To Our Shareholders,
For the quarter ended September 30, 2020, the KEELEY Mid Cap Dividend Value Fund's net asset value ("NAV") per Class A share rose 2.84% compared with a 6.40% gain for the Russell Mid Cap Value Index. For the year-to-date, the Fund is down -19.08% compared with a -12.84% fall 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% seasonally adjusted annualized rate, an impressive snap-back.
We see confirmation 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 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 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 within the Russell MidCap Value Index lagged non-dividend-paying stocks, a couple small overweights and underweights detracted further from performance, and the impact of Stock Selection on results was negative.
We estimate that non-dividend-paying stocks within the Russell MidCap Value Index gained 8.9%, while dividend-paying stocks only produced a 5.4% total return. While this is a narrower gap than last quarter, it remained a headwind and came after the dividend payers did not perform much better in the rst quarter's sell-o .
Among sectors, small underweights in the Industrials and Communications Services sectors and a small overweight in the Energy sector all detracted from relative performance. e impact from Stock Selection was broad and was most acute in the Utilities, Industrials, Technology, and Materials sectors.
- The performance of Utility stocks has been puzzling to us this year. Despite a steep drop in interest rates and relatively stable earnings expectations, Utility stocks within the Russell MidCap Value Index have declined almost as much as the Index itself. is is unexpected and we believe it represents an opportunity. In the quarter, the Fund's holdings lagged the sector mostly due to a decline in the shares of Evergy. e company concluded a strategic review without coming to the hoped-for conclusion of a sale
- The Fund's holdings in the Industrial sector detracted from relative performance as they failed to keep up with the strong gains in the benchmark. GrafTech, a leading maker of electrodes used in steelmaking was the only signi cant detractor despite the fact that earnings expectations stabilized and even improved a little.
- While gains in the Technology sector overall did not match the market, the Fund's holdings in the sector declined slightly. is was mostly due to a decline in the shares of government IT services provider Perspecta, which we discuss further below.
- Similar to the Industrial sector, the Fund's performance in the Materials sector was good, but not as good as the benchmark. Unlike in the Industrial sector, none of the Fund's holdings declined very much, they just did not go up as much as the strong 13% gain in the sector.
During the quarter, the Fund did not add or eliminate any positions.
Let's Talk Stocks
The top three contributors in the quarter were:
Fortune Brands Home & Security (FBHS, Financial) (FBHS - $86.52 - NYSE) is one of the leading manufacturers of products used in new home construction and repair & remodel with strong market positions in cabinets and plumbing products. Fortune Brands is a key bene ciary of the pandemic-induced dislocations as consumers shifted spending to home repair and remodel driving strong growth and pro tability in the company's agship plumbing brand Moen and composite decking Fiberon business. e improvement in new home construction should drive improvement in the cabinets segment as the value-priced o erings have performed well in this environment. e near-term outlook and underlying trends remain favorable.
Quanta Services, Inc. (PWR, Financial) (PWR - $52.86 - NYSE) is a specialty contractor in the electrical power, oil and gas, and communication industries. Quanta Services reported a very strong quarter as operating margins exceeded expectations. e company also reported strong cash ow generation in the quarter with YTD results already towards the low-end of upwardly-revised, full-year Free Cash Flow guidance. e backlog fell sequentially as the company removed the Atlantic Coast Pipeline (ACP) project but still increased almost 10% year/year. Quanta's balance sheet remains strong with net debt to EBITDA below its targeted range of 1.5x to 2x and the company reauthorized a $500 million share repurchase program.
KB Home (KBH, Financial) (KBH - $38.39 – NYSE) is one of the nation's leading homebuilders. KB Home is back as a top performer for the second quarter in a row as new housing demand continues to accelerate driven by rst-time buyers which represent more than half of the company's new orders. Pro tability has improved due to management's focus on cost reductions and pushing higher average selling prices. We expect this increased demand to continue near-term driven by the Millennials aging into prime home buying age. In addition, the current "work-from-home" dynamic introduces an element of mobility that could further accelerate housing trends. Importantly, record low mortgage rates remain supportive.
The three largest detractors in the quarter were:
Valero Energy (VLO, Financial) (VLO - $43.32 - NYSE) is one of the largest independent re ners in the US with re ning operations along the Gulf Coast, in Canada, and in the UK. Despite its advantageous footprint along the Gulf Coast, VLO was not immune to several issues that a ected the re ning industry during the quarter. ese included as sharply lower commodity prices which led to lower gasoline crack spreads, lower utilization because of a lack of jet fuel demand, and a surplus in diesel fuel. Finally, an announcement late in the quarter by the governor of California that would e ectively ban internal combustion engine vehicles by 2035 dampened sentiment for the group. VLO is a high-quality company which should see a pickup once the North American economy emerges from the COVID-19 recession.
Diamondback Energy (FANG, Financial) (FANG - $30.12 – NASDAQ) is a Texas-based exploration and production company with a large footprint in the proli c Permian Basin. Results for the second quarter were disappointing due to the rst quarter collapse in oil prices. is saw the company unable to generate free cash ow despite dramatically slowing its cadence for well completions. e company sees much lower capital spending in the second half of the year and into 2021. is should allow it to generate a healthy amount of free cash ow while keeping production at and reducing costs. FANG remains committed to its dividend, which is currently close to a 5% yield.
Perspecta, Inc. (PRSP, Financial) (PRSP - $19.45 – NYSE) is a leading provider of information technology services to the civilian and defense agencies of the Federal government. While Perspecta has seen limited impact from the COVID-19 pandemic thus far because its employees provide essential services to the government, social distancing procedures appear to be slowing some contracting operations and the ramp-up of new contracts. is has led to slight reductions in forward estimates and caused some softness in the stock in the third quarter.
Conclusion
In conclusion, thank you for your investment in the KEELEY Mid Cap Dividend Value Fund. We will continue to work hard to justify your con dence 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.
