To Our Shareholders,
For the quarter ended December 31, 2020, the Keeley Small-Mid Cap Value Fund's net asset value ("NAV") per Class A share rose 29.65% compared with a 28.51% gain for the Russell 2500 Value Index. For the full year, the Fund was up 0.63% compared with a 4.88% rise in the benchmark.
Commentary
In a year with as much volatility and uncertainty as we had in 2020, maybe it should not be surprising that the Russell 2500 Index had its two best quarters ever (the second and fourth quarters) and its worst quarter ever (the rst quarter). e fourth quarter ended on a strong note as small caps were particularly strong and mid caps also performed well.
In fact, small cap stocks outperformed large cap stocks by a record amount for a quarter. Whether using the Russell 2000 itself or the 2000 Value or 2000 Growth Indices, they all outperformed their large cap comparables (Russell Top 200) by 19-20 percentage points. You have to go back to the rst quarter of 1991 to get anywhere close to this. Given how much they have lagged in recent years, we have argued that small-caps were due for a catch-up rally, but we did not expect the magnitude of this move. e long awaited rotation has arrived. As a result of this, full-year returns for small caps trailed large caps by a couple points and they actually exceeded the returns for mid cap stocks; 20.0% for the Russell 2000 vs. 22.4% for the Russell Top 200 and 17.1% for the Russell Midcap Index. e Russell 2500 was up 27.4% in the quarter to end the year up 20.0%.
While Value stocks outperformed in the fourth quarter, Growth stocks built a sizable lead in the first three quarters and remained well ahead for the year; +2.9% for the Russell 3000 Value vs. +38.3% for the Russell 3000 Growth. Returns for Value have only exceeded those for Growth in three of the last ten years and the difference in annualized returns has been 3.3% per year. We call attention to 1990s when Growth outperformed Value in six of the ten years with an average return differential of 4.4%. The '90s were, of course, followed by the 2000s when Value outperformed in eight of ten years by an average of 6.7%.
It appears that we are in the early stages of a shift in market leadership from large to small and mid and from growth to value. is new cycle is being powered by the combination of the lagged impact of global massive monetary and scal stimulus along with the prospect of multiple vaccines. We could expect strong economic growth next year accompanied by an impressive recovery in corporate earnings. Given the positive backdrop, equities are positioned for sustained gains over the next few years. Our outlook for 2021 centers on the combination of historic excess liquidity, engineered by the U.S. Federal Reserve and global central banks, coupled with a synchronized global recovery. Along with a high consumer savings rate, the U.S. housing market remains robust as evidenced by record sales of both existing and new homes. Another engine of global growth is China, which is enjoying a prolonged v-shaped rebound throughout its economy. China's industrial production rose 7% in November, while retail sales grew 5%.
Since the lows in March, the market has regained its old highs. While valuations have been somewhat stretched, our value universe of smaller company stocks still o ers reasonable risk /reward. Since the initial snapback, the market grinded higher on improving economic data and progress in managing the pandemic. In the fourth quarter, we got a big dose of both of these developments as several vaccines in clinical trials passed key hurdles, including FDA approval, and Congress passed another round of stimulus payments.
In addition, the outcome of the national election with Joe Biden as President and Democrats in control of Congress, should lead to signi cant scal stimulus and infrastructure spending, generally bene ting cyclicals, industrials, nancials and materials companies, where we deploy much of our research e ort to uncover attractively priced equities. is should also have direct impacts on consumer and construction companies. On the negative side, President-elect Biden campaigned on a platform that included raising corporate taxes. We note that in the aftermath of President Trump's election win in 2016, Financial and Energy stocks performed very well because investors believed that a Trump administration would ease regulation on those industries. However, the pandemic changed all that with those stocks among the worst performing sectors since then. We remain optimistic about prospects for the equity markets.
We believe the trajectory of the COVID-19 pandemic will continue to unnerve markets, particularly in the early part of the year. e market seems to be pricing in a relatively smooth roll-out of vaccine programs and a tapering o of the pandemic as we work through the rst half of the year. If this schedule is thrown o by signi cant delays in manufacturing or distribution, unwillingness of healthy people to be vaccinated, or mutations of the virus that make the vaccine less e ective, we think markets would struggle. Our expectation: we think that there will be some slight delays and shut-downs could get worse in the near-term, but our expectations are for conditions to be "mostly normal" by end of the year.
As for in ation, with the exception of energy, commodity prices are higher over the last year despite the economic contraction. Gold is up 24%, silver is up 47%, copper is up 26%, but also corn is up 25% and soybeans are up 37%. Inflation can create cost issues for some companies, but more importantly, in ation expectations influence long-term interest rates and those impact valuations. We would expect in ation to ultimately meet the Fed's target goal of 2 percent as evidenced by the steepening yield curve. The trajectory of corporate earnings will likely influence the markets this year. Current estimates call for earnings in the Russell Top 200 to fall 10% in 2020 and then rise 18% in 2021. For small caps, we witnessed a fall of 50% last year and in 2021 expect a steep increase of greater than 100%. Mid caps land in between at down 29% in 2020 and up 42% in 2021. While estimates for the year are often high at the beginning of the year, this is not usually the case in recovery periods. Furthermore, forward expectations have been rising over the last several months. Our expectation: We think earnings will surprise to the upside. As bottom up, fundamental value investors, we seek to uncover high quality undervalued stocks that we believe offer the best risk/reward trade-off at any given time.
Portfolio Review
The Fund's performance continued to rebound and it has now outperformed its benchmark for three quarters in a row.
The Stock Selection effect drove the strong results as Sector Allocation detracted from performance. Even within Sector Allocation, almost all of that impact came from the Fund's small cash holdings (2.5% on average). Underweights in Real Estate and Health Care and an overweight in Technology helped performance while an overweight in Utilities and an underweight in Financials were small detractors.
The impact from Stock Selection was most positive in the Consumer Discretionary sector followed by Industrials and Financials. Performance of the Fund's holdings in the Technology sector lagged those of the benchmark.
- Several of the Fund's "recovery plays" drove performance in the Consumer Discretionary sector. Clothing manufacturers Kontoor Brands (Lee and Wrangler), which will be discussed later in this report, and PVH (Calvin Klein and Tommy Hil ger) were up 71% and 83%, respectively, in the quarter as it became apparent that Christmas spending would be okay. Visteon (auto parts) also appreciated sharply as car sales returned. TRI Pointe (homebuilding) declined, but had held up very well in previous quarters.
- Recovery and momentum were two themes in the Industrial sector. Chart Industries is an example of the latter as it was the Fund's largest contributor this quarter (and will be discussed later in this report) and was the second biggest contributor last quarter. e recovery theme was exempli ed by Air Lease (commercial aircraft leasing) and Altra Industrial Motion (industrial components). On the negative side, building products companies Fortune Brands (discussed later) and AO Smith (water heaters) lagged the strong performance of the market and sector, but had previously performed well this year.
- The Financials sector was the third best performing sector in the benchmark with a 35% gain in the quarter. It trailed only the Energy and Information Technology sectors (+47%, +37%). e Fund's holdings in the sector performed signi cantly better as its focus has been more on banks and capital markets-oriented companies than insurance companies. No one stock accounted for much of the outperformance as all of the Fund's sixteen holdings appreciated and eight of them rose more than 40%.
- While the Fund's holdings appreciated more than 27%, it was not enough to keep up with the strong gains for Technology stocks in the benchmark. Lackluster performance by the stocks of Black Knight (mortgage servicing software and services) and Teradata (data management systems) was a drag on the sector's performance. On a positive note, Wex (payment processing for fuel and travel purchases) rebounded sharply.
We continue to emphasize companies that are earlier in their restructuring e orts as well as expanding the number of corporate change events we look at. To that end, the Fund added ten new positions and eliminated two holdings during the quarter.
Let's Talk Stocks
The top three contributors in the quarter were:
Chart Industries (GTLS, Financial) (GTLS - $117.79 β NASDAQ) is the leading provider of cryogenic solutions for industrial gas, energy and biomedical customers around the globe. During the quarter, the company announced several transactions that will accelerate its exposure to the commercialization of hydrogen as a fuel, an area of considerable opportunity. In addition, on its third quarter conference call, Chart highlighted its momentum with several new customers outside of hydrogen applications.
Kontoor Brands (KTB, Financial) (KTB - $40.56 β NYSE) is the second-largest manufacturer in the global jeans market, with its portfolio largely consisting of the Wrangler and Lee brands. Shares rallied during the quarter as Kontoor management reinstated the company's dividend and also resumed earnings guidance at a level well ahead of where analyst expectations had been. With a strong sell-in of Lee at Walmart and robust digital sales, Kontoor saw its revenues stabilize sooner than previously expected, and a shift to casual wear during the pandemic also benefited Kontoor. Also, Kontoor's gross margin has been buoyed by product cost improvements, channel mix and product mix.
Air Lease Corporation (AL, Financial) (AL - $44.42 β NYSE) is a leading lessor of commercial aircraft to airlines around the world. While COVID-19-related travel restrictions and related lower leisure and business travel demand have made life very difficult for Air Lease's customers, the company has been partially insulated from the challenges they face. Its fleet of newer, modern aircraft remain desirable so airlines have continued to keep them in service and pay their leases. This is not to say that customer financial restructurings and delayed deliveries of new aircraft from Boeing and Airbus have not created challenges, only that the company has done a good job of managing these headwinds. Air Lease shares benefitted in the fourth quarter from a solid third quarter earnings report and an improving outlook for a 2021 recovery driven by the success of coronavirus vaccines in clinical trials.
The three largest detractors in the quarter were:
Note: It is important to keep in mind that the strength in the market created a situation where the detractors did not really cost much in an absolute sense. The Fund's worst-performing stock, TRI Pointe Group, was down only 3%.
TRI Pointe Group (TPH, Financial) (TPH - $17.25β NYSE) is one the nation's leading homebuilders. The company reported a good quarter beating consensus estimates, but sentiment turned negative on the stock. Housing orders accelerated in the quarter and more of those orders are from the Millennial demographic. Management noted that underlying trends remain favorable with strong growth in backlog both in dollars and units, but near-term sales mix will likely be a headwind. Historic low interest rates continue to be supportive to the housing sector.
Diamond S Shipping, Inc. (DSSI, Financial) (DSSI - $6.66 β NYSE) is a shipping company focused on crude and product tankers worldwide. Diamond S Shipping fundamentals are tied to oil prices and consumption which are under tremendous pressure due to the negative impacts globally from COVID-19. The company continues to execute as best it can in a very difficult environment. However, it does appear that spot shipping rates might be bottoming with current rates toward the bottom of the 10yr average. We started buying shares of Diamond S Shipping last quarter partly on the thesis that spot rates were likely to bottom in 2021 as the global economy recovers. The other part of the thesis is valuation as the stock trades at a discount to underlying ship values.
Fortune Brands Home & Security (FBHS, Financial) (FBHS - $85.72 - 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 has been a key beneficiary of the pandemic-induced dislocations as consumers shifted spending to home repair and remodel. The company continues to post strong results with double-digit revenue growth and modest profitability improvement. Despite this, the stock struggled in the quarter as sentiment turned sour on Fortune Brands on elevated expectations. Underlying trends remain favorable and management expects sales growth and margin improvement in 2021.
Conclusion
In conclusion, thank you for your investment in the KEELEY Small-Mid Cap Value Fund. We will continue to work hard to earn your confidence and trust.
This summary represents the views of the portfolio managers as of 12/31/2020. 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.
