John Keeley Annual Letter to Shareholders
Over the past year, we have been pleased with our relative and absolute performance, and even more pleased with the improvements our Funds have made in a difficult economic environment. Our portfolio companies have effectively navigated some of the headwinds of a slow growth environment and maintained impressive margins through effective cost cutting and other strategic initiatives. Corporate restructuring is the cornerstone of our investment process and in slow growth environments we expect companies to consider restructuring and other forms of financial engineering to manufacture growth. A good example of an industry that has experienced massive restructuring is homebuilders. From a macroeconomic perspective, the long-awaited housing recovery has finally arrived with improvement in a number of measures, such as increases in prices and permits, a substantial decline in inventory, and momentum in new and existing home sales. Each of these developments have a direct benefit to the homebuilding industry, where the larger, publicly traded companies have gained significant market share due to the loss of smaller local players during the peak of the downturn. At a company specific level, we have been impressed with PulteGroup (PHM), Toll Brothers (TOL) and Lennar (LEN). The swift collapse in demand forced each of these companies to undergo significant restructuring. Like many of our holdings in this low interest rate environment, many companies in this industry have beneficially refinanced a substantial amount of debt and strengthened their capital structures. They have also improved their inventory of homes by liquidating poorly performing holdings, and strengthened the performance of many existing communities. With a leaner structure, reduced costs, and an increase in demand, we continue to believe the industry has substantial upside. Lastly, after a substantial plunge in 2008 and 2009, new home starts are beginning to climb off decade lows, which we believe is a significant catalyst for future gains and momentum. However, despite our long-term enthusiasm for the industry, near-term valuations are stretched at current earnings levels, and we responded by reducing exposure to some positions during the most recent quarter.
From a portfolio positioning perspective, a number of notable changes have occurred over the past year. Although we will never waver from our bottom-up, fundamental approach to security selection, the market volatility that has persisted since the downturn in 2008 has caused us to place more emphasis on portfolio construction in recent years. More specifically, we focused heavily on how such construction can impact the overall volatility in our portfolios. In an over 35 year career of managing a multitude of portfolios and 19 years directing our longest-tenured mutual fund, the Keeley Small Cap Value Fund, I have always understood that preservation of capital is of the utmost importance. During the challenges of 2008 and 2009, we recognized that some of our industry and sector concentrations were factors in our relative underperformance. The results that you experienced over the past year are driven from not only good stock selection, which will always be the key driver of our results, but also from good sector allocation and, most importantly, what we believe is a more balanced portfolio. For example, the Keeley Small Cap Value Fund held over 25 percent of its positions in financials as of the end of the third quarter, which was our highest weight in the sector since 2003. Additionally, the weight in financials is also higher than our weight in industrials, also for the first time since 2003. This is in stark contrast to the past five years, where industrials commonly represented more than 30 percent of the Fund and our financial weight was often in the low-to-mid teens, even reaching an all-time low of less than 10 percent of the Fund in the third quarter of 2008. Historically we embraced the financial sector, especially Savings & Loan and Thrift conversions, which offer heightened transparency, a less complex business plan, and calculated exit strategies. 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 onerous regulatory changes remain a concern, we recognize that vast improvements have been made and we believe that many companies are poised to benefit from the restructuring that has taken place throughout the sector. We believe this says a number of things about our outlook with respect to the sector and the way we are looking at the portfolio in general. First, we are excited to see what we consider to be more attractive opportunities in the financial sector, an area where we have delivered strong outperformance in the past. Second, we believe that the past year is also indicative of the type of balance you will see in our portfolios going forward. Working closely with Assistant Portfolio Manager Brian Keeley and the other members of our research team, we have paid deliberate attention to risk and our ability to deliver strong risk-adjusted returns and, most importantly, improve our downside capture ratios. Although we will continue to direct our research process to identify the best opportunities regardless of economic sector, we believe that paying more attention to correlation and risk versus reward, and how such risks impact the portfolio as a whole, can have a meaningful long-term benefit on our returns.
With respect to our investment process of corporate restructuring, activity appears robust. The lack of credit in the early 2009 period caused a slow-down, but spin-off activity has been plentiful in recent years. In our March 31, 2012 Semi-Annual Report, we discussed the strength in the number of spin-offs in 2011, which provided our research team with the largest number of spin-off opportunities since 2003. Much of that momentum has continued in 2012, with a number of companies making attempts to unlock shareholder value through corporate restructuring. While spin-offs will always be a significant part of our portfolio we often become enthusiastic over “new” forms of restructuring that often evolve in challenging economic periods. For example, over the past year, we have witnessed a new wave of restructuring where asset-rich companies convert to Real Estate Investment Trusts (REITs) in a strategic move that can attract income-seeking investors. Our portfolio has benefited from this trend, and it is yet another example of our process of identifying unique opportunities in restructuring. In a slow growth environment, companies have even greater motivation to seek strategic alternatives that could improve efficiency or enhance public market valuations. A few companies that announced this form of restructuring are Gaylord Entertainment (GET), Iron Mountain (IRM), Lamar Advertising (LAMR), and Corrections Corporation of America (CXW). Typically, the primary cause for this move is to boost investor interest, especially in an environment where income becomes paramount. In a REIT structure, companies are required to distribute 90 percent of their taxable income to investors. The move to a REIT structure could also provide tax advantages to the companies as well. We view these types of conversions favorably. We believe the move to a REIT structure can maintain the growth potential of the company while at the same time attract a new shareholder base that will appreciate the transparency and consistency of regular income distributions. We anticipate more companies considering this strategic alternative, especially if market volatility and low interest rates persist.
Despite an investment backdrop that has been surrounded with fear and anxiety, we have remained committed to our time-tested approach and have been fully-invested in the face of this uncertainty. We have been pleased with our investment results over the past year and we were certainly happy to reward many of our patient shareholders with strong relative outperformance over that time period. With that said, we recognize that our work is not done, and a number of uncertainties remain.
The recession in Europe and slower growth in China and the U.S. will continue to be a drag on the long-term economic outlook. The looming “fiscal cliff” will also be a significant hurdle regardless of who wins the election in November. Although we expect politicians to delay a significant tightening in the short-term, we also recognize that any action may have a slight negative impact on GDP growth. However, a number of positive developments provide significant optimism from a macroeconomic perspective. We have already discussed our enthusiasm toward housing-related businesses, and the prospect of a continued recovery there should have a positive impact on U.S. households going forward. Monetary policy continues to be accommodative, and unlike the first rounds of Quantitative Easing (QE), this last round was communicated with unlimited duration. This could continue to provide a boost to risk assets, and also provide momentum to the recovery in housing. With interest rates expected to remain low through 2015, it is our view that equities will continue to offer an attractive alternative to low-interest rate bonds, which also carry the significant risk of capital losses in the future when interest rates rise. Regardless of the macroeconomic picture, our focus remains on identifying the best possible investment ideas in our universe of stocks. Our philosophy is based upon the belief that companies will unlock value through corporate restructuring or other catalysts and that this type of financial engineering will drive earnings despite any potential macroeconomic headwinds. Additionally, our companies have done an impressive job of maintaining margins and subsequently producing strong earnings in a slow growth environment. Although we have concerns regarding slowing top line growth, we also recognize that even subtle relief to the top line would produce another expansion in margins. These elements coupled with a still skeptical retail investor have created an environment of fear, which to a large degree has allowed our team to uncover attractive opportunities with compelling valuations. Strength in the equity markets over the past year surprised many, proving that fear and uncertainty often provide opportunity. Our process is designed to thrive on change and uncertainty, which was a primary driver in our ability to identify mispriced opportunities that positively impacted our results over the past year. We anticipate much of the uncertainty and hesitation that has been in the market over the last few years to endure, giving us optimism in our ability to capitalize on these mispriced opportunities in the coming year as well. I appreciate your confidence in our expertise to deliver long-term capital appreciation on your investment, and thank you for your patience and loyalty in an admittedly challenging environment for all investors.
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. The risks of investing in REITs are similar to those associated with investing in small-capitalization companies; they may have limited financial resources, may trade less frequently and in a