To Our Shareholders:
For the quarter ended June 30, 2017, the Keeley All Cap Value Fund’s net asset value (“NAV”) per Class A share declined by 2.21% versus a gain of 1.29% for the Russell 3000 Value.
Commentary
Despite various fits and starts, the domestic economy grew steadily in the second quarter of 2017. Although job growth reports during the quarter were muted, with March and May nonfarm payrolls falling short of consensus estimates, the April report presented a rosier picture. The general choppiness in this data seemed to create confusion for investors about the overall direction of the economy. Meanwhile, the Federal Reserve Board maintained its stance to raise the Federal Funds target rate despite inflation remaining below the Fed’s 2% long-term goal. Beyond macroeconomic data, President Trump’s first full calendar quarter in the White House was replete with turmoil, and his ambitious agenda of tax cuts, healthcare reform, increased infrastructure spending and reduced regulation remained in limbo amid bipartisan opposition to healthcare reform and general political gridlock. Additionally, public and media focus on non-legislative issues involving the President and his advisors also proved distracting. While there remains an opportunity for Congress to enact some of the President’s agenda, the economic data and the lack of action in Washington together raise some concern about U.S. GDP growth looking ahead. During the quarter, large-cap stocks generally outperformed small-cap stocks and growth stocks generally outperformed value stocks. The stronger performance from large-cap stocks, with their wider margins, better returns on invested capital and stronger balance sheets, may suggest investors are becoming more concerned about U.S. GDP growth. In addition, stocks with greater international exposure generally bested those with no business overseas, offering further evidence that investor worries over the domestic economy may be causing them to shift assets to companies with exposure to geographies that are less correlated to the U.S. While we believe that the economic outlook contains many cross-currents, it seems that a return to investor bullishness in the near-term would require some encouraging signals. It remains to be seen whether stronger this will come in the form of improved nonfarm payroll data, higher corporate spending or movement on still-stalled legislation in Washington.
Sector allocation had a slight positive effect in the quarter as we were overweight the best performing sector, Healthcare (+6%) and underweight the worst, Telecom (-7%). Stock selection led to positive relative attribution in Information Technology and Materials. However, these gains were more than offset by relative challenges in the Financial, Industrial and Utilities sectors.
In the quarter, energy names underperformed as the price of oil fell from $50 per barrel to the low $40’s before recovering to the mid-$40’s by quarter end. The oil market is generally over supplied and risks being dependent on OPEC to continue to limit their output. This over supply scare seems to have effected all energy exposed securities including our holdings in EOG Resources (EOG), Parsley Energy (PE), Delek (DK), and Paterson-UTI Energy (PTEN, Financial).
We remain cautiously optimistic regarding our outlook on the second half. We think the U.S. will continue to work on normalizing rates, though at a slow, controlled pace as inflation is still well-below the Fed’s target despite strong employment. The market continues to move forward on the economy’s apparent strength regardless of expectations regarding the passage of President Trump’s policy agenda. We believe that any reduction in corporate tax rates would be most beneficial to small cap companies given their domestic focus. This might also increase merger and acquisition activity due to clarity on tax policy. With little stimulus from Washington, the U.S. economy should continue to grow in the low single digit range as the World economies heal. A focus back onto company fundamentals and those companies that can do something to accelerate growth in this environment should benefit active management and our restructuring driven approach.
The top three performing stocks in the quarter were:
Zoetis (ZTS, Financial) is an animal health company that was a spin off from Pfizer. The company reported very strong quarterly earnings and raised guidance for the full year. Early in the quarter, the company announced the acquisition of Nextvet, which strengthens their pipeline by adding an injectable pain platform to further diversify their animal health portfolio. Zoetis remains well positioned to continue to increase share in the livestock and companion animal markets while being insulated from the drug pricing and healthcare reform issues pressuring the human pharmaceutical companies.
Abbott Labs (ABT, Financial) is a large, multinational health care products company focusing on pharmaceuticals, diagnostic and nutritional products. The company reported a nice quarter beating estimates for both sales and earnings, and continued to execute well on the integration of recently acquired St. Jude Medical. Abbott also cleared the last hurdle to complete the long-delayed purchase of Alere (ALR) which should close in the third quarter of 2017.
Howard Hughes Corp. (HHC, Financial) is a real estate development company that was a spinoff from General Growth Properties. The company has benefitted from growing excitement as they become more shareholder friendly under the leadership of new CFO, David O’Reilly. Showcasing one of their major developments, they held their inaugural investor day at South Street Seaport in New York City. This followed their first earnings conference call earlier in the quarter. Finally, the company has also begun to travel and proactively meet with investors. Operationally, HHC is continuing to progress on developing their five main projects and they remain focused on increasing the Net Operating Income (NOI) as the developments mature.
The bottom three performing stocks in the quarter were:
Wright Medical Group (WMGI, Financial) is a global medical device company focused on extremities and biologics. The company had exceeded analysts’ estimates for the past four quarters and EBITDA margins have increased from -5.5% in 4Q15 to 11.7% in 4Q16, on its way towards their 20% margin target by 2019. Unfortunately, the company missed first quarter 2017 earnings as a planned salesforce expansion did not lead to increased sales as quickly as hoped. Underlying metrics remain strong and the company should recover as the year proceeds. 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.
Kennedy Wilson (KW, Financial) is a vertically integrated global real estate investments and services firm that is involved in every aspect of real estate. Kennedy Wilson entered the UK/Ireland market in 2011 by acquiring $1.8bn of troubled real estate from the Bank of Ireland, and later took this entity, Kennedy Wilson Europe (KWE), public in 2014 retaining a 17.7% interest. With the decision for BREXIT, KWE traded down despite limited exposure to the UK and London. Believing KWE was being significantly undervalued, management increased their ownership stake to 24% via open market purchases, and then subsequently decided to acquire the remaining portion of KWE for stock, which has led to arbitrage trading pressure on the stock. Once the transaction is complete, we believe the cost savings and a more simplified structure will enable the stock to outperform and close the discount to its net asset value.
Patterson UTI (PTEN, Financial) is an oil services company that is a leading operator of high specification drilling rigs as well as an operator of a large pressure pumping fleet. Both businesses should see a dramatic recovery in margins as capacity in the industry tightens from a reacceleration in drilling activity based on exploration & production (E&P) customer budgets. To start the year, several E&P customers had acknowledged a 10-15% increase in service costs in their capital budgeting for 2017 due to a lack of availability in pressure pumping horsepower and high spec drilling rigs. Also, Patterson is about to close on its acquisition of Seventy Seven Energy, which recently emerged from bankruptcy, adding scale to both sides of its business. The stock performed poorly during the quarter as oil prices pulled back to the mid-$40 per barrel range which sparked fears that US drilling activity might slow its recovery. However, on the company’s earnings call, the company spoke to the activation of more pressure pumping crews and equipment which will be deployed in second quarter of 2017 as well as construction of two new high spec rigs for customers with day rates that are near pre-downturn levels. Both data points are indicative that our utilization and pricing recovery thesis is intact.
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 All Cap Value Fund. We appreciate your confidence and trust.
