Performance
For the quarter ended March 31, 2021, the Small Cap Dividend Value Strategy gained 18.85% gross (18.50% net of fees) versus a 21.17% gain for the Russell 2000 Value Index.
Macroeconomic Review
As the economy sustained its recovery in the first quarter, the stock market continued to make new highs. More important to the Small Cap Dividend Value Strategy was that the value rotation toward small caps that began in the fourth quarter accelerated in the first quarter. We believe this process has only just started as “value” stocks remain very attractive relative to growth stocks on a historical basis.
Economic data continues to show a recovering economy in the U.S. The trend has been positive for most of the last year since the steep decline in activity in the second quarter of 2020. We see improvement in a wide variety of measures, both in sentiment readings and in actual measures of activity. On the sentiment side, both the University of Michigan and the Conference Board measure of consumer confidence made new recovery highs in their most recent readings. Business sentiment measures from ISM and Markit have also been surprising to the upside and are well above the 50 mark that divides expansion from contraction. The regional Fed surveys have also trended positive. The March jobs reports showed a surprisingly strong 916,000 increase in non-farm payrolls, well ahead of the 635,000 consensus expectations. The March JOLTS (Job Openings and Labor Turnover Survey) showed 7.4 million open jobs, not far from the 7.6 million record of November 2018 and above pre-pandemic levels.
At this point, it is difficult to ascertain how much of the continued upward recovery is due to the recent rounds of federal fiscal stimulus. Some shorter-term measures seem to correlate with the timing of each batch of stimulus checks, but it is also likely that much of the improvement is driven by growing comfort with getting out and doing things and easing government restrictions on activities. The expanding vaccination program should provide much-needed help to the travel, hospitality, restaurant, and other industries that depend on people’s willingness to congregate. While these industries represent only a small part of the overall capitalization of the stock market, they employ tens of millions of workers. As a result, a recovery in these sectors should provide an additional boost to employment and the economy.
The other challenge is evaluating how much of the expected improvement in corporate results is priced into stocks. With the S&P 500 Index and the Russell Top 200 Index trading at about 22x forward earnings and the Russell 2000 Index trading at 30x earnings, a good deal of the improvement is probably priced in. As we indicated last quarter, we believe that estimates are relatively conservative and that expectations are likely to trend higher. This means that the “real” multiple on forward earnings is lower than it appears. We expect upward revisions as we enter second quarter earnings season.
Within sub-segments of the market, Value appears to be more reasonably priced. Small-cap value, in particular, trades at 18.9x NTM earnings compared to a historical average of 16x. The average valuation for the Russell 2000 Value Index is nearly the same as it is for the Russell Top 200 Index. With that Index now at 22.2x, the R2V looks relatively attractive.
So, when will dividend-paying stocks return to favor?
We have been arguing that small cap stocks looked attractive relative to large caps and value stocks appeared compelling relative to growth stocks for the last several quarters. Last fall, we also made the case that dividend-paying stocks were also unusually attractive relative to non-dividend-paying stocks. In the first quarter, the first two observations turned out positively. The 12.7% gain in the Russell 2000 was well ahead of the 5.1% gain in the Russell Top 200 Index. Value stocks did even better as the Russell 2000 Value Index rose 21.2% compared to the 4.9% increase in the Russell 2000 Growth Index.
So far, dividend-paying stocks have lagged as the 20.2% gain for dividend-payers in the Russell 2000 Value benchmark was shy of the 21.2% gain for the Index. This marks the sixth quarter in a row that dividend-payers trailed. Some of this can be explained by the makeup of the indices. Utilities and Real Estate are the two worst-performing sectors over the since the beginning of 2020 and typically pay dividends. When we look at the performance di erence between dividend-paying and non-dividend-paying stocks within sectors, we have tended to see outperformance by the non-dividend-payers over the last year. This was particularly the case in some of the more important sectors such as Consumer Discretionary and Industrials, and especially in the second, third, and fourth quarters as the market rebounded.
We believe that dividend-paying stocks could be poised to regain their performance edge. For example, with rates low, the environment should be good for Utilities. They o er great yields, have opportunities to invest in rate base assets to support the energy transition, and are relatively insulated from potential corporate income tax changes. In other sectors, we believe the continuation of the recent trend toward restoring and raising dividends will motivate investors to reposition. In addition, while the upward move in prices has driven equity yields lower and the ten-year bond has moved higher, yields on dividend-paying stocks are still above those for bonds. The average yield on dividend-paying stocks in the Russell 2000 was above 2.5% at the end of the first quarter.
Portfolio Results
While absolute returns for the Small Cap Dividend Value Strategy were once again strong, the Strategy’s performance fell short of its benchmark, the Russell 2000 Value Index. We would cite a couple of factors: First, dividend-paying stocks within the benchmark continued to trail the non-dividend-paying stocks and the benchmark in its entirety. We estimate that the dividend-payers advanced 20.2% compared with a 23.0% increase in the non-payers and 21.2% for the benchmark. This has been a familiar refrain as dividend-payers have only beaten the benchmark a few times in the last couple of years. Partially inflating benchmark performance has been the performance of certain “meme” stocks. In particular, the 900%+ gain in GameStop added 71bps to the performance of the Russell 2000 Value. It is unusual for one stock to have a significant impact on the benchmark, but its parabolic appreciation caused the impact. GameStop does not pay a dividend (or even earn a profit).
If we disaggregate performance into Stock Selection accounted for a majority of the performance shortfall. Most of the Allocation e ect was due to a slight underweight in Information Technology helped a little and a slight overweight in Utilities detracted slightly. Stock Selection was better than the benchmark in Utilities, Energy, and Communication Services, but lagged in Consumer Discretionary, Industrials, and Real Estate.
- The uptick in interest rates during the quarter led the Utilities sector to be the worst-performing sector in the market, although the Strategy’s investments performed better than the overall sector. Solid results from Black Hills and Allete helped performance.
- Energy was the best-performing sector for both the Strategy and the Index. A 120% gain in the shares of Texas Pacific Land (discussed later) accounted for much of the outperformance, but the Strategy also saw solid increases from Delek and Pioneer Natural Resources.
- Communications Services is a small sector in the value benchmark as it mostly includes internet service companies in the overall indices. Both of the Strategy’s holdings, Nexstar Media and Cinemark Holdings, outperformed the sector in the benchmark. Nexstar continued to benefit from a recovery in advertising while Cinemark saw an increase in optimism about movie theater reopenings.
- Stock selection in the Consumer Discretionary sector accounted for more than 90% of the overall negative Stock Selection impact. While the Strategy’s holdings gained more than 24%, they did not keep up with the 36% increase in the sector. The sector’s performance trailed only the Energy sector during the quarter. While KB Homes and Penske Automotive Group performed well on strong earnings results, Del Taco Restaurants and Culp performed poorly despite decent results.
- We saw a wide range of performance among the Strategy’s Industrial stocks. Thirty percent gains from Apogee and Astec were o set by a slight decline from Allison Transmission. The Strategy’s 16% gain within the sector did not match the 19% gain for the overall sector, which was slightly worse than the benchmark. Earnings results within the Industrial have generally been strong, driven by the rebound in economic activity we have seen over the last three quarters. The stocks have benefitted from this and the expectation is that this will continue.
- Like Utilities, the Real Estate sector also lagged the overall market, likely on concerns about rising interest rates. The Strategy’s holdings lagged slightly largely due to sluggish performance from health care REITs CareTrust REIT and Sabra Health Care REIT.
During the quarter, the Strategy added six new holdings, had one stock converted to another due to a merger, and completed the sale of one position.
Leading Contributors
Texas Pacific Land Corporation (TPL, Financial) is a large owner of surface and royalty interests in the PermianBasin in Texas. The company also provides water management and land management services to support oil and gas production in the basin. The stock performed well during the quarter for a couple reasons. First, the price of crude oil (WTI) increased 22% which directly benefits the royalty payments the company receives. Second, the company converted its structure from a land trust with a board of three trustees to a corporation with a full board of directors. This allows the company to issue debt or equity to support larger purchases of royalty interest packages. With this conversion, the company will also change its dividend frequency from annual to quarterly.
Mercer International (MERC, Financial) is one of the leading producers of NBSK (Northern Bleached SoftwoodKraft) pulp which is used in tissue paper and of lumber through its wood products segment. The company started to see improved pulp market dynamics in the quarter with increased prices and production volumes. This has been driven by improvements in global economic activity, especially in China. Mercer’s wood products segment reported record results in the quarter as it benefitted from continued strength in lumber pricing because of robust housing demand. Management remains cautiously optimistic about these improvements but is concerned about global logistics challenges. So far, these appear manageable.
Synovus Financial (SNV, Financial) is a leading regional bank in the Southeastern U.S., with more than $50 billionof assets and 288 branches. Bank stocks continued to perform very well in the first quarter as investors upgraded earnings expectations for them. Strong fourth quarter results, rising rates, and improving credit all contributed to the positive reassessment. Synovus benefitted more than most bank stocks due to its lower starting valuation, its higher level of reserves, and its greater than average asset-sensitivity.
Leading Detractors
Chemed Corporation (CHE, Financial) is one of the largest providers of hospice services through its VITASsegment and provides plumbing, drain cleaning, and water restoration services through its Roto-Rooter segment. The company reported in-line results and up until this quarter was not greatly impacted by the pandemic. Management noted on the quarterly earnings call that hospice admissions will be negatively impacted by disruptions in parts of its referral network which will pressure top-line results. Partly offsetting this anticipated weakness is continued strength within Roto-Rooter’s residential business and management is optimistic about a turn in the commercial business. The near-term pandemic headwinds have ended the “beat and raise” streak for Chemed but is well-positioned for the long term.
Allison Transmission Holdings (ALSN, Financial) is a manufacturer of fully-automatic transmission products formedium and select heavy-duty truck manufacturers. The company issued disappointing guidance for 2021 when reporting fourth quarter 2020 earnings due to the timing of certain customer program launches. Allison also su ers from a perception that the company does not have a role in the transformation to electric vehicles. On its quarterly conference call, however, management pointed out it works with 75% of existing OEMs that plan to introduce electric vehicles over the next few years.
Del Taco Restaurants (TACO, Financial) is a nationwide operator and franchisor of restaurants with fresh and fastmade-to-order cuisine, including both Mexican-inspired and American classic dishes. About half its locations are company-owned, while the other half are franchised. During the first quarter, Del Taco reported strong earnings and same-store sales guidance, continuing momentum from the third and fourth quarters in franchised markets outside of California. However, late in the quarter, investors turned away from Del Taco, likely out of mild frustration over the amount of time it will take for the company’s e orts to accelerate franchise-driven growth. Del Taco has targeted mid-single-digit unit growth for its franchised restaurants, and some investors favor a shorter ramp to that level.
Outlook
In conclusion, thank you for your investment in the Small Cap Dividend Value Strategy. We will continue to work hard to justify your confidence and trust.
Past performance is no guarantee of future results. As with all investments, there is a risk of loss. Any performance and/or attribution information contained herein are based on a representative account of the specific strategy discussed.
The opinions expressed in this document are those of Keeley Teton Advisors, LLC as of the date indicated and are subject to change without notice and are not intended as recommendations of individual securities.
The net performance numbers shown are for informational purposes only. Management fees are negotiable and a table of standard fees is contained in the Firm’s Form ADV Part 2A, which is available at no cost at www.keeleyteton.com.
