In the second calendar quarter of 2016, the KEELEY Mid Cap Dividend Value Fund (KMDVX, Financial) increased 6.76% compared to a 4.77% rise for the Russell Midcap 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 gained back its Brexit-related losses.
For the second consecutive quarter, value outperformed growth across all market cap segments, with the Russell Midcap Value Index leading the way. Given the challenging environment for value stocks over the past few years, most notably in 2015, we believe this reversal offers an optimistic sign for value investors.
The Keeley Mid Cap Dividend Value Fund benefited from both its market cap and value orientations as well as from strong stock selection. Within the Russell Midcap Value Index, only the Consumer Discretionary sector recorded negative performance, declining 6.2%. The remaining sectors ranged from +2.4% (Industrials) to +13.2% (Energy). Energy stocks continued to benefit from the rebound in crude oil pricing, which closed the quarter at $48.33 per barrel after touching $26.21 in early February. The Fund’s underweight in the sector (6.7% vs. 10.1%) slightly hurt performance. In addition, an overweight in the lagging Consumer Discretionary sector (9.3% vs. 8.4%) as well as an underweight in Consumer Staples (1.7% vs. 3.5%) were slight detractors.
The Fund’s performance this quarter was distinguished by strong stock selection. Of the ten economic sectors, the Fund’s holdings in seven outperformed the benchmark. Most notably, the Fund’s positions in Technology, Utilities, Financials, Industrials, and Health Care were leading contributors.
The Health Care sector has been volatile this year amid presidential campaigns and the strong Obamacare rhetoric. In the first quarter, you may recall that Health Care was the only sector in the benchmark with negative performance, dropping nearly 6%. This quarter the sector gained over 6% and the Fund’s leading contributor was St. Jude Medical (STJ, Financial). St. Jude Medical’s share price rose sharply in the quarter after it announced that it would be acquired by Abbott Laboratories (ABT, Financial) in a cash and stock deal initially at $85 per share, a 37% premium to the prior day’s close.
The Fund’s exposure in Technology was the leading driver of relative outperformance this quarter and another strong contributor came from this sector. Computer Sciences Corporation (CSC, Financial) rose over 44% and contributed 55 basis points in performance. The company’s shares rallied substantially in May after the company announced it would be combining with Hewlett Packard Enterprise (HPE, Financial)'s Enterprise Services division. This business is very similar to CSC, which should allow management to achieve its projected $1 billion synergy target and make the deal highly accretive.
The Fund’s Real Estate Investment Trust (REIT) exposure has been strong in recent periods and we believe the new Real Estate category (coming in August), which will include REITs, will offer positive support as institutions raise their allocations and demand for yield increases. In the second quarter, document and information management company Iron Mountain (IRM, Financial) continued its strong share price performance. At the beginning of the quarter it closed on the long-pending acquisition of rival Recall Holdings. The deal not only expands IRM's geographic presence and solidifies its competitive lead, it also improves the company's leverage ratios and dividend coverage.
Despite strong performance from the leading Energy sector this quarter, the Fund’s leading detractor was HollyFrontier Corporation (HFC, Financial), a refiner that produces gasoline, diesel, jet fuel, and other specialty products. The stock dropped over 32% during the quarter and cost the Fund 40 basis points in performance. Earnings expectations fell on continued pressure on refining margins. With a strong balance sheet, the company has bought back stock on the weakness and invested in high-return capital projects that should make it a stronger company when industry conditions improve.
Another leading detractor this quarter was ITT, Inc. (ITT, Financial). ITT engages in the manufacturing and sale of engineering and technology solutions in energy, transportation, and industrial markets. The stock was down over 13% for the quarter, lagging the market and other industrial stocks while costing the Fund 27 basis points in performance. Although first quarter results were in line with expectations and full year guidance was reaffirmed, ITT's businesses that support commodity markets remain pressured. As a result, investors believe a guidance cut may be on the way.
Voya Financial, Inc. (VOYA, Financial) was also a leading detractor this quarter. The stock price declined over 15% and cost the Fund 23 basis points in performance for a couple reasons. First, it missed first quarter earnings expectations due to underperformance in its alternatives portfolio. In addition, falling interest rates continue to pressure forward earnings expectations.
Looking ahead, we believe that high quality dividend paying stocks will remain attractive as investors seek both yield and the potential to protect against sporadic volatility. To date, the Fund has been able outperform the rising market and protect on the downside. As we enter earnings season, we will likely witness some companies blaming the Brexit for earnings misses. Prior to the vote, however, we initiated a review of the Fund’s holdings with the goal of better understanding our companies’ exposure to the U.K. and more broadly to Europe. We do not expect earnings to be materially impacted by this outcome. Nevertheless, if the dollar strengthens against the British pound and Euro, it could create a headwind on U.S. corporate earnings.
Anticipating the Fed’s next move has become increasingly strenuous. Most economists speculated that there would be no interest rate hikes this year following the Brexit aftermath. More recent employment data has changed this opinion, suggesting the Fed may raise rates in 2016. No matter which way the Fed goes, interest rates remain historically low and companies with healthy balance sheets and free cash flow yields ought to be in a position to sustain or grow their dividends. Our fundamental, bottom-up investment process is designed to find quality dividend paying stocks with attractive valuations. In our view, this process has created a portfolio that can help protect against market downturns while building long-term growth in rising markets.
As always, thank you for your support of the Keeley Mid Cap Dividend 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.
