Much of the momentum that equities experienced in the 4th quarter of 2011 carried over into the new year, as most major indexes produced some of their best quarterly returns ever. Although the monthly returns for domestic markets were slightly less robust in March than in the first two months of 2012, they remained positive. While the debt restructuring in Greece continued to garner headlines, economic data released for the U.S. economy in the first quarter was largely positive. Most notably, the employment situation showed signs of improvement, with the unemployment rate falling to 8.3 percent after hitting 10 percent in 2010. Domestically, there were continued signs of moderate economic recovery: Auto sales, retail sales and pending home sales all showed improvement. Manufacturing output grew, and durable goods orders increased. However, the rising price of energy presents a growing concern to the economic recovery. Oil and gasoline prices rose significantly in the quarter due to a combination of supply constraints and an increased risk premium. The U.S. sanctions program on Iran has constrained supply from that country, while supply disruptions in Syria, Libya, and Sudan, resulting from civil conflicts, have also been significant. The combined effect has tightened oil output, and although other producers are attempting to make up the difference, this effort has not been completely successful. In spite of the rising price of oil, the U.S. economy appears to be growing at a moderate rate, with economists forecasting Gross Domestic Product (GDP) growth of 2 percent in the quarter ahead. Even so, Fed Chairman Bernanke remains cautious and has signaled that the plan to keep interest rates near zero for as many as three years is still required to maintain economic momentum.
Although uncertainty remains with respect to rising energy prices and the sustainability of the recovery without central bank intervention, we continue to see positive fundamentals developing within many of our companies. The majority of our holdings continue to experience positive quarter-to-quarter earnings and revenue growth, productivity gains and strong outlooks. However, loftier valuations, peak profit margins, and more recently an increase in insider selling, are legitimate reasons to pause and in some cases reduce our exposure to positions with higher valuations. For example, although we continue to favor the industrial sector - in many portfolios it represents our largest relative weight – we are consistently using strong performance in the sector as a source of cash for new ideas. Later on in the commentary we will discuss some of the new opportunities within corporate restructuring where this cash is being deployed, but one area that has picked up noticeably in a few of our portfolios is financials. For example, the Small Cap Value Fund ended the first quarter of 2012 with an overweight position in the financial sector against the Russell 2000 Index for the first time since 2003. Historically we embraced the sector, especially Savings & Loan and Thrift conversions, which can offer heightened transparency, a less complex business plan and calculated exit strategies. Looking back at the Small Cap Value Fund in the early 2000's, exposure to financials was commonly over 30 percent of the value of the portfolio, with significant exposure to S&L's. Due to the financial crisis, S&L conversion activity went dormant for a number of years, as the remaining companies in the sector grappled with insufficient capital, poor loan portfolios and bleak growth prospects. Although looming regulatory changes remain a concern, we recognize that vast improvements have been made and we believe many companies may be poised to benefit from the restructuring that has taken place throughout the sector.
In a number of our quarterly commentaries as well as our shareholder reports, we have talked at length about our anticipation of more opportunities in our restructuring investment themes, notably corporate spin-offs. Recent developments within corporate restructuring as well as the increasing appetite of companies to pursue strategic mergers and acquisitions have been increasingly positive over the last two quarters. In 2011, spin-off activity was the highest it has been in over 10 years. Although a number of the 47 announced spin-offs were international, nearly 25 were domestic, providing our research team with an attractive opportunity set of ideas to consider. We believe our knowledge and enthusiasm toward this area of inefficiency is well-documented, and the value proposition of this theme continues to present itself. Examples of recent spin-offs include Suncoke Energy (NYSE:SXC), an operator of metallurgical cokemaking facilities, which was recently spun-off from Sunoco Inc. (NYSE:SUN). We anticipate strong growth opportunities as the stand-alone company is no longer capital constrained, given its parent company's lack of interest in growing the cokemaking side of the business. Additionally, international growth opportunities are now more relevant as the company seeks to partner with multi-national steel producers to provide coke for their steel mills. We believe the company's prospects are misunderstood by the market, and as a result we believe the company is currently underfollowed by sell-side analysts. Marriott Vacations Worldwide (NYSE:VAC) was another recent purchase after being spun-out of Marriott International (NASDAQ:MAR). Marriott Vacations Worldwide is the second largest (behind Wyndham) developer, marketer and financier of timeshare properties. It has over 400,000 owners of its properties in 64 resorts operated under the Marriott Vacation Club, Ritz-Carlton Destination Club, and Grand Residences by Marriott brands. The business has four inter-related revenue and profit streams: the development and sale of timeshare resort properties, the financing of those sales, the management of the resorts, and the rental of unsold or unused inventory. We believe Marriot Vacations offers the two things that can make for significant outperformance in a spin-out: margin improvement potential and a deeply discounted valuation. We believe that both of these factors will improve over the next several years, and an improving economy can be a significant catalyst to boost valuations. Frankly, we believe the stock has performed extremely well since being spun-out late in 2011, and while we remain optimistic long-term, the stock price has already exceeded our short-term expectations.
One surprise in 2011 and also in early 2012 has been the lack of Mergers and Acquisitions (M&A). With an abundance of cash on corporate balance sheets and the need to grow, we expected a substantial number of M&A announcements over the past year. Although many of our companies have made a number of small, "bolton" acquisitions and participated in alliances and joint ventures, larger deals have been slower to develop. We believe economic uncertainty and the lack of policy direction from Washington are the major culprits for the lack of mega deals. With that said, we believe that companies will continue to look for ways to expand their footprint and create long-term strategic value, which should encourage more M&A activity in the near future.
Given the economic environment over the last several years, we have also been surprised by the lack of opportunities of companies emerging from bankruptcy. Although we have capitalized on several ideas in this theme, the number of opportunities has been surprisingly scarce. One issue is that credit has been accessible at extremely favorable rates, which has allowed a number of debt-laden companies to extend maturities and refinance – potentially avoiding bankruptcy in the near-term. Additionally, many recent filers are simply troubled companies, such as Hostess Brands, which are making their second trip through the process. Although we examine every opportunity within this theme, we believe many companies (airlines would fit the bill here as well) often have broken business models that we do not view as attractive long-term investment opportunities. We have also seen a number of liquidations over the years, such as Borders Group, Circuit City, and Linens & Things. Although idea generation here has been limited, we expect acceleration in this area in the future, and as mentioned previously, over the last few years we have identified a few attractive ideas, such as CIT Corporation (NYSE:CIT) and Chemtura. We believe both companies have strong long-term outlooks. After CIT emerged from bankruptcy, it transitioned from a specialty finance company funded in the capital markets to a bank funded with deposits. While we anticipate that the asset side of the company will always be a bit different than most banks, we believe the liability side of the balance sheet should be more stable and fund the company at a lower cost. Assuming this transition is successful, we believe CIT should garner a much higher valuation and potentially higher than the 1.3-1.6x book value it traded at in the past. The stock has been a successful holding in our Mid Cap Value Fund, and we continue to believe the company has substantial upside from current levels. Chemtura (CEM), a maker of specialty chemicals, emerged from bankruptcy in late 2010, and while the stock has not made a material move since our purchase, we continue to believe in the company's long-term prospects. Rising raw materials costs, increasing litigation-related expenses, a high degree of leverage, and the global economic slow-down combined to drive Chemtura into bankruptcy in March 2009. It emerged with a lower debt burden, a slightly better product portfolio, and some resolution to its environmental and litigation liabilities. The company still suffers from below average profitability due to some lag in raising prices to offset recent increases in raw materials costs. As the price increases roll in, we expect earnings to recover. Even after this, we believe Chemtura has a meaningful opportunity to improve margins as its profitability is well below peers in similar businesses.
In conclusion, while we recognize the volatility in today's market environment, and are admittedly often frustrated by it, it is our view that the positive developments that have occurred in recent years are difficult to ignore. Low, but positive economic growth combined with easy monetary policy has allowed many companies to recover from the depths of the recession, and the low interest rate environment has provided the ability to restructure and strengthen their balance sheets. One issue that has lingered for much longer than we anticipated is the lack of investor participation in equities. Given the strong move in stocks since the lows in 2009, we would expect that investor confidence would improve. Interestingly, that has not happened, and investors continue to display a strong appetite for bonds and bond funds, despite their anemic yields and potential of future capital losses. Unnerving volatility, limited equity returns over the past decade, and growing skepticism of Wall Street and the financial system in general may be a cause of this reluctant behavior. While this is unfortunate for both professional and retail investors, we know that equities provide meaningful long-term upside potential, and we eagerly anticipate an improvement in investor psychology, which should lead to the eventual rotation from bonds to stocks. Although changing demographics is one factor that may prolong this transition, we continue to believe a conversion will ultimately take place and that will be another strong catalyst for equities. Here at Keeley, we are obviously reminded of the global macroeconomic headlines on a daily basis, but our experience has taught us many lessons, one of which is that volatility often provides some of the best opportunities to identify value. When stocks are sold off indiscriminately due to macroeconomic fears, the market often ignores the underlying fundamentals and the many positive developments reflected in a company's results. It is our job to uncover these opportunities regardless of market headlines or volatility. In general, we have been pleased with improvements in the economy and our absolute returns over the past six months. However, in some instances our relative performance has not met our expectations. We recognize our responsibility to shareholders to grow capital but also to preserve it during more challenging investment environments. Our long-term track record demonstrates our success in doing so, and with continued focus on fundamental, bottom-up research, we expect our time-tested investment process to produce improved results in the future.
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 Funds' prospectus. Please read the Funds' 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 forecasts can be guaranteed.