To Our Shareholders,
For the quarter ended March 31, 2022, the Keeley Small Cap Dividend Value Fund’s net asset value (“NAV”) per Class A share fell 1.1% compared with a 2.4% decline in the Russell 2000 Value Index.
For the last two years, the tone of the market has been set by the evolution of the COVID-19 pandemic and the fiscal and monetary actions undertaken by the government to “bend the curve” and blunt the economic impact on its citizens. Unprecedented levels of scale and monetary stimulus first stabilized markets and then started the rebound. The announcement of successful vaccine clinical trials drove markets to new highs and the roll-out of those vaccines allowed economic activity to recover toward something approaching normal. The pandemic is not over. The United States reported more new COVID cases in the first quarter than in any previous quarter and deaths from COVID were the second highest of any quarter since the beginning. Shutdowns in some of China’s largest port cities remind us that the supply chain disruption caused by this pandemic may be with us for a while. However, concerns about the potential impact from the pandemic have now been replaced by new worries over inflation.
For the last several quarters, inflation ran ahead of the 2% rate that the Federal Reserve targets as optimal. Initially, these price increases were dismissed as “transitory”. The theory was that COVID-related supply chain constraints and the rebound in energy prices from depressed prior-year levels (“base effects”) were overstating the real inflation rate. As supply chains normalized and we anniversaried the rebound in commodity prices, the inflation rate would settle back down to the target rate. This view eroded during the early part of the quarter and the Russian invasion of Ukraine in late February made it extremely unlikely.
The personal and humanitarian impact of the invasion of Ukraine is incalculable and this episode is another reminder of our good fortune to live in the United States. The economic and geopolitical impact of this incursion is difficult to estimate, but there are some clear impacts that we can identify at this early stage. First, the price of oil and gas and other key commodities has rocketed higher and may stay there for some time. Russia is one of the largest producers and exporters of oil and natural gas. While Europe continues to buy fossil fuels from Russia, most of those countries are looking for other sources and some countries are not buying Russian oil at all. This further tightened a market with little spare capacity leading to a 34% increase in the price of oil in the first quarter. In addition, both Russia and Ukraine are important exporters of corn and wheat. Grain markets have tightened, and prices have increased. Against this backdrop, inflation is rising to concerning levels and looking less “transitory,” than before the Russians invaded Ukraine and the impact on key commodities from this conflict is likely to sustain or accelerate this trend.
The longer-term impacts may also be inflationary. In response to supply chain disruptions from COVID and from the Ukraine invasion, decision makers are acting to lower their risks. Countries in Europe are seeking other sources of energy; liquefied natural gas (LNG), nuclear, solar, and wind. These cost more than their current sources which is likely to increase energy costs for the people who live there. Companies increasingly look at bringing some production back to their home country.
This uptick in inflation has not gone unnoticed by the markets. Interest rates across the yield curve moved higher in the first quarter with the ten-year Treasury bond yield moving up 0.81% to 2.32% at quarter end. The middle of the curve moved up even more with the two-year up 1.56% to 2.29%. The result of this rise was the worst quarterly performance for the bond market since the 1980s. The Fed and its various members have signaled that they intend to continue raising rates until inflation is more contained.
The good news in the inflation story is that it is partially symptomatic of a strong economy. Energy prices were strong before the Russian invasion because demand for fuels and other petroleum-based products had recovered from the pandemic-driven downturn. Higher wages reflect a tight labor market. A strong economy is generally good for companies and good for stocks.
The bad news about inflation is twofold. First, higher inflation usually leads to higher interest rates which usually leads to lower valuation multiples. This sets up a race between rising earnings and falling multiples. In 2021, earnings rose more than valuations fell which resulted in good gains for stocks. at will be harder to achieve in 2022 and we have seen that impact on stocks so far this year, especially for stocks with higher starting valuations. Value stocks, particularly small- and midcaps, look attractive relative to growth stocks and large caps. This likely contributed to their outperformance in the first quarter across the market cap spectrum.
The other challenge arising from inflation is that policymakers will seek to contain it and the cure may not be that palatable. The Fed plans to raise interest rates with the intention of curtailing excess growth. The recent turbulence in the market likely results from investors’ concerns about whether they will be able to accomplish their goals without tipping the economy into a recession. We are probably a little more optimistic than most investors in that we believe that the economy is well-positioned to absorb a little slowdown. Unemployment is low and job openings are high. Workers furloughed may find it easier to find new jobs. We continue to build the portfolio on a bottom-up, stock-by-stock basis.
The Fund extended its winning streak to the third quarter in a row of relative outperformance. This is something that we expect in challenging markets, but it is always nice when things work as planned. Several factors, big and small, drove the outperformance. The most important “Big Picture” driver was the outperformance of dividend-paying stocks compared to stocks that do not pay dividends. In addition, the Fund saw positive contributions from both Sector Allocation and Stock Selection. Within Sector Allocation, the Fund’s underweighting in the Health Care sector, and specifically its lack of biotechnology stocks, helped performance. A slight overweight in the poorly performing Consumer Discretionary and a slight underweight in the very strong Energy sector offset most of this benefit. Stock Selection in the Financials, Health Care, Communication Services, Utilities, and Materials sectors helped the Fund the most, while the Fund’s holdings in the Energy and Industrials sectors detracted the most.
- Overall, the Financials sector performed worse than the Russell 2000 Value index, but the Fund’s holdings performed much better. Much of this outperformance was due to 20%+ gains in the shares of Virtu Financial (discussed later in the “Let’s Talk Stocks” section of this report) and Silvercrest Asset Management. Both reported strong earnings and good underlying business metrics during the quarter. Most of the Fund’s holdings also produced very strong fourth quarter earnings but were not rewarded as much.
- Not owning biotechnology stocks again helped the Fund’s relative performance within the Health Care sector. This industry represents about half of the sector’s overall weight, so it has a considerable influence. Because none of the stocks pay dividends, it is likely that movements in biotech stocks will continue to impact sector-level relative performance. With all of that said, the stocks the Fund did hold were up in aggregate during the first quarter compared to the decline in the overall market.
- Communication Services was another area of strength for the Fund. This is a small sector in the Russell 2000 Value index and the Fund held only one stock, Nexstar Media. That stock, however, was one of the Fund’s biggest contributors and is discussed later in this report.
- The Utilities sector was the second-best performing sector in the benchmark during the first quarter, trailing only the Energy sector. We find that fact interesting in that utilities are often viewed as “bond proxies” and the bond market turned in its worst quarterly performance since the 1980s. It seems like the “flight to safety” impact offset the “bond proxy” impact, at least in the first quarter. The Fund’s Utilities holdings performed even better on the strength on the shares of South Jersey Industries. It accepted a $36 per share cash takeover offer in the quarter from the Infrastructure Investments Fund. We discuss this further later in this report.
- While commodity prices were strong in the first quarter, the Materials sector within the Russell 2000 Value index declined in a similar amount to the overall index. The Fund’s holdings in the sector appreciated nicely on rebounds in the shares of Compass Minerals and Mercer International. While neither company reported particularly strong fourth quarter results, Compass seemed oversold after reducing its dividend last quarter and the outlook at Mercer has materially improved.
- Energy was the largest relative detractor among the eleven sectors in the benchmark even though it was the largest absolute contributor! This speaks to the overall strength in the sector as we estimate small cap energy companies were up more than 40% in the first quarter. It is not a mystery why the sector was so strong given the 33% rise in the price of crude in the quarter. The Fund’s holdings in the sector simply did not keep up. This is not entirely unexpected as dividend payers are still in the minority in the small-cap energy universe and they tend to be more stable than the average company. This hurts in sharply rising markets, but generally helps when the pendulum swings the other way.
- The performance of Industrial stocks in the benchmark was similar to that of the overall index. Unfortunately, the Fund’s holdings declined slightly more. The Fund saw some big winners with Maxar Technologies, ABM Industries, and KBR, but declines in Griffon (discussed later), VSE Corporation, and John Bean Technologies more than offset the gains. These companies reported disappointing fourth quarter earnings as supply chain constraints and rising input costs pinched margins.
During the quarter, we added five new positions to the Fund, sold two holdings, and had one company acquired for cash.
Let’s Talk Stocks
The top three contributors in the quarter were:
Cactus, Inc. (WHD, Financial) (WHD - $56.74 — NYSE) is a manufacturer of wellheads for land-based oil & gas wells and aprovider of rental tools to oil & gas customers. In addition to a rising commodity price environment, Cactus has also grown its market share over time in the US. It recently also made inroads in Saudi Arabia by shipping its first order in 4Q21. In addition, Cactus seems to be managing the rising input cost inflation environment better than most other service and equipment providers in the US due to its strong market share which enables it to pass along these costs through meaningful price increases.
South Jersey Industries (SJI, Financial) (SJI - $14.89 - NYSE) is a regulated natural gas utility serving customers in Central andSouthern New Jersey. South Jersey was one of the Fund’s top performers during the quarter as the company agreed to be acquired by J.P. Morgan’s Infrastructure Investment Fund for $36 per share in cash. This represented a 53% premium to the previous day’s close. is transaction is expected to close in the fourth quarter of 2022.
Nexstar Media Group (NXST, Financial) (NXST - $188.48 – NASDAQ) is the U.S.’ largest television station owner, boasting affiliations with all major networks. During the first quarter, Nexstar reported fourth-quarter earnings that exceeded analysts’ expectations, fueled in part by better-than-expected core advertising growth. With that release, Nexstar also issued strong guidance for free cash flows for the next two years, with growth driven by continued improvement in core advertising, strong political advertising during the 2022 election cycle, a growing digital business, and a focus on keeping a lid on costs. Also, Nexstar — like other TV station owners — benefited in the fourth quarter from seeing a moderation in subscriber decline trends in U.S. cable systems. Finally, Nexstar and other traditional broadcasters drew more interest from investors during the first quarter due to their generally robust visibility into free cash flow generation.
The three largest detractors in the quarter were:
Griffon Corporation (GFF, Financial) (GFF - $20.03 - NYSE) has leading brands in consumer home and garden tools, closetorganization, and garage doors. The company reported better-than-expected earnings driven by continued strength in the Home and Building Products segment (garage doors). That segment saw favorable product mix and pricing. The stock underperformed, however, as margin contracted due to inflationary cost pressures and supply chain issues as well increased leverage associated with the Hunter Fan acquisition. Management plans to reduce debt with the proceeds from the anticipated sale of its Defense segment. Shares of Griffon appear cheap at less than ten times scal 2022 (September) consensus EPS.
KB Home (KBH, Financial) (KBH - $32.38 – NYSE), one of the nation’s leading homebuilders, saw its stock sell off during the firstquarter as the market grew more concerned about home price affordability because of rising mortgage rates and higher home prices, and the market also grew more concerned about profitability due to raw material and labor cost inflation. When KB Home reported its fiscal first quarter earnings on March 23rd, results were below consensus estimates because of labor constraints caused by Omicron absenteeism and supply chain issues. These issues extended build times by two weeks which negatively impacted deliveries and revenues. On an absolute basis, the company’s fundamentals were strong with revenue growth of 23% and EPS growth of 44% from a year ago. On its earnings call, management commented that it is not currently seeing signs of stress from higher mortgage rates or prices as the buyer profile remains strong. These market concerns have weighed heavily on KB Home’s valuation and driven it down to slightly more than three times consensus EPS expectations, the bottom end of its historical range.
Winnebago Industries (WGO, Financial) (WGO - $54.03 – NYSE), a leading RV manufacturer, saw its stock come under pressurethroughout the quarter despite posting strong earnings. These results beat consensus estimates across the board and the company’s backlog grew to a record $3.7 billion. The weakness in the stock reflects the market’s worry that earnings are peaking as well as concerns about demand destruction caused by accelerating fuel costs and higher interest rates. Management was cautiously optimistic in the company’s outlook due to continued demand from baby boomers/Gen-X/millennial customers. We believe Winnebago is well-positioned to capitalize during this current environment, but near-term sentiment remains negative despite shares trading at an attractive valuation on our view of normalized earnings.
In conclusion, thank you for your investment in the KEELEY Small Cap Dividend Value Fund. We will continue to work hard to justify your confidence and trust.
April 12, 2022
This summary represents the views of the portfolio managers as of 3/31/22. 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.
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