Heartland Mid Cap Value Strategy 4Q20 Portfolio Manager Commentary

Executive Summary 

  • A strong quarter helped propel the portfolio to outperform its benchmark for the full year.  
  • Success on the COVID-19 vaccine front and efforts by Central Bankers to boost inflation sent equities racing to new highs.  
  • Overlooked risks could make excessively optimistic earnings forecasts hard to meet.

Fourth Quarter Market Discussion

The roll out of two different successful vaccines to combat COVID-19, and an explicit acknowledgement by Central Bankers that they would actively work to boost inflation sent equities racing to new highs during the period. The turbo-charged rally served as a bookend to the severe selloff during the first quarter of the year.

The growing sense that a return to pre-pandemic life was on the horizon led investors to bid up cyclical areas, companies that were most impacted by the COVID-19-induced recession, and businesses that would benefit from inflation. Some troubled companies with high debt levels also rose during the period.  

The renewed focus on inflation may be warranted based on the chart below, which shows the price of raw materials for manufacturing hitting levels not seen since 2018.


Costs Climbing

Heartland Advisors High Beta/Low Volatility Source: Bloomberg L.P., 12/31/2015 to 12/31/2020
Raw industrials are represented by the Commodities Research Bureau BLS US Spot Index Raw Industrials Subdivision.
Past performance does not guarantee future results.

Attribution Analysis
Stock selection was strong in several sectors and the portfolio beat its Russell Midcap® Value benchmark for the quarter. Holdings in Materials and Financials performed particularly well on a relative basis while names in Consumer Discretionary rose less than those in the Index. The strong quarter helped propel the portfolio to outperform its benchmark for the full year.  
 
Digging deep. Investor confidence that the economy was recovering off depressed levels was clearly on display in the Materials sector where industrial metals and chemicals soared while miners of precious metals, which are often viewed as storehouses of value in volatile times, lagged. The portfolio’s holdings in the space outperformed the benchmark average, and the group contained a top performer, Freeport-McMoRan, Inc. (FCX).

Freeport-McMoRan is a leading supplier of copper with mines in the U.S. and overseas. The business came to our attention approximately two years ago based on what we viewed as attractive valuations. However, we waited until we saw sufficient progress on two issues—management reaching a critical operating agreement with the Indonesian government and transitioning from above ground to underground mining at one of its locations—before taking a stake in the company.

Our patience was rewarded this quarter with shares of Freeport-McMoRan up double digits as the price of copper jumped while Freeport’s self-improvement initiatives continued to bear fruit, and the company enjoyed a positive inflection in free cash flow generation. Results for the firm should continue to improve for the next several quarters, in our view, as the business benefits from declining capital expenditures over the next 12 to 24 months.
 
Rewarding resilience. Financials were up sharply for the period with strength coming from a broad range of industries. Our holdings in the space outpaced the benchmark average for the group including Raymond James Financial, Inc. (RJF), a diversified financial services company offering wealth advisory, asset management, investment banking, and banking services to retail and institutional clients.


Shares of Raymond James fell in the first quarter of 2020 as the market priced in a dramatic downturn in profits due to the potential impact of COVID-19. The company earns advisory and management fees based upon client asset levels, interest income from lending activity, and banking fees based upon capital markets activity. As equity and credit markets deteriorated and as interest rates fell throughout the first quarter, the stock fell more than 40% from its peak.

Raymond James’s earnings, however, have proven more resilient than the market had anticipated during the first half of the year. The company posted better than expected results for the third quarter with gains driven by a steepening yield curve that benefitted the entire Financials sector, as well as a favorable investment banking environment as the capital markets shifted from frozen to highly active. The business has also acted swiftly in reducing credit risk by selling loans the management team viewed as structurally challenged in a post-COVID world. 

We’ve been pleased with the ability of Raymond James to maintain its high capital levels and its decision to resume its share repurchase activity, which the company’s board of directors recently voted to increase. 

Longer term, we view Raymond James as attractive due to its impressive history of growing share and the opportunity it has to penetrate new markets outside of its stronghold of the Southeast. The potential for growth coupled with the company’s ability to generate returns on equity that far outpace peers should serve investors well in the years to come. While shares have bounced back since the COVID-sparked selloff of February, they remain attractive at just a 1.9x tangible book value vs. a 20-year median multiple of more than 2x. 

 
Healthy food? The portfolio’s names in Consumer Staples outpaced the benchmark average with strength coming from holdings in the food products industry, including long-time holding Bunge Limited (BG).

Bunge, a multi-line food and agribusiness company, has made organizational improvements under a new CEO who was hired in early 2019. Strides include cost cutting, noncore divestitures and enhancing risk management through more focused hedging activity. These actions have reduced volatility in earnings and improved efficiency by better aligning resources with the needs of end clients. 

As the leadership team continues to make strides, we believe the stock still has meaningful upside based on its historic average multiple to normalized earnings. 
 
Stuck in neutral. The portfolio’s Consumer Discretionary holdings were up for the period but failed to keep pace with the benchmark average for the group. Some of the discrepancy in performance stemmed from investors gravitating toward economically sensitive names as opposed to the more defensive plays found in the portfolio such as Advance Auto Parts, Inc. (AAP). The company is a dominant player in the fragmented auto parts industry and differentiates itself from peers through its client mix. 


Advance Auto Parts has posted better than expected earnings in recent quarters, however, investors have been cautious about difficult comparisons the industry will face in 2021. Given the double-digit growth in sales the company has experienced since the middle part of 2020, we recognize that comparable sales growth will be challenging in the near term. However, we also believe the company has more upside as the economy regains some normalcy and as the pandemic recedes in the face of vaccinations.

Based on our analysis, we believe margin expansion spurred by self-help initiatives will accelerate into the later part of 2021, as the company completes supply chain technology upgrades that will help management optimize distribution capacity. Margin expansion and robust capital allocation could result in earnings improvements over the next three to five years and should result in rapid growth of the company’s intrinsic value. 

Portfolio Activity  

In the face of extreme volatility for much of 2020, our focus has remained 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. The significant strength of economically sensitive names in the market during the past several months has left little room for error with 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. While that has reduced some of the economic sensitivity of the overall portfolio, we have continued to let our research lead us to what we view are attractively valued companies 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 level of euphoria has caused some to overlook potential risks ranging from a potential surge in inflation to a tepid rollout of COVID vaccinations. The potential headwinds these challenges could bring serves as a constant reminder to the team to focus on finding businesses with attractive 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.   
 

Portfolio Update

Effective January 1, 2021, Troy McGlone, CFA, will serve as co-Portfolio Manager of the Mid Cap Value portfolio joining current Portfolio Managers Colin McWey, CFA, and Will Nasgovitz. The move recognizes the significant contributions Troy made to the team during his tenure as an analyst. Troy has 12 years of industry experience including 6 years with Heartland. He also serves as co-Portfolio Manager of the Opportunistic Value Strategy. 

Thank you for the continued trust and confidence.
  
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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.

Composite Returns*

12/31/2020

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)11.349.8611.737.758.728.7225.78
Russell Midcap® Value10.2910.499.735.374.964.9620.43

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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©2021 Heartland Advisors | 790 N. Water Street, Suite 1200, 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.

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 12/31/2020, Heartland Advisors on behalf of its clients held approximately 3.19%, 1.00%, 1.81%, and 3.20% of the total shares outstanding of Advance Auto Parts, Inc., Bunge Limited, Freeport-McMoRan, Inc., and Raymond James Financial, Inc., 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.

Data sourced from FactSet: Copyright 2020 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

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

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. Intrinsic Value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Median is the number found at the exact middle of the set of values. A median can be computed by listing all numbers in ascending order and then locating the number in the center of that distribution. This is applicable to an odd number list; in case of an even number of observations, there is no single middle value, so it is a usual practice to take the mean of the two middle values. Normalized Earnings are earnings adjusted for cyclical ups and downs in the economy. 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. Tangible Book Value is the sum of all of a company’s assets, minus its liabilities and intangible assets, such as goodwill. Volatility is a statistical measure of the dispersion of returns for a given security or market index which can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.

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