Heartland Value Fund 3Q26 Portfolio Manager Commentary

In the third quarter, attention shifted away from the AI trade as macroeconomic themes and geopolitical worries reemerged as key market drivers. Concerns over rising Treasury yields, elevated oil prices, and the potential start of a Fed rate-hiking cycle slowed the small-stock resurgence that had been gaining momentum. For the quarter, the Russell 2000® Value Index sank 4.91%, compared to the 2.30% gain for the S&P 500. 

However, it’s important to keep a few things in perspective. For starters, we agree with Peter Lynch that it’s futile to try and forecast the direction of interest rates and other macro factors in hopes of predicting short-term market behavior. For us, our time is better spent analyzing the companies we own or assessing potential new investments to consider. Put another way, bottom-up research trumps top-down theories. 

Also, if we’ve learned anything this year, it’s that three months doesn’t make a trend. While small stocks lagged in the quarter, the Russell 2000® Value is still outperforming the S&P 500 on a year-to-date basis, +16.96% versus +12.75%. In addition, the backdrop for value investing is improving. Rising interest rates, which have been viewed as a potential headwind for small caps, are starting to force investors to think more about valuations as equities face stiffer competition for investment dollars.

The good news is that small caps continue to enjoy a sizeable valuation advantage over large stocks. As the chart below shows, the S&P Small Cap 600 Index, using consensus Price/Earnings ratios for the next twelve months, is trading at a substantial discount to the S&P 500.
 

Source: FactSet Research Systems, Inc., Monthly data 7/31/2001 to 9/29/2026. This chart represents the comparison of the NTM P/E (next twelve-month price to earnings) for the S&P 600 Index versus the S&P 500 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. S&P 600 Index is an index of small-cap stocks managed by Standard & Poor's. 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.

Importantly, the Heartland Value Fund trades at only 11X the next twelve months’ profits, for an earnings yield (the inverse of the price/earnings ratio) of 9%. That’s compared to the 5.2% on 10-Year Treasuries and the 6-7% payout for corporate bonds. By contrast, the S&P 500 is at 5.3%. This creates a favorable environment for active, valuation driven small-cap investors. In our opinion, we are well positioned to take advantage of market disparities because of our adherence to the 10 Principles of Value Investing™, which requires that fundamental factors such as strong balance sheets, profitable growth, and attractive valuations drive all of our portfolio decisions.

We’re mindful that the market continues to be fickle and unpredictable. We’ve been doing this long enough to understand this renewed focus on fundamentals may not persist. This is why a key element of our approach is to plan for a wide range of potential outcomes. For every investment we hold or consider owning, we establish four separate price targets: a base case, an upside scenario, a downside development, and a max loss circumstance associated with severe business stress. This approach is as useful to us now, after our benchmark hit a speedbump during the quarter, as it was earlier in the year, when investors’ appetite for small stocks rebounded sharply. 

Attribution Analysis & Portfolio Activity

In the third quarter, the Heartland Value Fund fell 6.96%, compared to the 4.91% loss for the Russell 2000® Value Index. Security selection was mixed, with positive effects in Health Care, Materials, and Communication Services but negative results in Energy, Industrials, and Technology. 

Within Energy, part of our underperformance was based on what we don’t own—we are under-exposed to pure-play refiners, which have recently been among the market’s best performers. In Industrials, a few holdings were impacted by the AI trade, as companies that were viewed as winners of the data center buildout earlier in the year were punished in the period, as AI interest waned. 

Against this backdrop, it seems prudent to take what the market is giving us while derisking some positions that saw rapid appreciation earlier in the year. It also makes sense to focus on what we do best: identifying well-run businesses priced well below their intrinsic worth. In the third quarter, one of our companies was taken private, bringing the total number of holdings acquired in 2026 to seven. We view this as validation of our disciplined investment process. 

One of our holdings receiving strategic interest is Integer Holdings (ITGR), a leading global medical device contract development and manufacturing organization (CDMO). A year ago, the stock sank more than 30% after reporting disappointing results and lowering guidance for growth and margin expansion this year. Yet bolstered by our research and insider buying we remained confident in the business. Also at year-end, a significant investor built a stake in the company and urged management to explore a sale. In the third quarter, KKR agreed to acquire ITGR for $127 a share, which was in line with our target price and represented a greater than 70% premium to our average cost.

A good example of our focus on valuations—and the value of active management—is Academy Sports and Outdoors (ASO). In the summer, we added to our position in this $6 billion in sales retailer, after rival Dick’s Sporting Goods missed badly on its second quarter earnings. That news sent the whole group down. 

But Dick’s issues stemmed largely from its footwear business, and shoes represent a much smaller portion of Academy’s business. At the same time, ASO has meaningful exposure to outdoor recreation, a category that’s begun to pick up following years of weakness. There are also company-specific catalysts to drive improvement such as revamping of its e-commerce business, launching a new credit card, growing its loyalty program, and continuing to expand merchandising for higher income consumers.

In September, the stock surged after Academy reported Q2 results that were stronger than investors had feared. Despite this, ASO is valued at just 7X this year’s earnings and 7X next. Giving us even more confidence is management’s use of strong free cash flow to repurchase 40% of ASO shares outstanding since Academy went public in 2020. 

A recently added holding is Hillman Solutions (HLMN). If you walk into your favorite hardware store and go to the fasteners’ aisle for items such as nuts, screws, and bolts, there’s a high likelihood it was sourced, supplied, and managed by Hillman. Fasteners are an important section of any home-improvement store because they drive traffic. Yet they are complex to manage due to the high number of individual items. Hillman has a team of dedicated associates that work with retailers to keep shelves inventoried and presentable, thus creating sticky partnerships and higher margins. 

High interest rates have depressed demand for home repairs and remodeling among Hillman’s core customer, the do-it-yourself crowd. Foot traffic at Lowe’s and Ace Hardware—HLMN’s top two retailers—have been choppy as well, weighing on its stock price. 

While it is hard to know when interest rates will be more favorable or when repair and remodel demand will improve, Hillman is driving growth in other areas, which should help it stand out versus its peers. HLMN, for instance, recently launched a new emphasis on top customers in the Pro channel, an opportunity which could drive 1-2% of annual top-line growth. Additionally, management made an acquisition that gives them a beachhead to expand in the Industrial fastener space.

The stock currently trades at less than 6.5X next year’s EBITDA, well below distributors in the Industrial sector. In fact, over the past two decades, Hillman has been sold to private equity firms twice, at 10-11X EBITDA. We forecast HLMN can achieve similar pricing once housing demand improves and management executes on the organic growth opportunities. 

Outlook

If there ever was a time for active management, this is it. While the past three months may have been challenging for our part of the market, the underlying backdrop for disciplined stock-picking has noticeably improved. As rates have risen and competition for investment dollars has grown, investors now care more about fundamentals and valuations. This is creating potential risk-versus-reward opportunities for our Strategy. It’s important to recognize, though, that not all companies in our benchmark are poised to outperform. This is why our 10 Principles of Value Investing™ are crucial to identifying fundamentally sound and attractively priced businesses with growth potential. We are excited about what lies ahead. 

Fundamentally yours,
The Heartland Investment Team