The third 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 investors in risk-on mode for much of the third quarter, volatility dropped and stock correlations rose, creating a meaningful headwind for active managers. In a departure from the prior two quarters, growth slightly outperformed value in the quarter as the risk-on environment in July faded by September.
The Keeley Mid Cap Dividend Value Fund returned 4.40% this quarter and its benchmark, the Russell Midcap Value Index, gained 4.45%. While the overall result was pretty much in line with the benchmark, there were several crosscurrents that summed together to get there. First, the nature of the rally in the quarter was a slight headwind to the Fund’s performance. Most importantly, non-dividend paying stocks were up 7.3% vs. 3.1% for the higher yielding stocks and 5.0% for the lower yielding dividend payers. Within the portfolio, allocation was a slightly positive contributor, while stock selection was a slight detractor.
With regard to sector allocations, the Fund benefitted from a slight overweight in Technology and a slight underweight in Utilities. These were the best and worst performing sectors, respectively.
From a stock selection perspective, the Fund’s holdings in Financials and Materials added value, while its positions in Consumer Discretionary, Technology and Energy lagged the returns of the benchmark.
The strong performance of growth stocks this quarter created a bit of a performance headwind for the Fund as investors generally avoided higher quality (i.e., dividend paying) stocks and actively pursued more volatile growth equities. In this type of environment, the quality of our dividend paying stocks often inhibits the Fund’s ability to outperform the benchmark. However, in periods where volatile markets drag performance lower, the intention of the Fund’s dividend paying stocks is to protect against falling markets. For this quarter, the Fund performed according to these expectations.
For the third quarter, Foot Locker, Inc. (FL, Financial) was the Fund’s leading performer, returning over 24% and contributing 36 basis points in performance. The company reported a strong second quarter, with both earnings per share and same-store sales beating consensus estimates. This came after a slight same-store sales growth disappointment in the first quarter and seemed to reverse what had been deteriorating sentiment about Foot Locker. In our view, this is a positive change from the first quarter, when same-store sales growth fell short, prompting a selloff. Foot Locker also bought back over 3 million shares, taking advantage of its relatively low share price. The company also benefited from a number of recent basketball shoe launches (Air Jordan, Stephen Curry, Kevin Durant, LeBron James models).
Lincoln National Corporation (LNC, Financial) was also a top performer this quarter, returning nearly 22% and contributing 32 basis points to the Fund’s performance. The company reported second quarter earnings that were in-line with expectations. More importantly, some issues that management claimed were transient that hurt first quarter results did not recur. In addition, the company bought back a significant amount of stock and showed good progress on the issues that led to last quarter’s disappointing results.
Linear Technology Corporation (LLTC, Financial) also had a strong lift in late July following the announcement that Analog Devices would be acquiring the company. For the quarter, the stock gained 27% and contributed 32 basis points to the Fund’s performance. We elected to sell the position after it exceeded our price target.
Utility company NRG Energy, Inc. (NRG, Financial) was the Fund’s leading detractor this quarter, dropping more than 25% and costing the Fund 38 basis points in performance. Weaker than expected power pricing and debt concerns at one of the company’s operating subsidiaries caused investors to worry about long-term earnings potential.
Of the Fund’s Technology holdings this quarter, only one had negative performance. Total System Services, Inc. (TSS, Financial), which provides services to credit card issuers, was down over 10% and cost the Fund 20 basis points in performance. With growth slowing as the company anniversaries some large new business conversions and worries about the impact of new Consumer Financial Protection Bureau rules regarding prepaid debit cards, investors did not see much reason to step up and buy this stock despite a good second-quarter earnings report.
Superior Energy Services, Inc. (SPN, Financial) was down a little over 3% for the quarter, but due to the Fund’s average weight in the stock, it ended up detracting 15 basis points in performance. The company continues to struggle with lower activity in oil field services despite the rally in crude oil prices.
Though a lot of the focus seems to be with the Fed’s next move and presidential election results, we are pleased to see a number of our positions 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 alternate from quarter to quarter.
Over the long term, we believe our value approach and its focus on dividend paying mid cap value stocks will generate a risk-return profile that protects against the inherent volatility of these stocks. However, this profile also limits the Fund’s upside when markets favor lower-quality growth stocks. Heading into the home stretch for this year, we would expect some short-term volatility should the Fed raise rates (similar to last December). If that happens, and in our view, it will, then the Fund’s positioning should help protect against the ensuing volatility. Depending on the presidential election results, we would expect some stock market repercussions. In our view, mixed White House and Congress parties offer markets better long-term stability.
We look forward to finishing this year strong.
Thank you for your support of the Keeley Mid Cap Dividend 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 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.
