To Our Shareholders:
For the quarter ended March 31, 2017, the Keeley Small Cap Value Fund’s net asset value (“NAV”) per Class A share appreciated 0.93% versus a decline of 0.13% for the Russell 2000 Value.
Commentary
Donald Trump’s unexpected Presidential election victory ignited a rally in equities that continued through the first quarter leading the bull market into its eighth year. While investors spent much of the beginning of the year enthused about pro-business policies out of Washington given expectations of tax reform, infrastructure spending and an easing of regulatory burdens, the rally lost some steam toward the end of the quarter. Although economic statistics remain favorable with many pointing to the first global synchronized economic upturn in some time, investors began to pause for three main reasons. First, where is the spending needed to fuel economic growth? Despite unemployment at its lowest levels in a decade, consumers remain very cautious, corporate capital investment has yet to return to normalized levels, and the government’s infrastructure spending program looks to be more of a 2018 event. Second, the newly inaugurated Trump administration is still feeling its way around Washington as evidenced by legislative setbacks such as its failed attempt to repeal the Affordable Care Act. How the administration fares with tax reform, which is the next major legislative item on the White House’s agenda, should have meaningful implications for equity markets which have already priced in some expectations of tax relief for 2017. Lastly, with the rate hike in March following the one in December, plus Fed talk of another two to three hikes this year, at what point do higher rates and a stronger dollar act as a headwind to the economy?
The uncertainty caused by the questions above became evident in the market’s actions. The potential for a slowing economy led the 10-year Treasury yield to decline from 2.6% to 2.3%, large cap stocks outperformed small cap due to more exposure to improving international economies and growth outperformed value; all a reversal of what occurred in the fourth quarter. In the first quarter, the Trump-related reflation trade began to unwind, and those areas of the market that would have benefitted from the policy changes and faster GDP growth such as the banking sector lagged as markets rebased with the realization that GDP is growing closer to 2% than 3%.
Even so, we view this economic environment as generally healthy for small capitalization company fundamentals. Though the new administration is still finding its footing, the likelihood of faster GDP growth remains high given President Trump’s focus to drive change. We are not alone in this viewpoint of optimism as current small cap stock valuations are at 19x earnings, above the upper end of historic norms. In recognition, we have become more selective about new investments, but are content to retain existing positions that demonstrate improving fundamentals and confirm our initial investment theses. Likewise, with the market’s weakness at quarter end serving as a reminder, much positive expectation toward unspecified future legislative policies is built into investors’ outlooks and presents a risk of downside potential.
The portfolio was underexposed to the Trump reflation trade in the fourth quarter and we remained disciplined in the first quarter not to chase the market. We held our view of slower policy adoption and a slower economic outlook. Coming into this year, the Fund was positioned to capture performance from the swing in the market mood. Although our economic bias from our continued overweight to Consumer Discretionary and Industrials contributed to performance, the Fund’s Utility and Real Estate sector exposure drove significant outperformance. Stock selection was also a large positive factor in driving outperformance. As the reality of the reflation trade unwind set in and investors were faced with a fairly-valued market, attention turned to the stocks that were left behind - the laggards from 2016 many of which were the restructuring stocks in which we invest. Verint Systems and Diebold Nixdorf, two technology turnaround names that were down 13% and 16% last year, respectively, compared to the Russell 2000 Value being up 32%, were each up over 20% in the quarter. We feel this more rational environment, where investors focus back on fundamentals versus Washington and the Fed, will be positive for active managers.
Merger and acquisition activity should continue to be centered upon small caps that by nature of their size and narrower business focus, provide less disruptive business integration while offering avenues of growth for constrained mid- and large-cap peers. For investors, such activity can be better captured through active management, as opposed to passive. Our strategy of seeking companies undergoing restructuring including spin-offs, often leaves these portfolio companies more susceptible to being acquired as they become much cleaner, pure play stories after restructuring activities have concluded. Two names in our portfolios that are excellent examples of this are Time Inc. (TIME) and Wright Medical Group (WMGI, Financial). In Time’s case, the company has implemented several rounds of restructuring after its spinoff from Time Warner and amidst major secular headwinds in the print magazine industry. After Time began receiving unsolicited overtures from bidders last year, the company hired bankers to advise on possible strategic options. Meanwhile, Wright Medical Group, an orthopedic device manufacturer, has done a fine job integrating its recent merger with Tornier. Given Wright’s strong market position in the orthopedics space plus management’s past willingness to sell, we envision Wright becoming part of a much larger player at some point in the future. During periods of high merger and acquisition activity, we have typically had 10% or more of our portfolio subject to premium takeover bids.
The top three performing stocks in the quarter were:
Nexstar Media Group (NXST, Financial) is a television broadcast company operating in medium-sized markets in the United States. About a year ago, the company entered into a drawn out, contested merger process with Media General, which resulted in significant share pressure from merger arbitrage activity. This selling pressure created an attractive entry price for the stock equating to a valuation with a 20+% free cash flow yield. The company completed the merger in early 2017 and has now significantly increased its scale and reach. Management is respected as a strong operator and was able to exceed expectations in 2016 in spite of disappointing political advertising revenues for the industry as a whole. Nexstar can now finally commence on realizing the meaningful synergies from the merger, while taking advantage of their increased bargaining power with distribution partners. The proactive manner in which the company undertook the transformative merger has been viewed favorably by the market, especially as further speculation around industry consolidation heats up with the proposed deregulatory plans of the new FCC administration. In the meantime, Nexstar’s valuation remains attractive, with a free cash flow yield in the high teens. The company has ample opportunity to reduce debt, fund further M&A, and continue to return capital to shareholders through dividends and share buybacks.
Wright Medical Group (WMGI, Financial) is a global medical device company focused on extremities and biologics. The company completed a merger of equals with Tornier NV in late 2015 becoming the worldwide leader in providing surgical solutions for upper extremities (shoulder, elbow, wrist and hands), lower extremities (foot and ankle) and biologics (bone graft stimulators) - three of the fastest growing segments in orthopedics. Both companies had been investing heavily for growth resulting in low, short-term profitability, but under new CEO Robert Palmisano, the combined company has substantial scale opportunities and would be a beneficiary of the aging, but much more active baby boom generation. The company has exceeded analysts’ estimates for the past four quarters post the deal closing and EBITDA margins have increased from -5.5% in 4Q15 to 11.7% in 4Q16, on its way towards our 20% margin target by 2019. In addition, a recent Financial Times article reported on speculation that a larger orthopedic company may be looking to acquire Wright. Given the consolidation in the orthopedic market and CEO Palmisano’s history of selling his prior companies, we would not be surprised if a strategic player recognizes Wright’s intrinsic value sooner than expected.
Air Lease Corporation (AL, Financial) is a leading global aircraft leasing company headquartered in Los Angeles, CA. Strong performance during the quarter reflects the company’s continued strong operating results. For 2016, Air Lease grew its revenue by 19% and EBITDA by 25% while maintaining a conservative financial profile – secured debt made up 8% of total debt, which was one of the factors in S&P upgrading its debt to BBB in October 2016. Our initial investment thesis was based on the rising global middle class and expectation of global passenger traffic growing at a healthy rate to double every 15 years. We believe that airline operators, particularly the capital constrained non-US operators will rely more on leasing companies to provide the aircrafts and remove the threat of residual risk. This thesis is playing out as expected. Despite economic and geopolitical issues roiling the travel industry, Air Lease has continued to keep its current fleet fully utilized and has a large order book of 363 aircraft which is 1.4x its current fleet of 267 aircraft, mostly the in-demand wide-body planes. We continue to believe that the stock is trading at a meaningful discount to its intrinsic value and that the quality of the management team combined with the strength of the balance sheet will help the company generate healthy returns.
The bottom three performing stocks in the quarter were:
Vista Outdoor, Inc. (VSTO, Financial) designs, manufactures and markets consumer products for the shooting and outdoor sports markets. The company was a division within Alliance TechSystems (ATK, Financial), an aerospace and defense contractor, and became its own stand-alone entity when it was spun out when Alliance merged with Orbital Sciences. Vista had become the leading consolidator of the fragmented outdoor sports industry diversifying away from its core shooting sports products via accretive acquisitions which leveraged the company’s customer base and distribution network. Unfortunately, sporting goods store closures/bankruptcies (Sports Authority) and hoarding of ammunition into the Presidential election (as most had expected a Democratic win), led to excess inventory in the channel. In addition, an expected pickup in shooting accessory sales (holsters, scopes, etc.), Vista’s most profitable products, has not materialized despite the strength in gun sales over the past two years. A perfect storm has hit this new company, but we believe expectations are extremely low and all the bad news is in the stock. The company has not lost market share, the excess inventory shall clear as the outdoor and shooting sports categories continue to grow, and management will thus reset guidance to rebuild credibility.
Ensign Group (ENSG, Financial) is a provider of healthcare services in the traditional skilled nursing, assisted living, and home health and hospice segments. We initially established a position in CareTrust REIT Inc. (CTRE), which was the spun-off real estate assets of Ensign, and through our maintenance research realized how good of an operator Ensign was compared to its peers. The company has had great success with its growth-through-acquisition strategy, which focuses on acquiring and turning around small struggling operators. However, Ensign recently diverted from this playbook and purchased a larger stable of assets that led to some integration issues which have weighed on near-term profitability despite posting tremendous top-line growth. We view these issues as short-term concerns as Ensign Group remains one of the best operators in the post-acute space.
Superior Energy Services, Inc. (SPN, Financial) is a diversified oil service company that offers drilling, completion and production-related services worldwide. A significant amount of capacity came out of the industry over the past two years when oil dropped below $30 per barrel. However, as oil has stabilized in the $50 per barrel range, drilling activity is picking up and we are beginning to see a recovery in pricing for pressure pumping and other land-based services. Superior is investing in additional pressure pumping horsepower that is expected to be deployed in the second half of 2017, but its higher than expected fleet reactivation costs and need to rehire personnel impacted the stock. Also, there has been some concern about the timing of a recovery in the offshore and international businesses, though we believe this will be more than offset by positive contribution from Superior’s land-based business. Management sees reactivation costs per crew declining over time and we would view the reactivation cost issue as an investment in growth as exploration & production customer activity picks up over the course of 2017.
Conclusion
We are cautiously optimistic for the remainder of 2017 and feel this more rational market will recognize the value inherent in our restructuring stories. We remain bottom-up, value-oriented stock pickers, committed to uncovering mispriced equities of companies undergoing some type of restructuring action to unlock hidden value. Thank you for investing in the Keeley Small Cap Value Fund. We appreciate your confidence and trust.
