In the second calendar quarter of 2016, the KEELEY Small Cap Value Fund (KSCVX, Financial) increased 1.17% compared to a 4.31% rise for the Russell 2000 Value Index. U.S. equity markets continued to build on first quarter gains as the appetite for risk strengthened. Large cap stocks, represented by the S&P 500 Index, rose 2.5% this quarter while small and mid cap stocks performed even better. The Federal Reserve held interest rates steady given low inflation expectations and tepid economic growth. At the end of the quarter, economists generally believed that the Fed would not be raising rates this year. Just as these positive tailwinds pushed the market higher, news of the U.K.’s exit from the Euro (‘Brexit’) hit the wires. On June 24th, global markets were shaken and suddenly a risk-off mentality ensued. The U.S. dollar strengthened and international equities were hit hard – particularly those linked to the British economy. By June 30th, however, the S&P 500 Index had regained its Brexit-related losses.
For the second consecutive quarter, value outperformed growth across all market cap segments. Given the challenging environment for value stocks over the past few years, most notably 2015, we believe this reversal offers an optimistic sign for value investors.
In the second quarter, the majority of the Fund’s relative underperformance came from stock selection, while sector allocation effects were slightly positive. The Fund’s overweight in Materials (8.6% vs. 4.5%) and underweight in Technology (7.4% vs. 10.1%) helped somewhat, but the positive performance was not able to overcome the negative stock selection effects. Stock selection in Financials, Materials, and Technology were the primary reasons for the Fund’s relative underperformance.
The Fund’s leading contributors this quarter came from individual positions in the Industrials, Energy, and Financials sectors. In the Industrials space, Ritchie Bros. Auctioneers (RBA, Financial) had a strong quarter, rising over 24% and contributing 49 basis points in performance to the Fund. The auctioneer of industrial equipment to on-site and online bidders has experienced strong stock price appreciation this year due to better-than-expected earnings; demonstrating that the new CEO is effectively executing his business transformation plan.
Another leading contributor this quarter was Parsley Energy (PE, Financial), which gained over 19% and contributed 36 basis points in performance to the Fund. The oil and natural gas company focuses on the acquisition and development of reserves in the Permian Basin, and the stock price has been steadily rising since February. The company has taken advantage of low oil prices to make accretive acquisitions of acreage and mineral rights during this downturn to further strengthen their position in the Permian Basin. The company’s stock has also benefited from the rebound in oil prices that has taken place the first half of the year.
BOK Financial Corporation (BOKF, Financial) also had a strong quarter, rising over 14% and contributing 36 basis points in performance. The stock price gained as the company provided better-than-expected guidance on their energy credit performance migration, which has been aided by a recovery in energy prices.
As mentioned, stock selection in the Technology sector was a leading detractor this quarter. One of the stocks pulling the Fund’s performance lower was Mitel Networks Corporation (MITL, Financial), which declined over 23% and cost the Fund 47 basis points in performance. The stock price fell following the announcement of its acquisition of Polycom, which was structured as a cash and stock payment deal. The stock was pressured as another bidder appeared, increasing the risk that Mitel would pay a higher price. Following quarter-end, the Polycom board accepted the higher competitive offer and Mitel, having remained disciplined on the price, walked away with a $60 million break-up fee.
EnPro Industries, Inc. (NPO, Financial) also had a challenging quarter, dropping over 23% and costing 37 basis points in performance. This industrial company manufactures sealing, engineering, and power systems products used in critical applications. Despite the asbestos settlement which will allow Enpro to reconsolidate its Garlock Seal division, weaker-than-expected first quarter earnings due to their oil and gas exposure and sluggish growth in the truck and large diesel marine engines divisions impacted the stock.
Another leading detractor from the Financials sector was Air Lease Corporation (AL, Financial). The company engages in the purchase and leasing of commercial aircraft to airlines worldwide. The stock price declined over 16% and cost the Fund 34 basis points in performance. The stock’s short-term underperformance was largely due to emerging market concerns given that the company’s lease concentration is primarily outside the U.S. Taking into account the age of fleets and demand growth beyond the U.S., however, we feel quite confident of the company’s backlog and delivery schedule.
Looking ahead, we believe this reversal in value outperforming growth over the past two quarters is a good sign for Fund investors. In terms of market cap size, small and mid cap stocks are likely to outperform larger caps during times when a risk-on mentality consumes investor behavior. Any upticks in volatility, such as what we saw earlier this year and following the Brexit vote, are likely to instigate a flight to larger cap stocks and high quality bonds. In our view, U.S. stocks offer a safer haven versus those in Europe and emerging markets right now. Any major flight towards safety will likely protect U.S. stock investors relative to investors with greater exposure to international markets.
Britain’s declaration to exit the European Union generated some volatility in our names. We have taken advantage of this volatility by adding to existing positions or buying new stocks, but have not changed the Fund’s overall positioning. Following the strong post-Brexit recovery, the market is clearly focused on one thing – continued accommodative policies by central banks to thwart economic disruptions when Brexit actually occurs – and thus, the risk-on equities trade. This story has been so overplayed that the popular notion as to whether or not these policies have become ineffective has shortened risk-on periods. The recent outperformance of value versus growth demonstrates this point. In our view, there is a fragile but improving world economy behind these macro winds and stocks that can produce better-than-expected results via corporate actions such as spin-offs or our restructuring changes will outperform.
As always, thank you for your support of the KEELEY Small Cap Value Fund.
This summary represents the views of the portfolio managers as of 06/30/16. 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.
