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Sydnee Gatewood
Sydnee Gatewood
Articles (3200) 

Keeley Small Cap Dividend Value Fund 3rd-Quarter Shareholder Commentary

Discussion of markets and holdings

To Our Shareholders,

For the quarter ended September 30, 2020, the KEELEY Small Cap Dividend Value Fund's net asset value ("NAV") per Class A share fell -0.86% versus a 2.56% gain for the Russell 2000 Value Index. For the year-to-date, the Fund is down -21.69% compared with a -21.54% decline for the benchmark.

Commentary

The market continued its recovery in the third quarter in tandem with the economy. It should not be a big surprise that the economy rebounded sharply given that the second quarter fall was so severe and the reason for the decline was transient. Second quarter GDP declined at a staggering 31.4% annualized rate, the worst ever. The good news is that the Atlanta Fed's latest GDPNow reading is for third quarter GDP to increase at a 35.3% seasonallyadjusted annualized rate, an impressive snap-back.

We see con rmation of this recovery in a wide variety of economic statistics: e unemployment rate rose to 14.7% in April but has since receded each month since to September's 7.9% reading. Industrial Production fell 16.5% in April, but only 7.7% in August. e ISM (Institute of Supply Management) Index plunged to 41.5 in April but bounced to 55.4 in the September report. e positive data points include Consumer Con dence, Retail Sales, Trade, and other measures. e most interesting data point is Home Sales, which are actually above pre-COVID levels. e stock market has shown an equally impressive rebound. Using the Russell 3000 Index as the benchmark, the market fell 35% between its peak on February 19 and its trough on March 23. It then staged a 54% rally to make a new high on August 21 and closed the quarter a little lower than that, but still up 53% from the lows.

The gains in the market have been driven by an increasingly narrow set of mega cap growth stocks. Because of their weight in the indices, they drive the overall performance of the Index. Most stocks, however, have been left behind. As of the end of the third quarter, 70% of the stocks in the Russell 3000 Index remained below their February highs and 45% of them were at least 20% below those levels. If we take this analysis a little further, 80% of the stocks in the Russell 2000 Value Index have not regained their February price level and 58% are down more than 20%. At the other end of the spectrum, only 37% of Russell Top 200 Growth stocks are below the February level and only 4% are down more than 20%. is has widened the valuation spread between the returns of large cap stocks and those of small cap stocks as well as between growth stocks and value stocks. rough the rst three quarters, the spread between growth and value has been a mid-twenties percentage for small caps and mid-caps and almost 38% for large caps! is valuation gap is a rare historical occurrence though the performance spread between growth and value for small caps and midcaps in 1999 was 45% and 51%, respectively.

The other interesting aspect of this downturn and recovery has been the underperformance of dividend-paying stocks, even within the value indices. Whereas historically dividend-paying stocks performed much better than non-dividend-paying stocks during downturns and lagged a little during recoveries, this year they have lagged by a fair amount in the second and third quarter.

The underperformance of small caps vs. large caps, value vs. growth, and dividend-payers vs. non-dividend-payers has made dividend-paying stocks, particularly small cap and mid cap dividend-paying stocks exceptionally attractive from an income generation standpoint. e aggressive actions by the Fed to lower short-term interest rates dragged down longer-term rates as well. e yield on the ten-year treasury remains well below one percent and near historic lows. e Russell Top 200 yield/10-year Treasury yield has risen to 235% at the end of the third quarter compared to 91% at year-end. While equities have yielded more than treasuries before, this condition is unusual as it has only happened in about 11% of months since 1978. Almost all of these months were between 1998 and 2001.

Even more unusual is the relationship between the yield on small cap stocks and large cap stocks. e yield on small caps has been higher than that of large caps since June and at the end of September, the yield on the Russell 2000 Index was 1.64% vs. 1.62% for the Russell Top 200. at has only happened in about 8% of months since 1978. e combination of higher equity yields and higher small cap yields has never happened before June of this year.

If we compare the yields on dividend-paying stocks, the income advantage increases. e average yield on dividend-paying stocks in the Russell Top 200 is now 2.63% whereas the average yield on the dividend-paying stocks in the Russell 2000 Index is an impressive 3.72%. Dividend-paying equities are very attractive from a yield perspective and we are now witnessing early stages of a rotation back to undervalued equities which should provide strong tailwinds for our portfolios going forward. While the 2020 and 2021 macro outlooks are diminished, the longer-term prospects for many of our companies remain attractive. It is our job to conduct fundamental bottom up research and invest in these best of breed companies selling at discounts to their intrinsic value.

Portfolio Results

While the third quarter posted challenges, we are optimistic going forward given the attractive values within our investment universe. Dividend-paying stocks continue to lag non-dividend-paying stocks which made it di cult for the Fund to outperform. In the third quarter, we estimate that the dividend payers in the Russell 2000 Value Index returned a negative 1.5% compared with the 2.6% for the overall benchmark and 6.8% for the non-dividend-paying stocks in the Index. Some slight overweights and underweights relative to the benchmark added to the problems, and stock selection detracted as well.

Slight underweights in the Industrials and Consumer Discretionary sectors and a slight overweight in the Utilities sector detracted from performance. Weak relative performance from the Fund's holdings in the Industrials, Consumer Discretionary, Energy, and Materials sectors offset good results in Health Care and Real Estate.

  • While the Health Care sector was one of the stronger sectors in the benchmark, the Fund's holdings outpaced the sector. is was mostly due to a strong gain in Ensign Group which was the Fund's largest contributor in the quarter and which we will discuss further below.
  • While the Fund's Real Estate holdings delivered a positive total return, those in the benchmark declined. e Fund's success was largely due to double-digit gains in National Storage A liates and PotlatchDeltic, which tend to be a little more economically sensitive than most Real Estate Investment Trusts.
  • The Industrial sector was the Fund's biggest detractor as a slight underweight and some disappointing stocks led to a performance shortfall in one of the better sectors in the quarter. Only two of the Fund's nine holdings outperformed the sector, but most of the weakness came from Health Care Services Group and Covanta despite both companies reporting better than expected second quarter earnings.
  • While the Fund's Consumer Discretionary holdings generated a 14% total return in the quarter, they did not keep pace with the 21% gain for the sector in the Index. e only real disappointment in the Fund's holdings was Winnebago which was the Fund's biggest detractor in the quarter and is discussed below. Interestingly, four of the Fund's seven holdings were up more than 20%. is included Kontoor Brands and Culp which were two of the biggest contributors and are discussed below.
  • Energy was the worst-performing sector in the Index and the Fund's holdings underperformed. Declines in the share prices of Delek (discussed below), Texas Paci c Land, and Parsley Energy accounted for the disappointing results. All three operate in the Permian Basin and su ered from uneven pricing in that area.
  • The Fund's results in the Materials sector were a "tale of two cities." While Compass Minerals and Olin performed well, weakness in Kaiser Aluminum and Mercer International o set these gains. Kaiser suffered from continued weakness in aerospace while Mercer has a good deal of exposure to exports to China.

During the quarter the Fund did not add any new positions and eliminated only one.

Let's Talk Stocks

The top three contributors in the quarter were:

Ensign Group (NASDAQ:ENSG) (ENSG - $57.06 – NASDAQ) is a provider of healthcare services in the skilled nursing and senior housing markets. Ensign reported a very strong quarter handily beating consensus estimates in an operating environment made more di cult by the COVID-19 pandemic. Importantly, the company contained the spread of the disease across most of its facilities putting Ensign's operating model towards the top of the pack. Acquisition activity slowed in the quarter, but pandemic-related issues could accelerate this activity. Underlying trends remain very strong allowing management to raise guidance above pre-pandemic levels.

Kontoor Brands (NYSE:KTB) (KTB - $24.20 – NYSE) is the second-largest manufacturer in the global jeans market, with its portfolio largely consisting of the Wrangler and Lee brands. Kontoor's shares lagged the broader market earlier this year, but they rebounded nicely in the third quarter as the company and its primary competitor both saw trends improve. In addition, Kontoor's signi cant launch of Lee in 2,000 Wal-Mart stores has been tracking very well. More broadly, as the pandemic has dragged on, consumers have continued their shift toward wearing more casual apparel. at trend initially had bene ted athleisure brands, but it's increasingly turning out to be a plus for jeans manufacturers as well. Finally, Kontoor is due to reinstate its dividend during the fourth quarter.

Culp, Inc. (NYSE:CULP) (CULP - $12.42 – NYSE) is a leading manufacturer of mattress and upholstery fabrics. Culp reported better than expected results this quarter as the mattress fabrics segment approached pre-pandemic levels by quarter-end. Management stated on its earnings call that trends heading into the second half of the year were encouraging. Additionally, the company is well positioned to capitalize on improved housing activity, which could lead to improved mattress and furniture sales and overall improving economic conditions. e cash-rich balance sheet provides exibility and support for this anticipated growth.

The three largest detractors in the quarter were:

Winnebago (NYSE:WGO) (WGO - $51.67 - NYSE) a leading recreational vehicle (RV) manufacturer seeing a resurgence of the "RV lifestyle" driven by pandemic related shutdowns and overall health and safety fears making the great outdoors appealing. However, this quarter reversed some of last quarter's very strong performance as the market digested the strong improvement in backlog that the company reported at the end of June as some investors start to question the sustainability of this recent spike in underlying demand. We believe that these trends do remain very favorable over the near-term and that this demand should translate into higher backlog and improving pro tability. Heading into this year, Winnebago increased its market share in the towable segment, and we see no reason for that to slow down. We believe Winnebago is well-positioned to capitalize during this current environment.

Delek US Holdings (NYSE:DK) (DK - $11.13 – NYSE) owns and operates four re neries in TX, LA and AR and 250 retail gas stations in several Southern states as well as partnership interests in several midstream pipeline projects. e quarter was extremely challenging with a collapse in oil prices having a severe impact on re ning pro tability at a time when the company was investing in its midstream projects. is had a negative impact on earnings and free cash ow. A recent announcement by the governor of California which set a 2035 deadline for essentially banning internal combustion engine vehicles also did not help sentiment for the group. In response, Delek is aggressively reducing costs and has made moves to simplify its structure.

South Jersey Industries (NYSE:SJI) (SJI - $19.27 – NYSE) is a utility holding company that operates a gas Utility in Southern New Jersey as well as providing Wholesale Energy Marketing and Fuel Management services. e stock has been under pressure the past couple of quarters along with the overall Utility sector. ere are fears that COVID-19 will negatively impact demand along with changing investor sentiment. However, the company reported solid results over the past couple of quarters along and rea rmed its full-year earnings expectations. We attribute some of the weakness to its partial ownership of the proposed PennEast pipeline. is is a partially constructed pipeline where the viability of its completion is in doubt as a result of the litigation-related cancellation of another pipeline project. Until it is resolved, this issue could remain an overhang. In addition, we would have expected the Utility sector to perform better in this low-rate environment given the regulated nature of the business and very attractive dividend yields. We continue to like South Jersey's attractive valuation (13x 2020 estimate of $1.53) and dividend yield of 5.9%.

Conclusion

In conclusion, thank you for your investment in the KEELEY Small Cap Dividend Value Fund. We will continue to work hard to justify your confidence and trust.

October 14, 2020

This summary represents the views of the portfolio managers as of 9/30/20. 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.

About the author:

Sydnee Gatewood
I am the editorial director at GuruFocus. I have a BA in journalism and a MA in mass communications from Texas Tech University. I have lived in Texas most of my life, but also have roots in New Mexico and Colorado. Follow me on Twitter! @gurusydneerg

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