In the fourth calendar quarter of 2015, the KEELEY Small Cap Dividend Value Fund (KSDVX, Financial) rose 2.87 percent compared to a 2.88 percent increase for the Russell 2000 Value Index. After a challenging third quarter, equity markets rebounded to post positive gains in the fourth quarter. However, many of the factors that weighed on markets throughout 2015 remain, and will most likely play a key role in 2016. The volatility in energy prices continued, and the situation may become even more volatile as companies succumb to the pressure of sustained low energy prices. China’s slowing growth is also having a spillover effect on the global economy and has placed additional pressure on the beleaguered energy sector. The decision by the Federal Reserve to finally end their run of monetary excess was welcomed by the markets, and we hope the decision will allow investors to finally place greater focus on company fundamentals going forward. One bright spot in recent years has been the U.S. consumer. Many factors point to continued momentum from the consumer, as employment growth, strength in housing, improving balance sheets, and an uptick in consumer confidence were all positive elements in the fourth quarter. The Small Cap Dividend Value produced results that were basically in-line with the Index during the quarter. Despite some positive data points for the consumer, the consumer discretionary sector was one of only two sectors that produced a negative return during the quarter. The sluggish energy sector was once again the worst performer. Technology, a leader in recent years, rebounded nicely in the fourth quarter and was the best performing sector in the index. The industrial sector had the best impact on our results during the quarter, where both sector allocation and stock selection made a positive impact. Despite an underweight to health care, which was the second best performing sector in the index, strong stock selection allowed that sector to make a positive contribution to our results. The consumer discretionary sector proved to be one of the few detractors, as both an overweight and stock selection detracted during the quarter.
The Fund's top performing position was National Storage Affiliates Trust (NSA, Financial) which climbed over 26 percent and added 47 basis points to our results. The company reported better than expected earnings on higher revenue driven by new properties and strong operating performance. Same-store net operating income (SSNOI) grew low double digits during the quarter surpassing peer results. Occupancy improved but the company has work to do there as they still lag peers in this metric. As a result of these strong numbers the company raised full year guidance which also had a positive impact on the share price during the quarter.
The Fund’s second largest contributor was John Bean Technologies (JBT), which increased over 30 percent and added 42 basis points of performance to the Fund. The provider of solutions for food processing and airport transportation continued its impressive string of exceeding earnings estimates by delivering results in the third quarter that were 12 percent ahead of expectations. The company continues to see strong FoodTech sales and they also made an accretive acquisition of A&B Process, which makes fluid food equipment.
The largest detractor during the quarter was LegacyTexas Financial Group (LTXB, Financial) which declined over 17 percent and cost the Fund 31 basis points of performance. LegacyTexas reported a disappointing third quarter earnings release due primarily to higher loan loss reserves. Although none of these were related to exposure to energy, there continues to be a perception that the company may face longer-term issues as oil approaches $30 a barrel.
The second largest detractor was Marriott Vacations Worldwide Corp. (VAC, Financial) which fell over 16 percent and cost the Fund 28 basis points in performance. Despite a number of business channels remaining strong, such as their resort management, rentals, and financing businesses, lower revenue and a stronger U.S. dollar had a negative impact on their earnings. The company also lowered its sales guidance placing additional pressure on their shares.
Going forward, we generally feel the same about the market as we did a year ago. Namely, we think the market will be pretty flat this year. When we look at the drivers, earnings and valuation, neither look all that compelling. The S&P 500 Index trades at 16.3x next twelve months earnings (NTM EPS). That is a little above its average since 1999 of 15.8x. As a result, multiple expansion could go either way.
Unfortunately, the P/E is based on EPS expectations that still look a little too high. Consensus has S&P 500 EPS growing 8 percent in 2016. That is a pretty big pick-up from the flat earnings in 2015, so it will probably come down. In fact, most years earnings expectations do come down throughout the year. Last year at this time, analysts forecast EPS growth of 9 percent for the S&P 500 Index so the decline in expectations was more severe than usual. In order to get comfortable with the idea that EPS won’t really disappoint, we have to be able to support the idea that earnings will grow at about 5 percent this year. Where will that come from?
The first factor that should not impact earnings expectations as much in 2016 as in 2015 is energy. Roughly 56 percent of the decline in earnings expectations for the S&P 500 (from 9% growth expected at the beginning of the year to flat results expected now) came from falling expectations for earnings from energy companies. While earnings will be probably be lower for the sector in 2016 (and could go negative), they only represent 4 percent of S&P 500 Index earnings so the impact is likely to be less. In the S&P 600, declines in energy earnings accounted for 29 percent of downward revision and the sector is now expected to lose money.
The other factor that was a headwind for earnings in 2015 that will probably not have as big an impact in 2016 is currency. Since mid-year 2014 the Euro has fallen 21 percent against the dollar. Some currencies have done better, but depending on how much revenue a company was getting from overseas sales, this could have been a 5%-7% impact on revenues and a drag on earnings as well. With FX flattening out in the second half of 2015 this looks like it will not be as big a drag in 2016. On the other hand, global economic growth looks like it is slowing on balance. In the US, growth seems to be slowing, but remains positive. China is still looking for a bottom on its growth rate and 2016 will likely be slower than 2015. On the other side of the ledger, Europe may improve.
In summary, the market (as measured by the S&P 500) looks reasonably priced at year end and has become more attractive from a valuation standpoint since then. Small-cap is more attractive than large and is more attractive on a relative basis than it has been for almost all of the last ten years. Additionally, value is more attractive relative to growth. Lastly, earnings expectations are too high (as usual this time of year), but some of last year’s headwinds should not have as great an impact going forward. On the other hand, economic growth looks a little harder to come by this year and the stock market swoon at the start of the year probably will not help. Although this could potentially be a challenging time for equity investors in the short-term, the Fund has historically performed well in these environments and we are pleased to see valuations come down in our universe of stocks. We expect any enhanced volatility coupled with better valuations will provide some attractive opportunities in the future. Thank you for your support of the Small Cap Dividend Value Fund.
