Heartland Advisors

Heartland Mid Cap Value Strategy 4Q23 Portfolio Manager Commentary

Executive Summary 

  • As the ‘soft landing’ narrative gained momentum, a new round of risk-taking took place, driving up speculative and highly leveraged stocks starting in late October.
  • In a market where so many investors have bought into a consensus view, we believe it’s important to focus on the fundamentals, such as valuations. 
  • While more speculative parts of the market won the quarter, our Strategy outperformed for the year thanks to stock selection and discipline.

​Fourth Quarter Market Discussion

The ‘soft landing’ narrative that began to coalesce earlier in the year gained momentum in the fourth quarter, as fixed income investors joined the fray and embraced the notion that a Goldilocks economic scenario may be at hand. With inflation fears moderating, yields on 10-Year Treasuries fell from close to 5% in late October to approximately 3.9% at the end of the quarter while high yield spreads tightened significantly.  

This resulted in another round of risk-taking in the markets, which sent the Russell Midcap® Index surging almost 20% since Oct. 27 and over 12% since the start of the quarter.

While it’s impossible to know with absolute certainty whether the soft-landing narrative will come to fruition, we do know that the impact of monetary policy tends to lag. We are also aware of risks related to discounting the possibility of surprises in the coming months that could complicate this script. 

For instance, the high yield market is priced as if there are no credit risks to worry about. Yet there are some potential canaries in the coalmine hinting at a potential turn in the cycle. Credit card delinquency and charge-off rates are now above their pre-pandemic levels, indicating that households have depleted their excess stimulus savings (see chart below).

Delinquency Rates v. Charge-Off Rates

Source: FactSet Research Systems Inc., Quarterly data from 12/31/1993 to 09/29/2023. This chart represents Delinquency Rates compared to Charge-Off Rates in the United States. The delinquency rate is the amount of debt that is past due. Charge-off is a debt deemed uncollectible by the reporting firm. It is written off and removed from the firm's balance sheet. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Add to this the fact that small business hiring plans have sunk to where they stood in February 2021, amid the global pandemic, and this would seem to signal the possibility of rising unemployment and challenges ahead for consumers. 

We believe this is the type of market where investors can’t fixate on what others are doing, to borrow a phrase from Warren Buffett. Instead, they should get back to investing basics, including fundamental research and price awareness. We set multiple price targets for every stock we own (or consider owning) to reflect both good and bad scenarios to prevent us from blindly chasing (or hanging onto) stocks. This enables us to stay true to our 10 Principles of Value Investing™, which demand paying low prices relative to earnings, cash flow, and intrinsic value to help create a margin of safety.

In addition to those core Principles, we believe identifying companies that are taking self-help measures to improve their efficiency, profitability, and competitive advantage, regardless of economic conditions, will provide investors with the best chances for success. 

Attribution Analysis

The Mid Cap Value portfolio was up more than 7.5% in the fourth quarter, trailing the Russell Midcap® Value Index, which returned 12.1%. Part of that underperformance was driven by names we don’t own, thanks to the big bounce that speculative and highly leveraged stocks have enjoyed since late October.    

Stock selection was also the chief reason why the portfolio outperformed the Russell Midcap® Value Index for the full year, posting returns of approximately 13.8% in 2023 versus 12.7% gains for the benchmark.  

Portfolio Activity

While the market’s attention seems to have shifted away from mid value to mid growth in the fourth quarter, we have built our portfolio for the long term by focusing on bottom-up stock selection. We overlay a two-bucket approach on our 10 Principles by seeking to own both high-quality companies trading at decent bargains (“quality-value”) and deeply discounted companies that have produced poor economic returns over time (“deep-value”). 

Just as growth and value tend to take turns outperforming, these two styles have also alternated market leadership. If we were to choose one style while ignoring the other in the mid-cap space, we would be introducing a top-down bet on the portfolio, which we want to avoid. We remain confident that effective stock selection in both of these buckets is the best approach in our space. 

Below are several examples of quality-value businesses we own that are trading at deep-value-like valuations. Most of the time, the market appropriately rewards high return businesses with premium valuations, but the following companies trade at low valuations because there are fundamental questions about the industry or because there is a company-specific overhang.

Financials. A big beneficiary of the soft-landing narrative has been Financials, especially highly levered, low-quality companies. While we are underweight the sector, Northern Trust (NTRS), is an example of a quality-value financial with less credit risk exposure than its peers. 

NTRS operates two independent financial services businesses. Its Asset Servicing (AS) segment provides a full range of back-office services including custody, fund administration, and investment operations outsourcing to institutional investors globally. Its Wealth Management (WM) segment provides wealth advisory services to high-net-worth individuals and families, business owners, and privately held businesses. Through these operations, Northern Trust generates more than 70% of its revenue from fees, far more than a traditional bank. 

The past two years, however, have been challenging for the business model. First, the AS segment is a labor-intensive operation, and the combination of wage inflation and downward pressure on asset values in 2022 caused outsized margin pressure. At the same time, the interest rate Northern Trust must pay for client deposits is closely tied to the Federal Funds rate. Rising short-term rates since 2022 led to deposits moving into alternative options including money market funds and Treasury bills. As a result, Northern Trust’s balance sheet has shrunk by around 15% since its peak in 2022, which in turn drove net interest income down throughout 2023. 

We believe net interest income headwinds are moderating as the Federal Reserve’s monetary policy stance has turned neutral to accommodative. Meanwhile, Northern Trust’s modest credit risk allows for more clarity of normalized earnings power relative to a traditional bank. NTRS trades at a price/earnings ratio of 14.9, based on next 12 month profits. That’s below its 20-year median multiple of more than 16, even after consensus earnings forecasts have fallen around 30% from their 2022 peak, making NTRS an attractive long-term opportunity.

Healthcare. We have mentioned Centene Corporation (CNC) earlier in the year as an example of a company utilizing self-help strategies to move beyond past missteps. 

The giant managed health insurance provider—which provides coverage to 25 million Americans, including 14 million Medicaid enrollees in 29 states—underperformed for much of the year. CNC faces reimbursement headwinds including a reduction in its 2024 Medicare Advantage premiums and higher healthcare utilization from the return of elective procedures.

But the stock has been rebounding since September and is up 7.7% for the quarter. In the past, CNC’s operational execution lacked the consistency of other large, premier managed care companies in the U.S. However, the company upgraded its entire executive leadership team in recent years with industry veterans that have a track record of success. 

CNC trades at just 11 times 2024 earnings, despite enjoying a 12-15% EPS growth rate. That pace will likely take a breather this year, thanks to Medicare reimbursement headwinds. But it should resume after 2024, with encouraging margin expansion and earnings growth prospects for years to come.

Communications. In theory, Cable One (CABO), a broadband provider with a focus on rural markets in the Midwest, Northwest, and Southeast, should have rallied in the fourth quarter as long-term interest rates began to fall. But 2023 turned out to be a challenging year for broadband providers all around, including CABO, whose shares are down more than 15% since mid-October. 

Thanks to rising rates between January and late October, the number of families moving fell to a multi-year low, as existing home sales sank to 2010 levels. This is an important metric since every move creates an opportunity for companies like CABO to win new customers. The fact that mortgage rates have fallen from nearly 8% at the start of November to approximately 7% today provides some relief but borrowing costs have not fallen enough to trigger a recovery in moves.  

This lack of new customer acquisitions has exacerbated concerns about rising competition from alternative modes of internet, mainly fiber-to-the-home and fixed-wireless access. While we believe CABO is relatively well insulated from this competitive pressure, the lack of new customer additions is fueling the current overhang.  

Management is reacting to the soft environment by testing new lower price offerings capable of attracting a new customer base. Longer term, moving activity should rebound, resulting in better customer acquisition opportunities. Meanwhile, the stock trades at 7.2 times Enterprise Value to EBITDA, which compares favorably to its median post-spinoff multiple of 11.1 and the 11.0 multiple for the Russell 3000® Value Index.

Outlook 

While those who bet on speculative, highly leveraged stocks won the fourth quarter, quarterly performance is not our objective. Our goal is to create consistent, lasting value for our shareholders over the long term. We cannot predict whether the soft-landing narrative will prove true at the end of the day. We simply believe that a balanced approach, which leaves open the possibility that the Goldilocks scenario could turn out to be right or wrong, is the wisest way to approach any market.

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Portfolio Management Team

Heartland Advisors Value Investing Portfolio Manager Colin McWey

Colin McWey

Vice President and Portfolio Manager

Heartland Advisors Value Investing Portfolio Manager Will Nasgovitz

Will Nasgovitz

CEO and Portfolio Manager

Heartland Advisors Value Investing Portfolio Manager Troy McGlone

Troy McGlone

Vice President and Portfolio Manager

Composite Returns*

12/31/2023

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Since Inception (%)10-Year (%)5-Year (%)3-Year (%)1-Year (%)YTD (%)QTD (%)
Mid Cap Value Composite (Net of Advisory Fees)11.469.8614.1712.4813.8313.837.64
Russell Midcap® Value10.088.2611.168.3612.7112.7112.11

Source: FactSet Research Systems Inc., Russell Investment Group, and Heartland Advisors, Inc.
*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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©2024 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

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 12/31/2023, Cable One, Inc. (CABO), Centene Corporation (CNC), and Northern Trust Co. (NTRS), represented 0.44%, 4.32%, and 4.20% of the Mid Cap Value Composite’s net assets, respectively.  

The future performance of any specific investment or strategy (including the investments discussed above) should not be assumed to be profitable or equal to past results. The performance of the holdings discussed above may have been the result of unique market circumstances that are no longer relevant. The holdings identified above do not represent all of the securities purchased, sold or recommended for the Advisor’s clients.

Statements regarding securities are not recommendations to buy or sell.

Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.

In certain cases, dividends and earnings are reinvested.

GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

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 this article are those of the presenter(s). 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.

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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. 

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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 2024 FactSet Research Systems Inc., FactSet Fundamentals. All rights reserved.

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

Bottom-up is an investment approach that de-emphasizes the significance of economic and market cycles. This approach focuses on the analysis of individual stocks and the investor focuses his or her attention on a specific company rather than on the industry in which that company operates or on the economy as a whole. Charge-off is a debt deemed uncollectible by the reporting firm. It is written off and removed from the firm's balance sheet. Earnings Per Share (ESP) is the portion of a company’s profit allocated to each outstanding share of common stock. Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization (EV/EBITDA) Ratio is a financial indicator used to determine the value of a company and is calculated by dividing the entire economic value of the company (enterprise value) by its earnings before interest, taxes, depreciation, and amortization (EBITDA). Federal Funds Rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. 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. Leverage is the amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. Margin of Safety is a principle of investing in which an investor only purchases securities when the market price is significantly below its intrinsic value. 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 Russell Investment Group. Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000® Index. All indices are unmanaged. It is not possible to invest directly in an index. 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. Russell 3000® Value Index measures the performance of those Russell 3000® 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. Treasury Bill (T-Bill) is a short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). Treasury Yield is the effective rate of interest paid on a debt obligation issued by the U.S. Treasury for a specified term. Unemployment Rate measures the number of people actively looking for a job as a percentage of the labor force. Price/Earnings Ratio of a stock is calculated by dividing the current price of the stock by its trailing or its forward 12 months’ earnings per share. 10 Principles of Value Investing™ consist of the following criteria for selecting securities: (1) catalyst for recognition; (2) low price in relation to earnings; (3) low price in relation to cash flow; (4) low price in relation to book value; (5) financial soundness; (6) positive earnings dynamics; (7) sound business strategy; (8) capable management and insider ownership; (9) value of company; and (10) positive technical analysis.

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