In the first calendar quarter of 2016, the KEELEY Small Cap Value Fund (KSCVX, Financial) increased 0.71% compared to a 1.70% rise for the Russell 2000 Value Index. The year began under a rather ominous cloud in January as U.S. equity markets faced tremendous headwinds. The S&P 500 Index, which dropped by 9% from the end of last year through January 21, recorded its worst start to a year in the history of the Index. Fortunately, the environment quickly reversed course following the European Central Bank’s announcement to expand its stimulus efforts against low inflation. In addition, the Bank of Japan’s surprise interest rate cut (to negative territory), helped turn around the declines seen early this year. In the U.S., market participants scaled back their expectations for the number of interest rate hikes this year as the Fed observed tepid GDP growth and continued low inflation. Further, the news from China remained subdued.
U.S. equity markets strengthened during February and March, closing the quarter in positive territory. However, there was wide dispersion among the various sectors during the quarter. Within the Russell 2000 Value Index, sector performance ranged from -9.0% (Health Care) to 12.3% (Utilities). Within Health Care, market cap size seemed irrelevant as a number of large cap companies reported negative earnings guidance. This downward pressure negatively impacted small cap stocks in the Index; however, the Fund’s health care positions were able to protect the downside through positive stock selection and a relative underweight.
In concert with the global economic concerns, market participants moved from riskier sectors into more defensive sectors such as Utilities. The Utilities market which had lagged in 2015, attracted yield-seeking investors in the first quarter of 2016 and has garnered further attention following a risk-off investment environment.
Another noteworthy factor in the quarter is that value outperformed growth. Last year, the spread was strongly in favor of growth as has been the trend in recent years. Large cap also outperformed small cap for the fourth quarter in a row.
In the first quarter, wide performance dispersion among the various sectors both helped and hurt the Fund. Overall sector allocation helped performance, but it was not enough to overcome the negative stock selection effects. From a sector allocation perspective, the Fund benefited primarily from a relative overweight in Materials and an underweight in Financials; however, weak stock selection in both of these sectors pulled performance down.
In terms of overall stock selection, the Fund benefited from strong stock selection in Industrials, Energy, Utilities and Health Care. The Fund has held a significant overweight in Industrials over the past year, and this quarter both our overweight and strong stock selection made it the leading contributor. This was followed by our Energy exposure, which benefited from positive stock selection and has been a relative underweight since late 2014.
The Fund’s outperformance in Industrials this quarter was led by Enpro Industries (NPO, Financial) and Generac Holdings (GNRC, Financial), two of the Fund’s leading stocks. EnPro, a manufacturer of products engaged in sealing applications, bearings, compressors and engines, rose over 30% in the first quarter. The company announced that it has reached a settlement with the current claim committee regarding asbestos claims against its bankrupt subsidiary, Garlock Seal. Legal costs over the past six years, which have amounted to $26 million, should begin to subside. Reconsolidating Garlock in the first quarter of 2017 will help broaden the appeal of what we feel is very good company trading at an attractive multiple.
Generac (GNRC, Financial), a designer and manufacturer of electric generators and engine powered products rose over 20% this quarter. In February, the company reported strong fourth quarter results and offered solid 2016 guidance. Additionally, guidance is conservative and does not assume a return to normal levels of power outages. We believe their core business is performing well and upside is capable via ‘normal’ weather events.
Health Care was the worst-performing sector for the Russell 2000 Value Index this quarter, but one of our leading positions helped protect against the sector’s decline. Alere (ALR, Financial), a manufacturer and marketer of consumer and professional medical diagnostic products, rose over 25% in the first quarter after announcing that it would be acquired by Abbott Laboratories (ABT, Financial) for $56 per share.
As mentioned, our stock selection in the Financials sector this quarter was one of the main drivers of our relative underperformance. Even though the Fund has maintained a relative underweight in the sector, a number of holdings detracted from overall performance. Life insurance company American Equity Investment Life (AEL, Financial) dropped over 30% during the quarter and was the Fund’s leading detractor. The company’s investment portfolio is highly leveraged and exposed to a high yield energy credit that has not fared well in recent history. In addition, a recent Department of Labor ruling will likely impact business, affecting sales of their largest product. Concerns over its exposure to high yield energy credit, continued low interest rates, plus the potential negative impact of the Department of Labor ruling has pressured the stock.
Poor stock selection in the Materials sector also hurt performance this quarter. KapStone Paper and Packaging (KS, Financial) dropped over 35% as the company announced a major earnings miss due to downtime and difficulty restarting their Charleston mill. Additionally, recent weakness in the price of linerboard has spread to boxes and the strong dollar has weighed on exports. Regardless of these challenges, we continue to believe the acquisition of a large national distributor, Victory Packaging, in 2015 will increase the vertical integration for the company and provide solid cash flow to reduce debt.
Another leading detractor this quarter came from the worst-performing health care sector. Despite a positive quarter and the completion of a recent European based acquisition, Wright Medical Group (WMGI, Financial) stock was pressured on fears of potential litigation involving metal to metal hip implants, which could exceed the company’s liability insurance. Other orthopedic companies have suffered from similar legal disputes involving alleged, early device failure in recent years. A judgement was recently handed down on its first case with 80% less in damages awarded than had been initially estimated. Regardless of what appears to be a favorable outcome, WMGI plans to appeal the case and ultimately hopes to certify and settle the class of claims well within its liability insurance limits. We believe WMGI will ultimately prevail on this issue and the stock remains attractive.
Looking ahead, we are fully aware that short-term market volatility will interrupt performance, but we are bullish on the long-term prospects taking shape in U.S. value stocks. In 2015, all the Russell value-oriented indices (i.e., small, small-mid, mid, and large) underperformed their growth counterparts. While this was stressful for value investors, we believe that value-oriented stocks, which have underperformed growth since 2006, are in a position to stage a comeback and outperform growth stocks. Furthermore, wide performance dispersion could be shaping an attractive stock-picker’s market. We believe our active management approach is well suited for this type of environment.
Economists are suggesting a 75% chance that the Fed will raise interest rates this June. As we saw last December, this had a negative effect on equity markets that carried into January of this year. We could see broader economic conditions influence the market, but we believe that stock-specific fundamentals will be favored over macroeconomic developments. In the corporate restructuring space that we focus on, we are seeing a rise in the number of spin-offs and takeouts, as well as companies emerging from bankruptcy. Globally, companies are sitting on more than $6 trillion in cash reserves. We believe this cash will be put to use as companies pursue M&A actions, dividend increases, or stock buybacks. We believe these represent attractive long-term opportunities and have positioned our strategy to take advantage of these situations.
As always, thank you for your support of the Keeley Small Cap Value Fund.
The performance reflected herein is for the Class A shares without load. "Without load" does not reflect the deduction of the maximum 4.50% sales fee (load), which reduces the performance quoted. Past performance does not guarantee future results. The performance data quoted represents past performance and current returns may be lower or higher. The investment return and principal will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. Most current performance data may be obtained at www.KeeleyFunds.com.
The Fund's adviser has contractually agreed to waive a portion of its management fee or reimburse the Fund if total ordinary operating expenses during the current fiscal year as a percentage of the Fund's average net assets exceed 1.29% for Class A Shares and 1.04% for Class I Shares. The waiver excludes expenses related to taxes, interest charges, dividend expenses incurred on securities that a Fund sells short, litigation and other extraordinary expenses, brokerage commissions and other charges relating to the purchase and sale of portfolio securities. The waiver is in effect through January 31, 2017.
This summary represents the views of the portfolio managers as of 03/31/16. Those views may change, and the Fund disclaims any obligation to advise investors of such changes. For the purpose of determining the Fund's holdings, securities of the same issuer are aggregated to determine the weight in the Fund. Portfolio holdings are subject to change without notice and are not intended as recommendations of individual securities.
