U.S. equity markets whipsawed in the third quarter, with the emergence of unexpected events as a common thread. The quarter began with equities in full, bull-market mode owing to a rebound from post-Brexit declines – declines that notably occurred because so few investors actually expected the Brexit vote to pass. Then, in July and August, generally positive earnings and strong, risk-on appetites produced nice gains.
In September, however, the appetite for risk lessened amid volatility from steeper valuations, weaker economic data and the inherent uncertainty in a presidential race that has been the very definition of the unexpected, with no shortage of surprises. Also weighing on equities in September was the prospect of an interest-rate hike, which investors previously had discounted. Although the Fed left rates unchanged in September, the likelihood of a December rate hike rose sharply, dampening investors’ moods. Another unexpected turn came at month’s end, when oil prices surged after OPEC leaders agreed to cut production.
With the bulk of the quarter in risk-on mode, intraday volatility dipped below its long-term average and stock correlations rose – making it yet another tough quarter for active managers. Although growth outperformed in the quarter, value was not far behind as investors searched for laggards in this more expensive market.
For the quarter, the Keeley All Cap Value Fund gained 6.06% and its benchmark, the Russell 3000 Value Index, gained 3.87%. The bulk of the Fund’s relative outperformance came from strong stock picking and secondarily from a handful of relative sector weights. In terms of sector allocations, the Fund benefited from underweights in Consumer Staples and Energy and an overweight in Consumer Discretionary. The Fund was also helped by avoiding investments in the Telecom sector, which hurt the benchmark this quarter.
Stock selection was the primary driver of relative outperformance this quarter. While the Fund’s overweight in Health Care was a slight detractor, strong selection made it the leading contributor. The Fund also benefited from specific stocks in the new Real Estate sector, as well as Financials, Consumer Staples, and Energy.
Poor stock selection in Materials, Utilities, and Consumer Discretionary as well as an underweight in Industrials served as the primary detractors this quarter.
One of the Fund’s main drivers this quarter was Wright Medical Group (WMGI, Financial), which gained nearly 40% and contributed 141 basis points in performance. The company provides surgical solutions for the foot and ankle market and its products include joint implants for hip and knee replacements. The company reported a strong second quarter and raised guidance, proving the benefit of the Tornier acquisition.
Another strong performer this quarter was Nexstar Broadcasting Group (NXST, Financial), a television broadcasting and digital company that focuses on acquiring, developing and operating television stations and social media websites. The company reported second quarter earnings that were in-line with expectations. Management noted that they are on pace to meet or exceed guidance and are optimistic the FCC will allow them to close the acquisition of Media General this year. The stock rose over 21% and contributed 81 basis points of performance in the third quarter.
Kennedy-Wilson Holdings (KW, Financial) was another leading contributor this quarter, rising over 19% and contributing 72 basis points in performance. This real estate investment company, which focuses primarily on multi-family and commercial properties, also sold off late in the second quarter post-Brexit given its U.K. exposure through its 17% stake in Kennedy-Wilson Europe. The company’s stock has since rebounded as the management team took advantage of the price weakness to purchase more stock in Kennedy-Wilson Europe.
NRG Energy (NRG, Financial) was the Fund’s leading detractor this quarter, dropping over 25% and costing 82 basis points in performance. The stock was strong in the first half of this year and was the Fund’s leading contributor last quarter, but the price has been in decline despite beating second quarter estimates and maintaining guidance. Its peers lowered guidance due to a warmer 2015 winter, thus lowering power pricing, yet NRG is hedged for the year and continues to execute its turnaround plan.
Tribune Media Co. (TRCO, Financial) was also a leading detractor this quarter, dropping over 6% and costing the Fund 26 basis points in performance. The market is overly concerned with potentially weaker election advertising spending and cord-cutting customers, but we believe the large discount to net asset value will close as management executes on its plan to monetize non-core assets.
Vista Outdoor (VSTO, Financial), which designs, manufactures and markets outdoor sports and recreation products, also was a detractor this quarter. The stock declined over 17% and cost the Fund 23 basis points in performance following weak first quarter earnings. Customers shifted their spending to handguns and away from Vista’s core shooting accessories given fears of increased gun control laws. The company expects these delayed purchases to occur later this year and did not lower full-year guidance.
Though a lot of investors’ focus seems to be with the Fed’s next move and presidential election results, we are pleased to see a number of our holdings being driven by company-specific fundamentals versus macroeconomic headwinds. However, we do seem to be in a mean-reversion type environment. A stock that performs well in one quarter may be the bottom performer the next, or value and growth stocks might alternate in performance from quarter to quarter. Over the long term, we believe our value approach in investing in under-followed and under-appreciated stocks undergoing major changes portends to an attractive return profile. As a company moves forward in its restructuring plan or identifies a catalyst, many investors move in too late to capture the upside. Our objective is to capture these moves well ahead of other investors. Indeed, many of our positions are not covered by Wall Street analysts until they already have risen.
In the past few months, we’ve seen a lot of companies putting their cash to work by announcing mergers and acquisitions or spinning-off divisions. With the potential for rising rates, companies may be in a hurry to finalize deals before rates go up. This type of environment speaks well to our strategy, and we look forward to finishing the year strong.
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 09/30/16. 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.
