Heartland Advisors

Heartland Mid Cap Value Strategy 2Q23 Portfolio Manager Commentary

Executive Summary 

  • Risk-taking returned to the market, as investors are hoping the Federal Reserve may be done lifting interest rates.
  • Though big tech and speculative parts of the market have been early beneficiaries of this thinking, there are reasons to believe that value stocks and mid-caps pose better risk/reward.
  • Despite economic uncertainties, this is a great backdrop for active long-term value investors, as many companies should be worth considerably more in the next three to five years, while others may never again fetch the valuations they received in 2021.

Second Quarter Market Discussion

After taking risk off the table earlier in the year, investors scrambled back during the second quarter. Sparked by better-than-expected inflation data, the resolution of the debt ceiling crisis in Washington, and newfound hope that the Federal Reserve might be done tightening, the Russell Mid-Cap Index® gained almost 4% in the three months ended June 30. Growth beat Value during the quarter, and speculative growth did even better.

While the Federal Reserve kept rates steady at its June Federal Open Market Committee (FOMC) meeting, the Central Bank still appears to be leaning toward cooling the economy. The Federal Reserve’s so-called “dot plot,” which depicts the expectations of each FOMC member, shows the median forecast for the Federal Funds rate currently at 5.6%. This would suggest the possibility of further monetary policy tightening later this year. If this became reality, we question how well-received it would be in the speculative parts of the market that have led so far in 2023.

Even if the Federal Reserve stops raising rates, we believe the economy will continue to face headwinds given that monetary policy takes time to be fully reflected in economic activity. Funding stress may have peaked, but we anticipate further credit stress in the coming quarters, as the effects of higher borrowing costs begin to take their toll. Consumer loan delinquencies are already climbing, led by late payments on credit card and automobile loans, which have hit multi-year highs. While commercial real estate loans have not experienced broad-based credit stress yet, that could change in the coming quarters as loans underwritten in a lower interest rate environment come due and the cost to hedge against rising rates increases.

In this tighter credit environment, balance sheet strength, while always important, should be rewarded. We also remain steadfast in our conviction that well-selected mid-cap value stocks will outperform broad market indices over a multi-year time horizon. For starters, returns in the mid-cap universe have not been driven by just a handful of stocks. This stands in contrast to the S&P 500® Index, where seven giant tech companies drove the vast majority of the Index’s recent gains.

Percentage of S&P 500 Stocks that Outperformed the S&P 500

Source: Ned Davis Research, yearly data from 12/31/1973 to 12/31/2022 and partial year data from 1/1/2023 to 6/22/2023. This chart represents the percentage of S&P 500® Stocks that outperformed the S&P 500® over the calendar year. All indices are unmanaged. It is not possible to invest directly in an index. Past performance does not guarantee future results.

In the S&P 500®, the top 10 names account for more than 30% of the benchmark. Among mid-cap value, the top 10 stocks represent only around 7% of the Index. Historically, narrow markets tend to be associated with poor performance while wider breadth has correlated with stronger price gains.

We consider this to be a great backdrop for fundamentally driven, long-term investors, with many holdings potentially being worth considerably more in three to five years, while others may never again fetch the valuations they received in 2021.

Attribution Analysis

Our Strategy was up 4.9% in the second quarter and outperformed the Russell Mid-Cap® Value Index, which returned 3.9%, owing almost entirely to stock selection, particularly in the Technology, Consumer Discretionary, and Utilities sectors. Stock selection was positive in six of the eleven sectors furthering the Strategy’s consistent performance.  

Portfolio Activity

While the second quarter was decidedly better for growth stocks, we think value will have an advantage going forward. That said, we do not rely on top-down forecasts to pick stocks. We build our portfolio through bottom-up stock selection, relying on our 10 Principles of Value Investing™ within a two-bucket approach.

Among Value investors, there are those who prefer owning high-quality companies trading at decent bargains (“value”) and others who focus on 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 within value investing also tend to alternate market leadership. Within the mid-cap space, choosing one while ignoring the other does not seem prudent, as this can cause a top-down bet to be introduced into the portfolio.

We remain confident that effective stock selection in both areas will provide opportunities for good relative performance, and potentially downside protection, in a market where many uncertainties remain.

Consumer Discretionary. Hasbro (HAS) is one of the world’s leading toy and game manufacturers with key franchises such as Peppa Pig, Play-Doh, My Little Pony, and Playskool. For several years, Hasbro’s returns on invested capital have been going the wrong way. That said, we believe the shares possess compelling turnaround and self-help potential. 

The company has made progress working down excess inventory at retailers. This progress comes in front of an impressive slate of new products and entertainment releases, including movies, which should help catalyze better sales. Hasbro is streamlining operations and strategic focus across its products/gaming/entertainment segments by allocating more resources to growing its larger brands, while simultaneously de-emphasizing smaller brands that have created unnecessary distraction in recent years. Additionally, we expect management to complete a partial divestiture of noncore assets in its entertainment segment to reduce expenses and relieve the burden of inefficiently deployed capital. Furthermore, we are encouraged by Hasbro’s undertaking of a $250-300 million multi-year cost-saving initiative and a necessary supply chain management overhaul.

Our purchase of Hasbro shares was motivated by these operational/strategic changes, our confidence in the company’s ability to significantly expand operating margins, and compelling multiples of earnings, cashflow and invested capital.

Industrials. Stericycle (SRCL) is the largest medical waste disposal and compliance company in the U.S. Over the past few years, the company has transformed itself from an aggressive, acquisition-driven company to one focused on organic growth, integrating core assets, reducing debt, and expanding profit margins. Toward that end, the company has undertaken several self-help strategies. This includes divesting non-core operations in order to focus on its core businesses of medical waste disposal and document destruction in the U.S. and Europe. Today, SRCL is largely complete with this portfolio reshaping and has successfully reduced debt to target levels. The critical action items left for the company pertain to integrating technology systems and demonstrating further progress in operational execution. In summary, SRCL is morphing from a ”holding company” into an “operating company”, with the latter offering far better prospects of rewarding shareholders.

Candidly, this is not our first time owning SRCL. The first time around, we became shareholders far too early in the company’s turnaround efforts and exited the position. However, we continue to monitor the progress made under a much-improved management team and expect a better outcome for shareholders going forward. Regulated waste companies with leading market shares and secular growth, like SRCL, trade at far more expensive multiples of EBITDA and free cash flow. Additionally, the company is significantly underearning its potential. As this dynamic changes, we can envision a virtuous circle where the company earns progressively higher trading multiples on higher earnings power.

Healthcare. Centene Corporation (CNC) is one of the largest managed health care insurance providers in the U.S. and the largest player in Medicaid. The stock has underperformed this year, as CNC faces reimbursement headwinds including a reduction in its 2024 Medicare Advantage premiums and higher healthcare utilization from the return of elective procedures. Investors also fear a potential loss of insured lives when Medicaid eligibility, which was expanded during the pandemic, gets redetermined in 2023-2024.

CNC’s historical results have lacked the consistency demonstrated by premier large managed care companies. However, since 2021, the company has steadily upgraded its leadership ranks from the CEO on down through the executive ranks and line-of-business leaders. CNC’s executive leadership is comprised of industry veterans with a demonstrated record of success. Their executive compensation is clearly aligned with shareholder value creation, and they recently bought large amounts of CNC stock personally in the open market, demonstrating confidence in their prospects. Self-help initiatives are well underway and include noncore divestitures, material expense streamlining, improved digital capabilities, improved provider contracting, and meaningful share repurchases. 

In our estimation, the market is too focused on near-term overhangs that will prove temporary and disregards the substantial value creation opportunities that lie ahead. CNC trades at just 10X 2023 earnings compared to peers valued at mid/upper teens P/E ratios. After a brief pause caused by the reimbursement headwinds in 2024, we expect CNC to resume its 12-15% EPS growth rate, comparable to leading industry operators. This should help close the valuation gap.

Outlook 

The risk-on, risk-off aspect of this market tends to garner headlines. Nevertheless, we remain focused on bottom-up stock selection because it is within our control unlike the stock market. We also know that it remains a key determinant of success for our clients. 

Fundamentally Yours, the Heartland Team.

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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*

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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.

As of 6/30/2023, Centene Corporation (CNC), Hasbro Inc (HAS), and Stericycle, Inc. (SRCL), 4.12%, 1.76%, and 1.61% of the Mid Cap Value Composite’s net assets, respectively.

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.

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.

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 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. Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) measures a company’s financial performance. It is used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. Federal Funds Rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. Federal Open Market Committee (FOMC) is the branch of the Federal Reserve Board that determines the direction of monetary policy. The FOMC is composed of the board of governors, which has seven members, and five reserve bank presidents. 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. Growth Rate represents the rate of growth of equity securities within the Fund’s portfolio and is not meant as a prediction of the funds future performance, income earned by the Fund, or distributions made by the Fund.  There can be no assurance that a company’s actual earnings growth rate will be consistent with the estimate. Inflation Risk is the possibility that the value of assets or income will decrease as inflation shrinks the purchasing power of a currency. Operating Income Margin is a ratio used to measure a company's pricing strategy and operating efficiency. 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. Risk on/Risk off Theory is an investment setting in which price behavior responds to, and is driven by, changes in investor risk tolerance. Risk-on risk-off refers to changes in investment activity in response to global economic patterns. During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments. 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. S&P 500 Index is an index of 500 U.S. stocks chosen for market size, liquidity and industry group representation and is a widely used U.S. equity benchmark. All indices are unmanaged. It is not possible to invest directly in an index. 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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