peepo/iStock via Getty Images Dear Fellow Shareholders: The intoxication with Artificial Intelligence (AI) related companies continued in 2025, in conjunction with a low-quality “junk” rally that added fuel to the fire. Investors who were willing to extend out along the risk curve were rewarded. The Russell 2000, S&P 500, MSCI EAFE (Local/USD), and MSCI World gained 12.81%, 17.88%, 20.60%/31.22%, and 21.09%, respectively. Many Wall Street strategists are now penciling in greater than 10% returns for the ...

Core Viewpoint - The investment strategy is shifting towards quality value stocks, particularly in the industrial sector, as earnings growth expectations remain strong for 2026 [1]. Industrial Sector - The industrial sector is favored due to higher return on equity and solid demand, with earnings growth projected at 16% [2]. - Industrial companies are expected to benefit significantly from accelerated depreciation policies, which will stimulate tech capital expenditures [3]. - The aerospace and defense industries are experiencing robust demand, indicating a positive outlook for these sectors [6]. Defense Stocks - Defense stocks have outperformed most sectors, with Boeing's stock rising 40% since November [4]. - Investors are advised to embrace geopolitical risks through investments in defense stocks and metals, rather than attempting to trade on geopolitical headlines [5]. Mid and Small Caps - Mid-cap stocks are gaining attention, with a notable participation in the market, contrasting with the focus on mega-cap tech stocks [7]. - Small and mid-cap stocks are showing strong earnings momentum, particularly in the industrials and regional banks [9]. Regional Banks - Regional banks are experiencing double-digit earnings growth and active M&A activity, although they face potential headline risks and regulatory challenges [10]. Economic Outlook - The economy is showing signs of good growth with controlled inflation, countering fears of stagflation [12]. - Economic indicators such as PMI and ISM are expected to remain above 50, signaling positive growth [13]. - Inflation is projected to moderate into 2026, with housing prices stabilizing and energy prices remaining manageable [14].

Market Overview - The equity market experienced significant gains in 2025, with the Russell 2000, S&P 500, MSCI EAFE, and MSCI World increasing by 12.81%, 17.88%, 20.60%/31.22%, and 21.09% respectively, driven by a speculative "junk" rally and enthusiasm for AI-related companies [2] - Wall Street strategists are forecasting over 10% returns for the S&P 500 in 2026, which would mark four consecutive years of double-digit returns, a rare occurrence in market history [2] Investment Trends - FMI's portfolios have generated solid double-digit annual returns over the past three years but have not kept pace with broader indices due to a current market preference for low-quality investments [3] - High-quality businesses have underperformed low-quality ones sharply in the U.S. in 2025, despite long-term outperformance trends [4] - The small-cap sector has seen a significant outperformance of low-quality companies, with active managers struggling to keep pace during this "junk" rally [5] International Market Insights - The MSCI EAFE Quality Index has underperformed the MSCI EAFE by approximately 10% in both local and USD terms, indicating a global trend of low-quality stocks outperforming [6] - In Europe, the top-performing sectors in 2025 included Defense (+89.9%), Rate Sensitive Financials (+72.1%), and EU Miners (+55.5%), which are generally considered low-quality investments [6] AI Impact on Markets - AI-related stocks in the S&P 500 represent 45% of the index's market cap and have accounted for 78% of S&P 500 returns since the launch of ChatGPT in November 2022 [12] - The tech sector's capital spending has contributed 40%-45% of U.S. GDP growth in 2025, a significant increase from less than 5% in the same period of 2023 [15] - Major tech companies are expected to spend over $500 billion on capital expenditures in 2025, with a projected capex-to-revenue ratio of 29% in 2026 [21] Company-Specific Insights - Hayward Holdings Inc. is positioned well in the pool equipment market, with strong pricing power and a resilient business model, despite current weak demand [27] - Accenture Plc is adapting to the AI landscape, with expectations that AI adoption will drive demand for its consulting services, despite facing headwinds in IT spending [28] - Smiths Group PLC is transitioning to a more focused portfolio, with improvements in growth and profitability, supported by a strong balance sheet [29]

Core Viewpoint - Heartland Mid Cap Value Fund's fourth-quarter 2025 performance was negatively impacted by the underperformance of high-quality value stocks, while speculative and low-quality stocks gained attention, leading to widening valuation gaps [1]. Group 1: Fund Performance - The Fund's portfolio experienced a loss of 1.92% in the fourth quarter, compared to a 1.42% return from the Russell Midcap® Value Index [1]. - The underperformance of Quality Value holdings significantly affected the overall strategy performance during the quarter [1]. Group 2: MarketAxess Holdings Inc. - Heartland Mid Cap Value Fund initiated a new position in MarketAxess Holdings Inc. (NASDAQ:MKTX), which operates the largest electronic trading platform for corporate bonds in the U.S. [3]. - As of January 12, 2026, MarketAxess Holdings Inc. stock closed at $170.10 per share, with a one-month return of -5.22% and a 52-week loss of 21.48% [2]. - MarketAxess Holdings Inc. has a market capitalization of $6.356 billion [2].