For the quarter ended September 30, 2021, the Mid Cap Dividend Value Strategy declined -2.41% gross (-2.65% net of fees) compared with a -1.01% fall for the Russell Mid Cap Value Index. For the year-to-date period, the Strategy has advanced 16.37% gross (15.52% net) compared to a 18.24% gain for the benchmark.
The portfolio demonstrated solid gains across many of its equity holdings during the quarter as the U.S. economy continued its robust growth trajectory. After declining nearly 20% in the first quarter of 2020, the market (as measured by the S&P 500 Index) went up five quarters in a row with the smallest quarterly gain being 6.2% and a cumulative gain of 70%. That is the best five-quarter gain in more than forty years. Small-cap and mid-cap stocks did even better. The style indices were mixed as Value outperformed in small-cap but lagged in the large- and mid-cap indices.
As the economy has rebounded from its pandemic lows, so have corporate earnings: Total pretax profits have surged $0.84 trillion from the lows of 2020 and now stand 17% above their pre-pandemic high. Moreover, corporate profits are estimated to grow another 7% in 2022, fueling capex spend as domestic manufacturers scramble to rebuild supply
chains amidst component shortages, lean inventory and surging consumer demand.
- Peak Growth - Some commentators express concern about a slowing of year-over-year economic and earnings growth. The US economy su ered a steep contraction in the second quarter of 2020 and began to recover in the third quarter. Recent quarters of year-over-year growth have baselines that are significantly depressed. A more important question is whether we will see as much growth as we currently expect. We believe that the risk to the economy appears to be more on the supply side than the demand side. Many press reports, company presentations, and our own discussions with companies are about the challenges they face in managing their supply chains. Whether it is semiconductors, shipping containers, ocean freight, labor, or other elements of production and distribution, bottlenecks have emerged. It seems the physical economy is not geared to produce the economic growth emerging from the contraction in 2020. It appears that these constraints likely will last into 2022.
- COVID-19 – The US and the World saw another wave of the COVID pandemic during the quarter. Not only did this begin to strain health care systems in some places, but parts of the global supply chain (Mexico, Malaysia, Vietnam) saw significantly higher spikes than they had experienced in previous waves. This wave appears to be ebbing. With vaccination rates increasing and promising new therapies moving through the drug development pipeline, we are hopeful that next year will have fewer COVID-related disruptions.
- Interest rates and inflation – The yield on the ten-year Treasury has been on a wild ride this year; it started strong in the first quarter, faded in the second, and sprang back to life late in the third. The Fed has signaled that it thinks it is nearing the time to remove some of the stimulus it put into place in the early months of the COVID pandemic. This seems to be contingent on two factors. First, the economic recovery continues, which we think is likely. Second, the uptick in inflation which has gone past the Fed’s target proves to be transitory as the Fed has indicated. More strength in the recovery than anticipated or more stickiness to the rate of inflation than expected would likely accelerate the Fed’s tapering actions. Because of the Fed’s involvement in the market for long-term Treasuries, their withdrawal as a purchaser could lead to higher rates. It appears that these worries do not have much impact on small- and mid-cap stocks, but they serve as a headwind for some of the large-cap growth stocks that dominate the S&P 500 and Russell Top 200.
- China – Many commentators expressed optimism when Joe Biden was elected President that our country’s relationships with our major trading partners would improve. While things may be a little better with Europe, the relationship with China remains contentious. No tari s have been rolled back, China continues to take aggressive actions toward its neighbors, and it also seems to be restricting some of its freedoms internally. We do not know how this development will unfold, but it is potentially important because China is not only one of the US’s largest trading partners, but it has also been a significant source of global growth over the last several decades. Slowing growth in China, whether due to internal or external factors, means slower global growth.
- Valuation – While our discipline makes us sensitive to valuations, we are not more worried about multiples now than earlier this year, even with markets near their highs. The reason for this is that while the market is up by a mid-teens percentage through the end of the third quarter, earnings expectations have risen even more. Since the beginning of the year, earnings estimates for the S&P 500 in 2021 have increased by 20% and they are up 13% for 2022. Mid-cap and small-cap earnings expectations have risen even faster. As a result, forward EPS multiples have decreased this year. In the case of the S&P Midcap 400 and S&P Smallcap 600 indices, valuations are not far from historical average. The areas where valuations remain well above average are large-cap stocks and growth stocks. Unfortunately, those dominate the headlines and influence investor sentiment. It seems likely that small caps regain their lead (in the case of the Russell indices) and retain their lead (in the case of S&P). Value stocks also seem primed for outperformance.
When we analyze the performance of the Strategy, we disaggregate it into the impact from Sector Allocation and the impact from Stock Selection. The Strategy generally sees more impact from Stock Selection and did so this quarter as well. Sector Allocation was a slight contributor, but Stock Selection detracted. Most of the impact was felt in the Consumer Staples, Information Technology, and Real Estate sectors, but Financials, Industrials, and Materials were negative as well. None of these sectors were big detractors, but all were on the negative side of the ledger and only Energy provided a significant benefit.
- The Consumer Staples sector was the biggest detractor and all four of the Strategy’s holdings in the quarter declined more than the 3% the sector declined in the index. The biggest decline came in Lamb Weston which is covered later in this report.
- The Strategy’s holdings in the Information Technology sector also declined more than that of the benchmark. Most of the weakness came in CDK Global (covered in Let’s Talk Stocks below) and Synnex which gave back some of its strong gains from earlier in the year.
- The Strategy’s holdings in the Real Estate sector were down slightly, while real estate stocks in the Russell Midcap Value index were up slightly. Most of the di erence in performance came in Sabra Health Care REIT and VICI Properties. The former su ered from concerns about the impact the resurgence in COVID cases will have on senior housing, while the latter executed a secondary o ering to partially fund the acquisition of MGM Growth Properties during September which pressured the stock.
- Energy was the only sector where the Strategy added significant value in the quarter as the Strategy’s holdings were up while the index’s holdings were flat. Four out of five of the Strategy’s positions were up in the quarter led by a nearly 20% gain in Chesapeake Energy and a more than 20% gain in Devon Energy.
During the quarter, the Strategy added one new position and sold three holdings.
Quanta Services (PWR, Financial) is a specialty contractor in the electrical power, oil and gas, and communicationindustries. Quanta Services reported another “beat and raise” quarter which resulted in a record quarter for revenues, EBITDA, EPS, and backlog. Revenue growth was just shy of 20%, driven by strong demand in the Electric Power segment. Underlying demand remains very robust, driving backlog to a record of $17 billion. Towards the end of the quarter, the company announced the acquisition of Blattner Holding Company for $2.7 billion, adding one of the largest utility-scale renewable energy infrastructure solutions providers in North America.
Devon Energy (DVN, Financial) is an independent oil and gas exploration and production company with a largefootprint in the Permian Basin in west Texas. The company delivered outstanding second quarter results as evidenced by its healthy quarterly free cash flow with roughly half of that total being returned to shareholders in the form of a base dividend and a variable dividend. Devon was also able to pay down some of its debt during the quarter. With rising commodity prices, the company should comfortably generate enough free cash flow to bring its leverage ratio down to the target level of 1.0x EBITDA by the end of the year. Should commodity prices remain elevated, this should translate to even higher quarterly dividend payments in the second half of the year and into 2022.
Chesapeake Energy (CHK, Financial) is an independent exploration and production company with its mainfootprints in the Marcellus Shale in Pennsylvania and the Haynesville Shale along the Texas/Louisiana border. In addition to rapidly rising natural gas prices, the company also announced the acquisition of Vine Energy (ticker VEI) which bolsters its position in the Haynesville and is accretive to cash flow. The company also announced a variable dividend policy which will be paid out quarterly.
Lamb Weston (LW, Financial) produces and distributes value-added frozen potato products, most notably Frenchfries, to a variety of customers, including quick-service restaurants, sit-down restaurants, and foodservice operators. Despite rebounding sales, the stock was weak in the third quarter after Lamb Weston cited input cost inflation, higher transportation costs and elevated packaging costs as likely pressuring earnings going forward. The hot weather in the summer of 2021 also sparked concerns about a softer upcoming potato crop, which would lead to higher potato costs for Lamb Weston. The company plans to combat higher costs through a series of price increases, which should fully take e ect by the end of the year.
CDK Global (CDK, Financial) is the leading provider of IT systems used by automobile dealers to manage theirbusiness. The company reported calendar second quarter earnings that were a little shy of expectations across the board. More concerning to the Street is that the company continues to spend heavily on growth initiatives, even though the previous spending does not seem to be generating the hoped-for results. With a good market position, attractive returns, and a cheap valuation, we are willing to give this experienced management team a little more time to hit its stride.
Oshkosh Corporation (OSK, Financial) is a manufacturer of light construction equipment and specialty vehiclesfor defense and municipal customers. The company reported an earnings shortfall as supply chain issues led to lost shipments in its Access Equipment segment (a subsidiary called JLG which makes scissor lifts and telehandlers). Rising raw material costs also hampered profitability. Management expects this to persist for the next two or three quarters although the company plans to raise prices to o set much of the headwind. Backlog in all segments continues to look promising so we view this as a short-term issue that should not derail a healthy multi-year outlook in both its Access Equipment and Defense segments.
As we look ahead, we believe that the global economic recovery will continue, but acknowledge that the path could be a little bumpier in the next year. We expect to use market pullbacks as opportunities to uncover outstanding companies that investors discard for short-term reasons.
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.
Market Performance presented solely for informational purposes. The S&P 500 Index is designed to act as a barometer for the overall U.S. stock market and consists of 500 stocks that are chosen on the basis of market size, liquidity, and industry grouping. The S&P 500 is a market value weighted index with each stock's weight in the index proportionate to its market value.
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.
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