To Our Shareholders,
For the quarter ended June 30, 2021, the Keeley Small Cap Dividend Value Fund’s net asset value (“NAV”) per Class A share rose 1.34% compared with a 4.56% gain for the Russell 2000 Value Index. For the year-to-date period, the Fund advanced 20.06% compared to a 26.69% gain for the benchmark.
Commentary
Fueled by the lifting of COVID-related restrictions and ongoing reopening activity, the economy and the stock market advanced further in the second quarter. e economic numbers continued to improve both on an absolute basis and because we are cycling over last year’s downturn. e results might even have been a little better if not for issues in ramping economic activity back up. As companies have worked to get “back to normal,” they have experienced signi cant constraints that have slowed progress. We have heard of signi cant supply chain problems such as shortages of semiconductors, lumber, shipping containers and other inputs. ere has also been a lot of discussion about tightness in the labor market even though unemployment remains above pre-pandemic levels. Slowly, but surely, these challenges are being met which suggests that the rebound will continue.
Are we all the way back? In some cases, it would appear that we are. If we de ne recovery as recouping all the previous losses, stocks (as measured by the S&P 500 Index) had recovered by August 2020. Mid cap and small cap stocks took a little longer but passed their pre-pandemic highs in November 2020. If we de ne recovery using earnings, we recovered in the fourth quarter when earnings were up from the prior year. If we use a little tougher de nition and de ne recovery as being back to where we thought we would be, we are on the verge of recovery now. Earnings expectations for 2021 for the S&P 500 Index are only 3% below where they were at the end of 2019. Estimates for small cap stocks are only 2% below “old” expectations and midcap stock earnings expectations are higher than eighteen months ago.
On the other hand, only 44% of the companies in the Russell 1000 Index have analysts’ estimates for 2021 that exceed where they were before the pandemic. is factor, combined with additional easing of production constraints and a further reduction in unemployment suggests that the recovery has further to run.
As a way of proving that moves within a bull market can take many forms, this quarter’s internals were markedly di erent from the last few quarters. Indeed, unlike the last several quarters where a recovery in economic indicators and increases in earnings expectations led to the outperformance of cyclical, small-cap, and value stocks, this quarter returned to the theme of the last few years which was driven by growth stocks. Beginning with the Fed’s assurances that it was not worried about what it sees as a transitory uptick in in ation, yields on bonds, particularly at the long-end, began to retrace much of the increase we have seen over the last year. is rekindled the move in large-cap growth stocks.
For the quarter, large-cap beat mid-cap which beat small-cap stocks. Growth beat value, except in small-cap where meme-stocks like AMC Entertainment and GameStop lifted the Russell 2000 Value Index. ese moves allowed large-cap growth to close the gap with large-cap value, but value stocks further down the market cap spectrum remain well ahead of small- and mid-cap growth stocks. Within industry sectors, Energy and Real Estate showed strength across market cap segments while Utilities and Consumer Staples were generally laggards. e other sectors were more of a mixed bag depending on style and market cap.
As we look ahead, it is interesting to note that stocks look cheaper now than they did at the beginning of the year. While the S&P 500 is up 14% year to date, forward earnings estimates are up 21%. Small caps have seen an even larger improvement in earnings prospects with forward expectations for the S&P 600 Index are up 31%. is is not to say that valuations have become compelling. Usually, however, when the market makes a big move, stocks become a lot more expensive and this time they have not.
The other factor supporting valuations has been the fall in interest rates. At the beginning of the year, the 10-year US Treasury bond yielded 0.92%, but it moved higher in the rst quarter and ended at 1.74%. But that was about the peak as rates declined throughout the quarter and really fell o late in the quarter to end at 1.45%. Maybe just as importantly, the concern about rising rates, and the potential impact on valuations, has diminished.
So, with the business outlook improving, valuations no worse than they were despite strong gains, and lower rates, what could go wrong? We do not think any new risks have emerged over the last few months and some may have diminished. Investors should continue to watch developments with the COVID pandemic. e emergence of the Delta variant is causing problems in some countries and slowing reopening plans in others. If it worsens, we could see some impact at speci c companies and potentially the market. We will also be watching for signs that the recent increase in in ation is truly transitory. We also want to see improvement in the employment numbers. If the relatively muted level of improvement over the last few months is really a matter of incentives, employment gains should pick up. If not, there may be a longer-term skills mismatch that could restrain the recovery. Finally, the change in the direction of interest rates has driven the consensus toward thinking they will fall further. While this could happen, the unanimity of opinion makes us a little nervous.
Portfolio Results
The Fund lagged its benchmark in the quarter for a few reasons. First, our strategy of investing in companies that pay dividends continues to be out of favor. Non-dividend paying stocks again outperformed dividend-paying stocks within the Russell 2000 Value benchmark. Second, and partly related, a few stocks had an outsized impact on returns of the benchmark. In particular, AMC Entertainment, which eliminated its dividend in 2020, rose 455% and contributed more than 100bps to the return of the index. is is highly unusual for an index with more than 1,400 stocks. Finally, the Fund’s holdings did not perform as we would have expected. is sounds a little obvious, but what we mean is that many of our worst performing stocks were very good performing companies. Ordinarily, problems with stock performance arise from problems with company performance. is was generally not the case this quarter which makes us optimistic about future performance.
As we break down relative performance into its components, Sector Allocation and Stock Selection, we note that both elements hurt performance, but the vast majority of the shortfall came from Stock Selection. No one element within Sector Allocation had much impact with the largest drag coming from the Fund’s slight overweight in Utilities. e underperformance in Stock Selection primarily came in the Communications Services, Consumer Discretionary, Industrials, and Financials sectors. Utilities was a slight positive.
- Almost all of the underperformance in Communications Services came from a stock that the Fund did not own, AMC Entertainment. Lots of words have been written about the so-called “meme” stocks and the in uence of Redditers and Robinhood day traders, but it is still hard to understand AMC’s 455% increase in the quarter (or its 2573% YTD gain). is alone added 1.14% to the Russell 2000 Value index’s return in the quarter! Maybe the most frustrating part of this was that it did not help the shares of its more solvent competitor, Cinemark Holdings, which the Fund owned.
- While the stocks we did not own were also a problem in the Consumer Discretionary sector last quarter (GameStop), this quarter’s shortfall arose from weakness in a few of our longer-term winners. Winnebago, Marriott Vacations, and Penske Automotive all saw share price declines despite strong earnings results. In fact, Winnebago reported very strong April quarter results late in the quarter and Marriott preannounced better than expected second quarter sales near the end of the quarter. We think these stocks are due for a rebound.
- Declines in a handful of stocks also contributed to underperformance in the Industrials sector. Construction companies Primoris Services and Argan, Inc. both saw double-digit declines in their share prices despite reporting strong earnings and growing backlogs. In addition, the increasing odds of a new infrastructure spending program should sustain the cycle for these companies. Other detractors like Hillenbrand and ABM Industries also reported good results. On the positive side of the ledger, waste-to-energy company Covanta was one of the leading contributors in the quarter and is discussed later in this report.
- The Financials sector was the last of the four main sectors detracting from performance and was one of only three sectors that fell in the quarter. While the Fund’s asset management-oriented stocks (Brightsphere, Oaktree Specialty Lending, Silvercrest Asset Management, and SLR Investment) all performed well, the Fund’s bank holdings generally disappointed. Interestingly, almost all of the banks reported much stronger than expected rst quarter results. e weakness likely came from two things. First, the fall in rates in the second half of the quarter led to weakness across bank stocks broadly. Second, four of the banks the Fund owns announced meaningful acquisitions. While this is good over the intermediate/long-term, these announcements have usually been met with falling stock prices in recent years. is was the case with three of the four this quarter.
During the quarter, the Fund added seven new holdings, sold four stocks in a normal course, and sold two stocks as the completion of their acquisition neared.
Let’s Talk Stocks
The top three contributors in the quarter were:
Oasis Petroleum (OAS, Financial) (OAS - $100.55 – NASDAQ) is a Williston Basin-centric exploration and production companywith headquarters in Houston, TX. It has really hit the ground running after it emerged from bankruptcy in late 2020. e rise in crude oil prices from roughly $60 to almost $75 during the quarter helped as demand increased as economies globally unlocked from COVID restrictions. Also, Oasis Petroleum announced two separate transactions in the quarter: 1) the acquisition of more acreage in the Williston to improve its scale in the basin and drive more operating e ciencies; and 2) the sale of its acreage in the Permian basin which were unlikely to gain the needed scale. e company also sold down its interest in Oasis Midstream Partners (ticker OMP) in a transaction late in the quarter.
Covanta Holding Corporation (CVA, Financial) (CVA - $17.61 –NYSE) is a leader in sustainable waste and energy solutions with aglobal network of over 50 energy-from-waste and material processing facilities around the world. Shares were strong this quarter due to waste volumes almost back to pre-COVID levels and a rebound in recycled metals pricing driving year-over-year growth and exceeding analyst expectations. Additionally, the recent change in CEO has led to a strategic plan for the company to be on a path to more consistent pro tability through cost optimization/savings plan. In addition, Covanta will address underperforming assets through new contract negotiations or sale, third-party interest in non-core assets. It will use the bene ts of these initiatives to reduce debt. e stock received an additional boost from an industry report that the company is exploring a potential sale.
Kontoor Brands (KTB, Financial) (KTB - $56.41 – NYSE) is the #2 player in the global jeans market behind Levi Strauss & Co.Kontoor’s brands primarily are Lee and Wrangler. Shares continued to rally in the second quarter as the company reported a strong rst quarter and raised its earnings guidance. It saw particular strength from online sales and an added short-term boost from some product shipments being pulled forward due to a software implementation. e shift to casual wear during the pandemic continues to bene t Kontoor, and Kontoor continues to expand its gross margin due to product mix, restructuring e orts, and a competitive environment that has seen little promotional activity.
The three largest detractors in the quarter were:
Winnebago Industries (WGO, Financial) (WGO - $67.96 – NYSE), a leading RV manufacturer, saw its stock come under pressurethroughout the quarter despite posting a very strong results that beat consensus estimates across the board and posting a record backlog with a combined value of $3.7 billion. e stock’s weakness despite strong fundamentals re ects the market’s worry of peak earnings and input cost in ation. Management is very con dent and bullish in the company’s outlook due to continued strong demand from baby boomer/Gen-X/millennial customers driving record retail demand. is strong retail demand will likely elongate the inventory restocking cycle as current demand is outstripping supply providing a pathway for multi-year growth for Winnebago and the industry. We think Winnebago is well-positioned to capitalize during this current environment as pandemic-related shutdowns created a renewed spark for the love of the outdoors again.
KB Home (KBH, Financial) (KBH - $40.72 – NYSE), one of the nation’s leading homebuilders saw its stock sell-o in the quarter asconcerns increased about the impact on demand from higher home prices and the impact of raw material and labor cost in ation on pro tability. e Company’s fundamentals tell a di erent story as KB Home reported a very strong quarter ( scal 2Q-2021) with revenue growth of 58% year-over-year, margin expansion, EPS growth that exceeded consensus estimates, net new orders up 145%, and ending backlog increasing 98%. Management commented that net new orders were the Company’s highest second-quarter level in 14 years. e 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. Additionally, KB Home’s valuation (P/E and EV/EBITDA) remains attractive trading towards the low-end of the historical valuation range.
Primoris Services Corporation (PRIM, Financial) (PRIM - $29.43 - NASDAQ) is a diversi ed engineering and constructioncompany focused on the construction of pipelines, utility-scale transmission and distribution, telecom, and heavy civil. e company exceeded consensus estimates reporting a pro table quarter in a seasonally weak period. Despite this beat, the stock was one of the laggards in the quarter as EPS guidance was reduced due to the additional equity dilution from its o ering in March to fund a portion of the Future Infrastructure acquisition. Backlog remains strong at $3.1 billion and Primoris is seeing increased opportunities in the renewable sector which should help mitigate the deceleration in the pipeline segment given the new administration’s emphasis on renewables and away from oil and gas.
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 con dence and trust.
July 13, 2021
This summary represents the views of the portfolio managers as of 6/30/21. 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.
