Dear Fellow Shareholder,
The past year in the equity markets proved to be extremely volatile, and the month of September 2011 marked the fifth consecutive month that domestic stock indices lost ground. This decline, which began in early May 2011, accelerated through the months of August and September as U.S. equity indexes posted some of the worst single day declines since the crisis of 2008. In the third quarter, the continuing cloud of European sovereign debt weighed on the markets. Adding to these concerns was the protracted debate by U.S. lawmakers in their attempt to negotiate a deal to raise the nation’s borrowing limit. Though an agreement finally was reached to avert an immediate crisis, the debate which ensued prior to the deal seemed to generate a meaningful decline in our political system, and the eventual deal failed to produce enough spending cuts or tax hikes to permanently reduce the national debt. All of this happened under the watchful eyes of the credit rating agencies, which have been particularly interested in the debt ceiling debate and had stated that the AAA rating of the United States was at risk if lawmakers did not implement meaningful measures to reduce the long-term deficit. Despite passage of the debt ceiling bill, S&P downgraded the U.S. credit rating in early August, which had an immediate impact on the markets, abruptly sending most indices lower. Despite the credit rating downgrade, volatility in equities caused a “flight to safety.” The U.S. dollar and the U.S. Treasury market therefore rallied sharply, sending the 10-year treasury yield to an all-time low of less than 2 percent.
In spite of the negative sentiment that has been evident throughout the year and especially the last quarter, recent economic indicators have been showing improvement. For example, in some of our recent railcar data, shipments of industrial products, iron ore, lumber and wood products all showed modest gains for the year-to-date. In addition, recent weekly container loadings are up 5.5 percent, which is on par with year-to-date growth of 5.7 percent. There also are several examples of improvement on the retail front, with U.S. same store sales rising 5.5 percent on a year-over-year basis and car sales in September moving up to an annual rate of 13.1 million, the best level since April 2011. Additionally, although unemployment remains stubbornly high at 9.1 percent, private sector job growth has been steadily improving. Although we believe that the markets will stabilize in the coming year as economic growth improves and if our political leaders work on a credible solution to our long-term debt concerns, we recognize that a number of concerns remain. The European debt crisis is expected to be a constant overhang, and we are concerned that the “Supercommittee” created by lawmakers as part of the borrowing limit deal to seek to put the U.S. on a path of fiscal responsibility will continue to face political challenges. Until these key issues are confronted and reasonable long-term solutions are adopted, we anticipate continued volatility in the equity markets.
With respect to our portfolios, many of our longer-standing clients are well aware of our key areas of focus, as well as the characteristics we value in our quest to find the best investment opportunities. Due to our emphasis on companies with long product cycles, our restructuring portfolios often have maintained a cyclical bias. Frankly, our dedication to these areas, especially the industrial sector, in recent years has been called into question when markets became volatile and our holdings in the sector detracted from our results. Remember, we do not employ a tactical approach, and our buy and hold investment philosophy allows us to absorb periods of volatility while our long-term thesis remains intact. With respect to many of our industrial holdings, we do not foresee some of the panic and doomsday scenarios that many experts have been forecasting in recent months. Additionally, managements have taken advantage of enhanced liquidity in the credit markets to refinance higher cost debt and/or extend maturity dates. This fact has created a landscape that we believe is vastly different than the 2008-2009 timeframe, when many companies were unprepared to handle the credit crisis. Despite the macroeconomic headwinds, a number of our companies remain optimistic, as they are communicating increasing backlogs, rising cash positions, solid order inquiry, and strong balance sheets. With margins holding steady and capital costs down significantly, we believe that only a slight improvement in sales volumes will lead to strong earnings results for many of our companies.
The long-term catalyst for our fundamental positioning in the industrial sector is our belief that we remain in an improving economic environment, and more importantly, we anticipate an increase in infrastructure spending on a global basis. Developing economies have a substantial amount of pent-up demand for infrastructure as they address the need to accelerate urbanization and increase their standards of living. Capital expenditures remain strong, especially in China, which supports a number of our investments related to transportation, transmission, and power generation. Additionally, we believe that many developed economies will be forced to consider investments as a means to stimulate job growth and upgrade their languishing infrastructure in the near future. Therefore, we believe that a number of our companies should benefit from developments in infrastructure. For example, companies such as A.O. Smith (NYSE:AOS) are already experiencing substantial growth overseas. The water heater equipment manufacturer currently generates close to 22 percent of its revenue from China and India. Revenue from India of $20 million is up from a mere $8 million a year ago. The company also expects to look for acquisitions in developing areas such as Brazil and parts of Africa. Although we continue to recognize the short-term headwinds with respect to the global economy, we believe that many of our industrial companies are well-positioned for international growth and that any weakness in the short-term may offer excellent long-term buying opportunities.
Collectively, the majority of our restructuring portfolios have overweight positions in the energy, materials, and industrial sectors. We have presented a number of reasons regarding our bullish outlook in these areas with respect to valuations and the long-term demand for infrastructure spending. Potentially more significant than these factors is what we are observing in the various shale developments across the U.S. There is a transformational shift taking place in the energy sector, which we believe will have a significant impact on supply and demand for many years to come. The abundant natural gas reserves that are now accessible due to new technology will have a profound impact on a number of related industries. New sources of natural gas and oil will create demand for tank cars. Sand demand for “fracking” will create demand for sand transport. Finally, plentiful natural gas should benefit the U.S. chemical industry. Specifically, to meet anticipated demand, rail car loadings out of the Bakken Shale are projected to increase over 8 times from 2011’s record car loadings. We expect many of our companies to benefit from this transformation and have structured the portfolios with broad diversification across a number of related industries within the energy, industrial, and materials sectors.
Additionally, increased Merger and Acquisition activity, especially in our space where many small, “bolt-on” type deals can be quickly accretive to earnings, has benefited the portfolios over the past year.Companies of allmarket capitalizations are flush with cash, and in a challenging environment to expand organically, many of these companies are looking to make strategic acquisitions in order to grow. Due to our emphasis on focused, often single industry companies, our portfolio companies historically have been highly prone to take-overs. Over the past year we had 6 premium priced acquisitions. Recently, one of our long-term holdings, Petrohawk Energy (NYSE:HK), was taken over at a 55 percent premium and proved to be one of the largest contributors to several of the portfolios in 2011. We continue to be optimistic toward our existing holdings in the energy sector, and the Petrohawk deal vindicated our long-term thesis on the company and our remaining positions in the natural gas industry.
Another positive development in recent months has been the noticeable increase of share repurchases and more importantly, an impressive amount of insider buying. This was especially evident during periods of price deterioration that many of our companies experienced in the third quarter of 2011. Companies of all market capitalizations were buying more stock at any time since the depths of the recession in early 2009. Although insider buying is never a guarantee that an investment is attractive, we believe that no one understands a company better than those that are on the inside. We thus are encouraged when executives are willing to risk their own capital, especially when we similarly believe that valuations are attractive.
In our letter last year, we talked at length about number of opportunities emerging within our primary investment theme – corporate spin-offs. We continue to believe that with continued pressure on corporate board members to enhance shareholder value, a spin-off remains the most tax-efficient, and often the most strategic way of unlocking shareholder value. This year is proving to be the best year for spin-off activity since 2007, and the number of opportunities is expected to grow through the end of the year and into 2012. Although we are intrigued by a number of recent opportunities, we believe that the three-part breakup of ITT Corp., which will take place in the fourth quarter of 2011, looks very compelling. The original ITT was founded in 1920. From 1960 to 1977, with Harold Geneen at the helm, ITT acquired more than 350 companies – at one time securing deals at the rate of one acquisition per week. ITT’s portfolio of companies included well-known businesses such as Sheraton Hotels, Avis Rent-a-Car, Hartford Insurance and Continental Baking, the maker of Wonder Bread. Under Geneen’s management, ITT grew from a medium-sized business with $760 million in sales to a global conglomerate with $17 billion in sales. In 1995, ITT split into three separate independent companies: ITT Corporation, which was focused on the hotel and gaming businesses, ITT Hartford which became a stand-alone insurance operation, and ITT Industries, which started as a collection of manufacturing companies (which subsequently changed its name back to ITT Corporation). On January 12, 2011, ITT Corporation announced its plans to separate into three independent publicly traded companies by the end of the year: ITT Corporation (NYSE:ITT) – Industrial Products, Xylem Inc. (NYSE:XYL) –Water Products and Services, and Exelis Inc. (NYSE:XLS) – Defense and Infrastructure Solutions. While we have conducted research on all three components of the restructuring, we believe two of the three opportunities to be the most compelling and expect to establish positions soon after the spin-offs are completed.
Although we remain cautiously optimistic that the economy will continue to slowly recover, we understand that a number of hurdles remain. We talked last year about the lack of confidence that existed in equity markets in general, and this continues to be a factor in today’s environment. The severe day-to-day volatility is unsettling for even the most experienced investor, let alone a retail investor that may be dealing with anemic equity returns in their portfolios after experiencing the result of two major recessions in the past ten years.We also believe that a change in the political landscape (i.e. less regulations and controlled Federal Government spending) will result in job growth and increased consumer confidence. It is our view that this period is very reminiscent of the late 1970’s and the period after World War II – both subsequent time periods experienced improved stock market performance. Unfortunately, the uncertainty in Washington and the constant volatility in equity markets appears to have caused most investors to be positioned for the worst possible outcome. One of the few benefits of this mentality is that it potentially creates a plethora of excellent long-term opportunities. This type of dislocation in the marketplace, in our view, is in essence the foundation of active management, and we will seek to exploit these inefficiencies by finding the best opportunities for our portfolios. However, we believe that more clarity in Washington and stability in the equity markets would be a positive long-term development for everyone involved in our business, and most importantly, the shareholders of our funds.
Thank you for your continued commitment to the KEELEY Funds.
John L. Keeley, Jr.
President and CIO
There are risks associated with investing in small-cap mutual funds, such as smaller product lines and market shares, including limited available information. You should consider objectives, risks and charges and expenses of a fund carefully before investing. Additional information regarding such risks, including information on fees is located in the Fund’s prospectus. Please read the Fund’s prospectus carefully before investing. Past performance is no guarantee of future results.
The opinions expressed in this letter are those of Mr. Keeley, and are current only through the end of the period of the report as stated on the cover. Mr. Keeley’s views are subject to change at any time, based on market and other conditions, and no forcasts can be guaranteed.
Dear Fellow Shareholder,