Despite a number of fearful macroeconomic headlines that caused many investors to position themselves conservatively, much of the past six months has proven to be a strong period for risk assets. Equities rose sharply in the face of uncertainty over a hard landing in China, the European sovereign debt crisis, and the “fiscal cliff” here in the United States. Despite double digit returns for most equity indices, it appears that many investors continue to question the recovery. Moreover, trends in overall mutual fund cash flows indicate these investors continue to watch the market climb the “wall of worry” and remain hesitant to commit their capital. We believe this trend continues to be an indirect catalyst for future growth as investors should eventually capitulate and move from low yielding cash and bonds to equities. Frankly, it is hard not to question the amount of money that has poured into fixed-income funds since 2007 (over $1 trillion) given the low interest rate environment we find ourselves in today. I plan on returning to this topic later in my comments, but I wanted to address it early since I think it may continue to be an important catalyst in support of equities along with a continued economic recovery.
From an economic perspective, the recovery in the U.S. has continued, albeit at a somewhat sluggish pace. There have been a number of positive announcements more recently such as a rise in consumer spending, lower unemployment, increased factory orders and higher retail sales. In addition, the housing sector continues to show increased strength as reports of housing starts, existing home sales, and housing prices have all exceeded expectations and produced year-over-year growth. Another positive surprise was the lack of an impact that the debate over the fiscal cliff had on the economy. Although the corresponding tax increase reduced personal income and may create further long-term drag, consumer spending remained strong, and the recovery seems to be progressing smoothly. Similarly, the sequestration spending cuts that took effect in early March seem to have had minimal impact on the economy as well. With that said, it is still too early to evaluate the full long-term impact of the cuts as they will be implemented slowly over time.
Although the U.S. recovery has been broad based and appears to be driven by fundamentals, a number of risks remain. The impact of a potential breakdown in the current bipartisan cooperation in Washington, and the long-term consequences of the Federal Reserve’s experiment with Quantitative Easing (QE) are largely unknown. Globally, Japan is undergoing a massive easing experiment of their own to try to weaken the Yen in an attempt to win a decade-long battle with deflation. Other major economies (primarily in Europe) continue to struggle with growth and frustration continues to mount as the populace of those countries struggle under the pressure of the stifling austerity measures placed upon them. Essentially, Europe was the primary drag during a period with a great deal of optimism. The developments in Cyprus early in 2013 were a stark reminder that some unpredictable uncertainties may remain.
Clearly, the environment for equities over the past six months has been extremely productive, and our portfolios have posted strong results over that time period. While certain aspects of the Fed-induced low interest rate environment have been controversial, it is clear that their policies have had a positive impact on the markets and created more confidence due in large part to the “wealth effect” generated by rising stock prices, an improving housing market, and easier access to credit.
While a great deal of attention has been focused on the Federal Reserve’s impact on consumers, we have witnessed massive improvement in corporate balance sheets since the depths of the recession. Corporate profits now stand at record levels relative to GDP, and it is no secret that companies have taken advantage of the low interest rate environment to “clean up” their balance sheets by retiring or refinancing debt, and many of them now have significant cash balances. Although we are puzzled as to why this has not created more buzz on the Merger and Acquisition (M&A) front, improvements in corporate profitability and balance sheet enhancements have been key factors in the economic recovery. Our strategies that focus on corporate restructuring are commonly involved in more complex financial situations where debt is often a facilitator of much of this activity. One can easily recognize that the low interest rate environment has provided a strong tailwind for many of our companies that went through restructuring during or before the 2009 economic crisis by allowing them the financial flexibility to manage debt more effectively. The current environment has been an incredible time for companies to restructure existing debt and/or potentially use new debt to fund strategic growth opportunities. Economic recessions often create a plethora of restructuring opportunities, as companies are forced to reassess their business strategies in a rapidly changing environment. This is exactly what we have witnessed since 2009, and regardless of how one may feel about the Federal Reserve and Ben Bernanke, cheap credit has been instrumental in this process. I can remember back when the debt loads of some of our companies were viewed with disdain during the depths of the recession, and the stock prices of those holdings were punished accordingly. Strong companies with good cash flow such as DineEquity (NYSE:DIN) were left for dead in that environment and have turned out to be some of our best investments since that time. Ashland Inc. (NYSE:ASH) was another, as their acquisition of Hercules Inc. in July of 2008 proved to be ill-timed due to the amount of debt that Ashland assumed in the transaction. That stock suffered a similar fate as DineEquity, falling to below $10 a share in 2009 but has since been one of our best performers, setting new highs in the first quarter of 2013 at over $70 per share. Although it was painful to endure many aspects of the “Great Recession” in 2008 and 2009, we learned a number of valuable lessons from the experience, and now believe the “light at the end of the tunnel” is within view. The performance of many of our positions provide evidence of this improvement.
When credit was scarce after the downturn, much of the activity in our space was suppressed for a number of years. Today, we perceive a great deal of pent-up demand, and we anticipate companies to seek financial engineering to foster growth. Companies that may have been reluctant to make a small, “tuck-in” acquisition are now poised to use their renewed balance sheet strength and the low-cost financing available to make acquisitions happen. A healthy credit environment also places more pressure on companies to unlock hidden value inside their own businesses. We believe that this is why we are seeing a number of headlines where activist investors are becoming more vocal in their displeasure over management-driven actions. We believe that they see the value in companies and realize that in this environment there are few viable excuses as to why a company should not attempt to realize that value. We further believe these are all elements where the Federal Reserve’s policies have been beneficial to equities. We would agree that the timing and impact of the Fed’s QE endeavor remains unknown and certainly could have negative consequences in the future. However, our job is to identify the best investment opportunities in our universe of corporate restructuring, and we believe many companies have taken advantage of what the market is offering them and have become strategically positioned for the present and future. We view this is an element that the market has simply underestimated. And despite the unknowns with respect to the future, we are comforted by the fact that many companies are much better positioned in case the economic environment slows. During conversations with many of the Funds’ long-term holdings since the recession, all of them recall the difficulties they encountered just five years ago, and they want to make sure they don’t find themselves in that type of situation again. This may be one factor as to why the larger M&A deals recently have been scarce. Other than a brief uptick in the fourth quarter of 2012, where companies may have been rushing deals to avoid potential changes in the tax code, there have been a limited number of mergers. As mentioned earlier, this has us puzzled given that many companies may be able obtain financing below the projected growth rate of an acquisition target. Again, we can speculate on the reasons, which may include uncertainty in Washington, a rapidly evolving and changing global economy, and the desire to hold cash in case credit markets freeze up again. Although we are surprised by the lack of M&A activity, we believe the current interest rate environment has had a number of positive effects on the economy. We perceive the evidence of such benefits in a more granular fashion when looking at the balance sheets of the Funds’ holdings and prospective new opportunities.
Overall, we were pleased with the Funds’ performance over the past six months on both an absolute and relative basis. Most importantly, stock selection played a significant role in the Funds’ returns for the most recent quarters ended in 2012 and 2013. We would always prefer to have the Funds’ outperformance generated by our selection of stocks that perform better than those selected by our peers and included in our benchmarks. We have believed for quite some time that the market environment would eventually favor our process where low cost capital has the ability to foster event driven restructuring. The additional number of spin-offs in 2011 and 2012 and the noticeable increase in M&A activity late last year was evidence that cheap financing may very well be providing opportunities for our portfolios. Given the Federal Reserve’s well publicized communication to keep interest rates low, and global central banks now in a coordinated effort to boost liquidity, we see few reasons why M&A and other forms of growth driven by financial engineering will not continue in the remainder of 2013 and beyond. Additionally, as I mentioned at the beginning of this Letter, flows into equity mutual funds are improving. We continue to believe this trend will persist. With Corporate America flush with cash, which could provide more flexibility to pursue share buybacks and dividend increases, we believe the case for stocks versus bonds is very compelling. Should interest rates move higher, fixed income investors stand to potentially suffer losses in an asset class of perceived safety. Consequently, we are optimistic that these catalysts will provide a strong tailwind for our portfolios as we head into the second half of 2013. We hope you have been pleased with the recovery in the Funds’ returns in recent years, and we certainly appreciate your patience and devotion to our investment approach during this unprecedented period in the history of the equity markets.
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 and mid-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 limited volume, maybe subject to more abrupt or erratic price movements than larger company securities, and may be subject to changes in interest rates. 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. 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.