Heartland Opportunistic Value Equity Strategy 3Q26 Portfolio Manager Commentary

The U.S. equity market remained resilient through much of the third quarter, supported by strong second-quarter corporate profit growth despite rising energy prices related to the conflict in Iran. Equities weakened beginning in late August as interest rates rose sharply. The U.S. 10-year Treasury yield was 5.3% at quarter end, the highest rate since 2007, and the real yield (nominal yield less inflation) rose to 2.9%, the highest level since 2008.  

The third quarter also highlighted sharp divergence between major indexes. After surging in the second quarter, many semiconductor stocks retreated as enthusiasm surrounding parts of the AI trade began to waver. Meanwhile, hopes for Fed rate cuts at the start of the year gave way to concerns about renewed tightening. As a result, the Russell 2000® Index fell 4.91% over the past three months, while the S&P 500 gained 2.30% aided by double-digit percentage gains in several multi-trillion dollar companies including Microsoft, NVIDIA, Apple and Meta.

But while stock prices are oscillating on ebbing and flowing news, the intrinsic value of those underlying businesses is not moving nearly as much. For example, Microsoft rose more than 35% in the third quarter while the consensus estimates for 2027 and 2028 operating profit increased less than 3%. How could the value of a blue-chip company worth more than $3 trillion move in such an extreme way? The answer comes down to expectations and valuation. Earlier, from November 2025 through June 2026, shares of Microsoft fell by roughly 35% despite modest increases in those same profit estimates. The magnitude of stock price volatility was therefore driven less by changes in expected earnings than by changing perceptions of whether Microsoft was a loser or a winner from the proliferation of AI. Among smaller companies, these narrative-driven swings can be even more pronounced. 

We continue to believe AI is very real; however, history suggests that capital cycles can front run the economic returns ultimately generated by the technology. The sharp rise in public and private financing for AI infrastructure suggests that possibility deserves careful consideration. We believe corporate profit growth remains at historically strong levels, thanks to elevated margins and the tailwinds created by the massive capex spending tied to the data center buildout. As the chart below shows, the 10-year S&P 500 earnings growth rate now stands above the level seen in the Dotcom era and is approaching post-WWII record highs.

Corporates are over-earning: one of the strongest EPS cycles in history

Source: Wells Fargo Securities. Monthly data from January 1881 to September 2026. This chart represents the ten-year growth rate of the S&P 500 earnings per share (EPS) compared with a long-term NTM (next-twelve-month) earnings growth forecast. Earnings Per Share is the portion of a company’s profit allocated to each outstanding share of common stock. 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. All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.

Stepping back, fewer than ten public companies are poised to spend about $1 trillion of capital on technology infrastructure in 2026, which would boost GDP by about 3% alone. These same companies are forecasted to spend $1.3 trillion in 2027. However, this data excludes certain operating leases that don’t qualify as capex per accounting standards, but the leases are being guaranteed by the tenant, which unlocks additional financing to fund the capital cycle.

Companies may be ‘over-earning’ because of the front-loaded nature of the AI investment cycle. On the one hand, positive drivers of earnings are often realized upfront. Financial intermediaries recognize fees as capital is raised, while equipment suppliers, contractors, semiconductors manufacturers, and optical connectivity providers, among many others, benefit from extreme pricing power as the capital is deployed. In contrast, much of the cost to hyperscalers is recognized later because depreciation begins only after assets are placed in service, and they are expensed over their useful lives. The result is a timing mismatch with many of the earnings benefits appearing early in the cycle, while some of the associated costs emerge later.

This does not mean the AI capex boom is certain to peak anytime soon. Using a baseball analogy, a capital cycle bubble does not pop in the ninth inning. It bursts in extra innings. Whether the game lasts ten, twelve, or more innings is anyone’s guess, but a classic indicator that we’re late in the game can be found in the rising dependence on third party capital to fund marginal capex growth. In addition, Wall Street is relying on a few critical assumptions to add leverage to the mix including the idea that a new chip architecture won’t render existing infrastructure quickly obsolete and/or that none of the large capital spenders of today ultimately fail despite many of the top spenders, both public and private, generating negative free cash flow. Current valuations in parts of the market appear to assume that unusually high returns can persist despite the competitive response those returns are likely to attract.

As a capital market bubble approaches the crescendo, even the bulls recognize that excesses are unsustainable, but market speculators assume they’ll be able to sell before the bubble bursts. The problem with this concept is that many of the same firms publishing forecasts that predict abnormal growth far into the future are the same firms earning fees from capital raising efforts. Their incentive is not to let the world know when the cycle is over. Rather, they’re incentivized to raise as much capital as quickly as possible. For this reason, it’s important for investors who think like business owners to consider all possible tailwinds and headwinds that could impact a company’s cash flows, which in turn will impact their assessment of intrinsic value. This is why it’s so important to plan for a range of potential outcomes. 

At Heartland, we address uncertainty by evaluating a range of potential outcomes for every business we hold or consider owning. Our research incorporates base, upside, downside, and severe-stress scenarios to assess both potential appreciation and permanent capital risk. The discipline is embedded in our 10 Principles of Value Investing™, which guides our portfolio decisions and directs us toward financially sound companies with durable economics that can be purchased at attractive valuations.

Attribution Analysis

During the quarter, our Strategy returned -2.96%, versus the 2.31% gain for the Russell 3000® Value Index. Security selection in the Technology sector was responsible for a majority of that underperformance. 

The annual FTSE Russell index rebalance took place in late June and materially changed the composition of Technology sector constituents. Most impactful were the additions of Microsoft and Apple to our benchmark because they were two of the three biggest contributors to the Russell 3000® Value Index’s performance in the third quarter. We admire both companies, but we don’t view either as materially undervalued.

Stock selection for our Strategy was weakest among the absolute largest-capitalization stocks because we don’t own Microsoft or Apple. By contrast, our stock selection was more effective among smaller- to mid-cap stocks under $15 billion in market cap.

Portfolio Activity

Bentley Systems (BSY), a newly initiated position during the quarter, is an example of a stock getting heavily discounted by a negative top-down industry narrative, with defensible and compelling long-term prospects. To be clear, we are wary of the outlook for many software products, especially those that serve administrative functions and are prone to faster switching decisions in a widening competitive landscape. Our research has centered on “vertical software” companies that provide end-to-end solutions for a specific industry because domain expertise drives higher customer loyalty and switching costs.  

Among the vertical software companies in our universe, we find BSY’s characteristics especially attractive from both a “moat” and opportunity perspective. The company provides engineering software for critical infrastructure around the world for public works and natural resources end markets. Over 40 years of proprietary data and deep integration has made BSY the industry standard for infrastructure modeling and simulation. Their software represents roughly five basis points (0.05%) of total project cost for mission critical infrastructure, with BSY’s engineering customers facing severe engineering labor challenges and their asset owner customers relying on BSY’s software to ensure reliability and minimize expenses while avoiding a high cost of failure. With end market demand buoyed by a need to address structural underinvestment, we expect BSY sales and free cash flow to accelerate further as customers consume more of their offerings for AI-oriented workloads.

Sometimes, opportunities can be found inside your existing portfolio—if you have the patience to find out. Case in point, Watsco (WSO), the largest wholesale distributor of HVAC and refrigeration equipment in the U.S., which was one of the biggest detractors to performance in the quarter.

The residential HVAC industry is going through a demand lull created by a combination of factors including declining new construction activity, weakening consumer financial conditions, and a pull-forward of demand caused by a refrigerant change in 2025. Watsco and the major residential HVAC equipment manufacturers underperformed following disappointing Q2 earnings results, characterized by persistent demand weakness and margin pressure associated with a lack of volume growth and tariff-induced cost volatility.  

While the market is myopically focused on short-term volume headwinds, we believe WSO is positioned to benefit from technology investments that uniquely favor the industry’s juggernaut. For example, the company has a modern tech stack and a fully digitized platform unlike most of their peers. Watsco is also using AI to optimize for demand elasticity and to identify pricing outliers that can be addressed by their sales team quickly. We believe management’s investments in AI-enhanced customer service, technical support, and software development will drive margin expansion and share gains for years to come.

Recently, Watsco announced the acquisition of two separate family-run businesses. These acquisitions should increase revenue and cash flow by roughly 10%. Given the company’s unlevered balance sheet, greater cash flow generation accrues to equity holders through an increase in intrinsic value. Yet the stock trades at a free cash flow/enterprise value yield of 6%, based on 2027 cash generation.

Our biggest contributor to performance in Q3 was MarketAxess Holdings (MKTX), which operates the largest corporate bond e-trading platform in the U.S. 

In the prior quarter, this stock was one of our biggest detractors, as heavy primary bond issuance volume and tighter credit spreads temporarily diverted trading volume away from MKTX's core secondary market. Yet we remained committed to the business for reasons highlighted in our Q2 letter. In late July, competitor Intercontinental Exchange, Inc. announced its intent to buy MKTX for $167 per share in cash representing a 47% premium relative where shares traded at the end of Q2.

The market can change its mind quickly, as the past three months demonstrated. Rather than trying to anticipate the next headline or market narrative, we believe investors are better served by looking past the top-down noise and analyzing businesses from the bottom up. We remain focused on identifying companies where the range of potential outcomes offers an attractive balance of upside opportunity and downside protection, guided by our 10 Principles of Value Investing™. Markets will continue to fluctuate; our process will not.

We are grateful for your continued trust.