The market entered the final quarter of a bullish 2016 with some trepidation. Stock market implications surrounding the U.S. presidential election and the Federal Reserve’s (Fed) interest rate hike raised investor caution. But the uncertainty was quickly dismissed and a risk-on rally ensued post the Trump victory. U.S. equity markets finished the year strong, with the S&P 500 Index gaining 12.0% for the year and 3.8% for the quarter. Small cap stocks were especially strong, and value outperformed growth across all market caps. Among U.S. equities, the leading Russell 2000 Value Index gained 31.7% for the year, rising 14.1% in the fourth quarter. Midcap value stocks also finished the year in bullish fashion with the Russell Mid Cap Value Index closing the year up 20% and the quarter up 5.5%.
Energy and Financials were particularly strong in the fourth quarter. The Energy sector continued to rebound from last year’s plummeting oil prices as crude gained 11.4% in the fourth quarter (up 45% for the year) following OPEC’s decision to cut production. The Fed’s interest rate hike had a positive effect on Financials this quarter, though rising interest rates may pose challenges for high dividend yielding stocks in Telecom, Utilities, and Consumer Staples sectors. Given the uncertainty surrounding the Affordable Care Act (Obamacare) and potential reforms by the new administration, Health Care stocks struggled in the fourth quarter. In our view, the U.S. economy looks relatively healthy – GDP gained 3.5 percent in the third quarter (its best quarterly change in two years), and the unemployment rate closed 2016 at 4.7%. We are also encouraged by generally positive earnings growth and believe that companies should see positive growth and revenues in 2017.
For the fourth quarter of 2016, the Keeley Small Cap Value Fund underperformed the Russell 2000 Value Index, gaining 8.96% versus 14.07%. Over the course of the quarter, the bulk of the Fund’s relative underperformance came from meaningful sector weight differences, and secondarily from stock selection. The Fund’s significant overweight in the lagging Consumer Discretionary sector, as well as weak stock selection, was the leading detractor. In addition, the Fund had difficulty in keeping pace with a strong Technology sector both in the fourth quarter as well as the rest of the year. Within the benchmark, Technology was one of the leading performers, rising just over 39% and placing second only to Materials, which gained over 68% on the year.
The Fund benefited from its exposure in Consumer Staples, both in terms of sector allocation and stock selection; making it the Fund’s leading sector for the fourth quarter. In the space, the Fund’s only position (Flower’s Foods, Inc. (FLO, Financial)) rebounded from a rough third quarter, gaining over 28%.
The Fund also experienced positive stock selection in Financials, however, the significant underweight versus the Russell 2000 Value Index hurt relative performance during the quarter. Separately, the Fund was also hurt by weak stock selection in Industrials, Materials, and Energy as well as an overweight in Real Estate.
Given the strength in Financials this quarter, it is not surprising that the Fund’s top three performing stocks came from the sector: Hilltop Holdings (HTH, Financial), UMB Financial Corporation (UMBF, Financial) and Provident Financial Services (PFS, Financial). All three companies would be beneficiaries of higher interest rates, a lower corporate tax rate, and less regulation. In addition, Hilltop has announced it is shopping its Insurance business to increase its focus on its core banking operations while UMB continues to streamline costs at its banking operations.
As mentioned, performance in the Consumer Discretionary sector was a leading detractor this quarter. From a holdings perspective, the Fund’s leading detractor was TRI Pointe Group (TPH, Financial) which was impacted by the fear that rising rates would hurt home sales. Another leading detractor was Kennedy-Wilson Holdings (KW) that despite beating expectations for its third quarter report, was similarly impacted by macro concerns on higher interest rates on its real estate operations. Kaiser Aluminum Corporation (KALU, Financial) also had a difficult quarter. The company missed third quarter earnings expectations due to inventory destocking at its aerospace customers as well as the timing gap between the completion of one large auto bumper program and the start of another.
Over the course of 2016, we noticed a lot of mean reversion tendencies within the Fund. Sectors or stocks that had a rough month or quarter rebounded the following quarter, or vice versa. Similar behavior occurred between growth and value stocks as well as large caps versus small caps. We believe this type of activity is likely to persist in 2017, especially as markets grapple with the uncertainty of a Trump administration. Rising interest rates should benefit Financials, yet Health Care will likely be volatile given the uncertainty surrounding Obamacare. Looking forward, we are excited about the prospects for more corporate changes in the small cap value space.
Though we are disappointed by the Fund’s relative underperformance this quarter, we are encouraged by the amount of performance dispersion that took shape. Within the Russell 2000 Value Index, the worst-performing sector was Health Care, declining -1.7%, while the top performing sector was Financials, up 24%. We believe this dispersion is highly advantageous for active stock pickers, particularly when it comes to the inefficiencies in the small and mid cap value segments. In addition, when markets shun or avoid particular stocks due to the lack of readily available information, we believe in our investment process to identify those names that are undergoing some form of transformation. These transformations include ownership changes (spin-offs, divestitures, de-mutualizations), operating changes (new management, cost cutting, M&A) and capital restructurings (emergence from bankruptcy, refinancing, capital reallocation). We also look forward to taking advantage of shifts in the marketplace, including regulatory changes and industry consolidation.
As always, thank you for your support of the Keeley Small Cap Value Fund.
