In the second calendar quarter of 2016, the KEELEY All Cap Value Fund (KACVX) increased 2.27% compared to a 4.57% rise for the Russell 3000 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 and 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.
The Fund’s underperformance this quarter was equally attributable to both sector weighting and stock selection. From a sector allocation perspective, the Fund’s performance was primarily hurt by an overweight (15.7% vs. 5.2%) in what we view as very undervalued Consumer Discretionary names. Consumer Discretionary was the only negative sector in the Russell 3000 Value Index in the quarter. In addition, the Fund’s underweight exposure in Energy (6.8% vs. 13.0%) detracted from performance as energy-related commodities continued to rebound.
Stock selection in Financials, Health Care, and Energy also hurt performance this quarter. In the Financials sector, Air Lease Corporation (AL, Financial) and Voya Financial, Inc. (VOYA, Financial) detracted from performance. Air Lease Corporation engages in the purchase and leasing of commercial aircraft to airlines worldwide. The company’s stock price declined over 16% and cost the Fund 55 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.
Voya Financial also had a difficult quarter, dropping over 17% and detracting 53 basis points from the Fund’s performance. The company’s stock was hit hard by a significant earnings miss from lower-than-expected alternative investment income in the first quarter. Looking ahead, Voya expects continued improvement in ongoing operations, good capital management, and appropriate management of its closed block of business. While the 10-year Treasury yield falling below 1.50% is perceived to be a headwind for life insurance firms, the company is somewhat shielded from the pernicious effects of a low interest rate environment due to its fee-heavy retirement and asset management segments. We continue to believe that VOYA is inexpensive, trading at more than a 50% discount to intrinsic value.
Perrigo Co. (PRGO, Financial) was the Fund’s leading detractor this quarter. The stock price dropped over 22% and cost the Fund 62 basis points in performance. The company focuses on the production of over-the-counter consumer goods and specialty pharmaceutical products. The stock price dropped after the former CEO departed to join Valeant Pharmaceuticals and the Board of Directors named a new CEO. The new CEO promptly reduced guidance, causing an increase in skepticism about management’s ability to integrate a recent European acquisition.
Utilities was the Fund’s strongest performing sector and also held the Fund’s two leading contributors. The first, NRG Energy, Inc. (NRG, Financial) rose over 15% and added 74 basis points in performance. NRG Energy engages in the production, sale, and distribution of energy and energy services in major competitive power markets. The stock price gained as independent power producer valuations were broadly re-rated higher following the announced acquisition of Talen Energy by Riverstone Holdings. Higher energy prices also provided earnings upside.
The second, MDU Resources Group, Inc. (MDU, Financial) gained over 23% and contributed 71 basis points in performance. MDU Resources reported strong first quarter earnings with superior aggregate business results. In addition, management announced in June the sale of a struggling refinery which had been losing money, in a move that will also help reduce the firm’s risk exposure to commodity prices.
BOK Financial Corp. (BOK, Financial) was also a leading contributor this quarter as the stock price rose over 14% and contributed 60 basis points in performance to the Fund. 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.
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.
We believe the Fund’s ability to invest in small, mid, and large-cap U.S. stocks speaks well to the current environment. The Fund is positioned with significant overweights in Consumer Discretionary and Health Care and has moderate underweights in Energy and Industrials. Despite the low-growth environment, unemployment data has been strengthening – suggesting the consumer may be putting more money to work. This may spark the Fed to raise rates; however, the strength of the U.S. dollar may be a bad omen on corporate earnings, especially those companies that have business overseas.
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 All 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.
Risks: Smaller and medium-sized company stocks are more volatile and less liquid than larger, more established company securities.
