Performance
For the quarter ended March 31, 2021, the Mid Cap Dividend Value Strategy rose 14.29% gross (14.00% net of fees) compared with a 13.05% gain for the Russell Mid Cap 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 Mid 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 would 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 is the most attractive relative to the past, but Midcap value is not too far behind. The Russell Midcap Value Index trades at 18.7x NTM earnings compared to a historical average of 14.2x. It trades at only 52% of the multiple accorded to the Russell Midcap Growth Index compared to an average of 72%.
So, when will dividend-paying stocks return to favor?
We have been arguing that small- and mid-cap stocks looked attractive relative to large caps and that 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 8.1% gain in the Russell Midcap Index was well ahead of the 5.1% gain in the Russell Top 200 Index. Value stocks did even better as the Russell Midcap Value Index rose 13.1% compared to a 0.6% decline in the Russell Midcap Growth Index.
We also saw the dividend-paying stocks in the Russell Midcap Value Index outperform the non-dividend payers, 14.5% vs. 7.4%. This was the first quarter since September 2019 that dividend-payers led the pace. Much of the underperformance over that period can be explained by the makeup of the indices. Utilities and Real Estate are the two worst-performing sectors the since the beginning of 2020 and have very high propensities to pay dividends. In addition, when we look at the performance di erence between dividend-paying and non-dividend-paying stocks within other sectors, we have tended to see outperformance by the non-dividend-payers over the last year. This was particularly the case in the strong second 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 Midcap Index was about 2.3% at the end of the first quarter.
Portfolio Results
The Strategy outperformed its benchmark in the first quarter. Dividend-paying stocks slightly outperformed the benchmark, but with about 80% of the benchmark in the dividend-paying segment, the di erence was somewhat muted.
In disaggregating performance into Sector Allocation and Stock Selection, the latter contributed to performance while the former detracted slightly. Aside from this, a small overweight in the Financial sector helped performance, while a small overweight in the Utilities sector hurt performance a little. Stock Selection in the Utilities and Industrials sectors had notable positive impacts on relative performance. Financials had a slight detriment, but Stock Selection in most sectors either added or detracted 15bps-25bps.
- The Utilities sector was the second worst performing among the eleven sectors, beating only the Health Care sector. The Strategy’s holdings with the sector outperformed enough to more than o set its slight overweight positioning. Strong gains from MDU Resources and National Fuel Gas were more than enough to overcome a decline in American Water Works and sluggish gains in a couple other stocks. MDU, in particular, should benefit from any e orts by the Biden Administration to boost infrastructure spending.
- The Industrials sector performed in line with the Russell Midcap Value Index, but the Strategy’s holdings performed several points better than the sector. Strong fourth quarter earnings results and building momentum in the construction market drove strong gains at Oshkosh, Acuity Brands, and Quanta Services. Of the ten Industrials stocks the Strategy held in the quarter, only Allison Transmission declined. It is discussed further below.
- The slight overweight in the strong-performing Financials sector was not enough to o set Stock Selection that was slightly worse than that within the Index for the sector. The di erences were small (28bps) and cannot really be attributed to one or even a couple of stocks. None of the Strategy’s fifteen holdings during the quarter declined.
During the quarter, the Strategy added three new positions, sold two holdings, and had one exchanged for a new stock through a merger.
Leading Contributors
KB Home (KBH, Financial) is one of the nation’s leading homebuilders and bounced back from being one of thebottom contributors last quarter. Trends for homebuilders remain very strong and the environment for KB Home is favorable. The company increased prices faster than costs which drove expanding margins in the quarter. Demand for housing continues to accelerate with net new orders up more than 20% in the quarter which drove strong backlog growth. The medium-term outlook for home builders remains attractive supported by low mortgage rates, accelerating economic activity, and favorable demographic trends with Millennials/Gen Z entering the household formation phase.
Diamondback Energy (FANG, Financial) is an independent oil and gas exploration and production company witha large footprint in the Permian Basin. In addition to a 22% increase in crude oil (WTI) during the quarter, the company announced two accretive acquisitions which closed in the first quarter. These should drive higher free cash flow and support the company’s dividend policy. Diamondback also improved its Environmental, Social, and Governance (ESG) score by announcing a new “Net Zero Now” policy which targets a 50% reduction in greenhouse gas emissions and a 70% reduction in methane emissions by 2024.
Olin Corporation (OLN, Financial) is a leading producer of chlorine and caustic soda as well as epoxy resins andsmall caliber ammunition. Due mostly to improved industry fundamentals but aided in the near term by industry supply outages stemming from winter storms in Texas, the company was able to implement two significant price increases for caustic soda recently. Under leadership of new CEO Scott Sutton, the company has overhauled its approach to the chlorine and caustic soda markets by selectively managing production to firm up pricing as the company has scale in both markets. The company also refinanced some of its high-cost debt during the quarter.
Leading Detractors
Chemed Corporation (CHE, Financial) is one of the largest providers of hospice services through its VITAS segment 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 the company 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.
FMC Corporation (FMC, Financial) is a leading manufacturer of agricultural chemicals such as insecticides,herbicides, and fungicides. The company pre-announced weaker than expected earnings as the quarter was negatively impacted by logistical challenges and weather in Brazil. On its conference call with investors, management noted that these challenges are likely to persist through the first half of 2021. We expect a much better second half of 2021 for the company due to new product introductions, higher prices, and potentially, acquisitions. Despite the near-term soft patch, cash flow should remain strong and management has been willing to return capital to shareholders through share repurchases in the past.
Outlook
In conclusion, thank you for your investment in the Mid 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.
