth investing strategy emphasizes capital appreciation; a value investing strategy emphasizes investments in companies believed to be undervalued. 

Dividend paying stocks cannot eliminate the risk of investment losses. 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.

Additional Information for Indexes in Chart (monthly returns %):

  12/15 1/16 2/16 3/16 4/16 5/16 6/16 7/16 8/16 9/16 10/16 11/16 12/16
Russell 3000® Growth Index -1.72 -5.97 -0.09 6.81 -0.78 2.00 -0.40 4.86 -0.38 0.45 -2.64 2.67 1.25
Russell 3000® Value Index -2.40 -5.29 0.03 7.29 2.10 1.58 0.83 3.09 0.90 -0.13 -1.68 6.28 2.63

Source: FactSet Research Systems Inc. and Russell®
All indices are unmanaged. It is not possible to invest directly in an inde

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.