To Our Shareholders:
For the quarter ended December 31, 2017, the KEELEY All Cap Value Fund’s net asset value (“NAV”) per Class A share rose 6.03% versus a gain of 5.08% for the Russell 3000 Value Index. For the year, the Fund gained 12.29% compared with a 13.19% gain for the Index.
Commentary
The markets ended the year on a strong note, with the major US equity indices at or near all-time highs. The holiday cheer was not confined to the US as stock markets in the UK, France, Germany, Japan, India, and Brazil all closed the year at or close to highs. Equity markets, however, were not the only places displaying strength. Commodities also advanced into the end of the year with the Goldman Sachs Commodity Index closing near its year-high, as underlying components such as oil, aluminum, and nickel exhibited strength. This global optimism led the yields on the 3-month treasury bill and 5-year treasury note to close 2017 at near highs, even though there was little evidence of inflation. In fact, the only major benchmark seeing a significant retreat in 2017 was the CBOE Volatility index – also known as the VIX Index – which tends to decline when US equities rally.
The global stock rally appears to have been fueled by improving corporate earnings, strengthening economies around the world, and supportive monetary policy from the global central banks. Many of these factors have driven gains in US stocks, as domestic economic data has been setting six-year records. And with the passage of a new tax law that will reduce corporate tax burdens, investors remain bullish that economic expansion will continue in 2018.
Taking a closer look at economic trends both in the US and overseas, one sees that economic expansion has been broad-based by sector. Business confidence surveys such as the purchasing manager indices (“PMI”) reveal that 96 percent of the 28 countries tracked showed expansion of their manufacturing sectors and that 83 percent saw services sector expansion. Recent data suggest business spending is also starting to pick up. Although tax reform was the sole item on the Trump agenda that successfully passed, the new Administration has been quietly reducing regulation which in turn is giving companies confidence to invest.
This strong economic expansion has produced continued job growth. The Eurozone jobless rate of 8.8% is at its lowest level in nine years. The picture is even rosier in the US, where the unemployment rate remains historically low and the US continues to add jobs at a brisk clip: December’s unemployment rate held at 4.1%, the lowest in 17 years.
This labor-market strength has helped drive growth in US consumer confidence during the year, despite a small decline in December. Although wage growth has been slow, consumers have remained confident amid low unemployment and near record job openings. Confidence may improve further as many companies have announced measures to share some of the benefits of lower corporate taxes with employees through wage increases, one-time bonuses and benefits improvements.
Overall, the global economy appears to be on solid ground heading into 2018, with strong business and consumer confidence, further strength in labor markets, higher wages and low borrowing costs. All this should set a backdrop for growth in consumer spending.
With lower corporate taxes, companies should have greater earnings and operating cash flow leading to other interesting capital allocation options besides stock buy-backs and dividend increases, which have been used more frequently over the past few years. The new tax law encourages capital spending, so we expect a rebound from current low levels of corporate investment. In addition, limits on interest deductibility will likely encourage certain companies to pay down debt, or spur highly levered private companies to sell. Other companies will look to use the cash to grow via acquisitions, thereby increasing M&A opportunities.
Worldwide merger and acquisition activity has exceeded $3 trillion for the fourth consecutive year, extending an unprecedented wave of deal making that should accelerate under new US tax reform. The US remains the most active region with a record 12,400 deals, amounting to $1.4 trillion. As value investors, we search for companies that are neglected, overlooked and selling at discounts to our calculation of intrinsic value. We also seek companies where restructuring improves their outlook and therefore makes them attractive consolidation candidates. M&A activity should not only help smaller companies that may be acquired at a premium, but also larger companies that can either sell divisions to become more focused or that can acquire to increase operating leverage. We believe our style of active investing will benefit from M&A wave as a result.
We do, however, see three potential threats to further stock market gains - higher inflation, valuation and geopolitical risk. Oil and other commodity prices have ticked up and this could push prices higher. In addition, the tighter labor market may ultimately drive higher wages and more inflation. So far, these factors look manageable, but if they accelerate, the Fed and other central banks may tighten more aggressively.
Valuation is the second challenge. We are eight years into a stock market recovery. Over the last several years, earnings gains have failed to keep pace with stock price appreciation. At year-end, the S&P 500 traded at 18.2x estimated 2018 earnings, well above the 15.7x average since 1999. At this point in the business cycle, the market has historically had a difficult time exceeding 19x forward earnings. However, we think that valuations are not as high as they appear because the impact of tax reform is not yet fully reflected in analyst estimates, and many strategists think that the new lower tax rate will add 5%-10% to corporate earnings. For our smaller, mid-sized companies, we think the positive impact could be double this amount, largely owing to the more domestic sources of earnings for these companies vs. those in the S&P 500. There remain many unanswered questions, such as how much of the benefit will be shared with employees and/or customers, how much will be reinvested and how much will be competed away. In addition, even adjusted for the impact of tax reform, valuations remain above average.
Finally, unexpected geopolitical developments now seem likely to be more of a challenge than an opportunity.
For the fourth quarter, our returns were slightly negatively impacted by our overweight allocation in Real Estate, which underperformed in the quarter, and our slight underweight to Financials which outperformed in the quarter. Positive sector allocation came from Utilities and Telecom weights.
Importantly, stock selection led to positive results in the quarter. Our positive selection was led by contributions from the Industrial, Energy and Utility sectors. In Industrials, ITT and Air Lease posted strong performance given global economic strength. In Energy, both Delek and EOG posted strong quarters as the outlook on energy improved. In the Utility space, NRG continues to execute its simplification plan, again pushing its share price closer to what we perceive as fair value. On the negative side, Del Taco was a tough name in the Consumer sector due to concerns over potential wage and food cost inflation.
The top contributors in the quarter were:
Delek US Holdings (DK, Financial) operates four mid-sized refineries in Texas, Oklahoma, and Louisiana. Its plants are well-located to benefit from wider crude differentials. Earlier in 2017, Delek acquired competitor Alon USA and as a larger, better capitalized combined company, it has opportunities to reduce costs and fund additional capital improvements to generate higher levels of income. During the quarter, Delek also benefitted from greater profitability due to declining crude and product inventories plus some price divergences created by the disruption from Hurricane Harvey.
Voya Financial, Inc. (VOYA, Financial) is a leading provider of retirement and investment services such as life insurance, annuities, and 401(k) plans. It was carved out of Dutch financial services conglomerate ING in 2013 and has worked to lower its risk, change its product mix, and improve returns in recent years. Despite its operating improvements, the stock traded at a discounted valuation due to the overhang from a large closed-block of older, riskier variable annuities. Late in the fourth quarter, Voya announced that it had sold this block and an annuities business to a new private-equity backed company. We believe that these sales will further reduce risk, improve returns, and remove the overhang. The company has already bought back ~ 40% of the outstanding shares since going public in 2013, and has announced that they will buy back another $1.5 Bill of stock in 2018.
Intel Corp. (INTC, Financial) engages in the design, manufacture, and sale of computer, networking, and communications platforms that power the cloud and the connected world. The company has been in the process of transforming its business away from its mature, slower growing personal computer (PC) exposure to higher growth data center, communications and memory markets. After several lackluster quarters, Intel posted a better than expected 3Q17 with growth across all businesses along with excellent expense control.
The three largest detractors in the quarter were:
Del Taco Restaurants, Inc (TACO, Financial) engages in developing, franchising, owning, and operating Del Taco quick-service Mexican-American restaurants. Led by a recently promoted CEO, John Cappasola, the California based company has been successful at revitalizing the brand and introducing new products as evident by sixteen consecutive quarters of systemwide sales growth. Despite reporting sales growth of 4.1% in the third quarter, the stock sold off on concerns regarding future margin headwinds stemming from both food and labor inflation. In addition, the industry continues to fight for market share by pushing “value bundles” led by the larger brands such McDonalds. We continue to believe the company is well positioned to weather this environment and will continue to prudently grow outside its’ core West Coast roots utilizing a barbell menu strategy of new entrees combined with compelling “buck and under” menu items.
Wright Medical Group, NV (WMGI, Financial) is a global orthopedic medical device company focused on upper/lower extremities and biologics. The company underperformed as it suffered disruption from a sizable sales force expansion that ultimately resulted in the company reducing earnings guidance. While it is taking much longer for the new sales representatives to reach full productivity, the 50% increase in the size of the salesforce will ultimately be beneficial for the company as it results in accelerating sales and earnings growth.
Seritage Growth Properties (SRG, Financial) is a real estate investment trust (REIT) that owns 258 properties totaling 40 million square feet on 3,000 acres across 49 states. While the company continues to redevelop former Sears Holdings (SHLD) properties and lease them to specialty retailers at substantially higher rents, it still receives more than 50% of gross rental revenue from Sears Holdings. Such rental revenue contribution combined with constant fear of Sears underperforming during the crucial holiday season has created a headwind on SRG’s stock price.
Conclusion
In conclusion, thank you for investing alongside us in the KEELEY All Value Fund. We will continue to work hard to justify your confidence and trust.
