To Our Shareholders,
For the quarter ended September 30, 2022, the Keeley Small Cap Dividend Value Fund’s net asset value (“NAV”) per Class A share fell 4.4% compared with a 4.6% decline in the Russell 2000 Value Index. For the year-to-date, the Fund has declined 17.3%, outperforming the 21.1% drop in the benchmark by 3.8%.
Commentary
After a very strong start, the market rolled over in August and fell further in September to end down for the quarter. At the end of the quarter, the market was testing the June lows. During the quarter, stocks declined less than bonds, small caps outperformed large caps, stocks of unprofitable companies did better than companies that make money, and non-dividend-payers outperformed dividend payers. Within the fixed income markets, high yield bonds outperformed Treasuries. In all these cases, riskier assets outperformed less risky assets.
According to the Federal Reserve Board’s Summary of Economic Projections the governors expect the Fed Funds rate to end between 4.25% and 4.50% this year and 4.50% and 4.75% next year. While there are a lot of paths to get there, the Fed has been aggressive in boosting rates in 75bps increments thus far. If they stay on this path, we should expect a couple more hikes this year of similar size and maybe a little more next year. The goal of this rate hiking program is to slow demand in order to reduce inflation and prevent inflationary expectations from becoming entrenched.
Unfortunately, many of the current drivers of inflation may not be responsive to monetary policy unless rates move high enough to cause a recession. After all, higher rates don’t end the war in Ukraine which might increase the supply of Russian oil and gas. They also do not remove the bottlenecks to the export of grain from Russia and Ukraine which would reduce food inflation. On the positive side, much of the rate of price increase has been driven by these and other transient factors. Even if those factors do not reverse, their impact will eventually work its way through supply chains and later be anniversaried. This should begin to happen early next year. In addition, many commodity prices have begun to retreat. Crude oil was off more than 20% in the third quarter and will be down on a year-over-year basis by the end of January if prices stay at this level. Metals and some agricultural commodities also declined in the third quarter. Finally, job openings have trended lower over the past several months suggesting labor market tightness may be easing. With signs pointing to a slowdown in the economy, it seems increasingly possible to us that the Fed may have to pause its rate increase campaign and assess the impact of increases thus far on the economy and inflation sometime in the first half of next year.
We think that the conditions as they stand today, however, create the potential for better outcomes than we have seen in the past. First, unemployment is very low and job openings are very high. This might mean that employees furloughed from one position can find new jobs quickly. Second, there are few obvious signs of excesses that need to be unwound, unlike during the popping of the Housing Bubble in 2008 or the Internet Bubble in 2000. This leaves the financial system in better condition to support the economy. In addition, household liquidity is still relatively strong.
Through the first nine months, the S&P 500 declined nearly 25%. With forward earnings estimates up slightly, the index’s P/E ratio contracted from 21.5x at year-end to 15.2x on September 30. This puts it below the 16.2x average since 1999. While this is not far from the lows in September 2002 (14.7x), it is well above the lows in 2009 (10.7x).
We think conditions look more like the early 2000 bear market, rather than the 2008 financial crisis . At this point, much of the valuation contraction has already occurred. Earnings expectations likely have to come down, but they already have in many sectors. Indeed, if not for commodity-driven upward revisions in Energy sector earnings, estimates for the S&P 500 would be about 5% lower than at the beginning of the year.
More importantly to the small- and mid-cap strategies we manage is that valuations for small caps and mid caps relative to large caps are unusually favorable. e forward P/E ratio for the S&P Small Cap index was 10.4x at quarter end making the relative multiple (S&P Small Cap/S&P 500) only 0.68. This is the lowest it has been since March 2001! Small caps outperformed for years after that time.
We believe the outlook for positive returns in stocks is good. While the economy will likely be in worse shape, we think that the outlook for inflation will be better in six months.
Portfolio Results
The Fund outperformed its benchmark again in the third quarter. is marked the fofth quarter in a row of outperformance. It was particularly encouraging in a quarter when non-dividend-paying stocks in the Russell 2000 Value outperformed dividend-paying stocks by a fairly wide margin. With factors working against relative performance, decisions on individual stocks were the driver of outperformance in the quarter.
When we break down relative performance into Sector Allocation and Stock Selection, we see that Stock Selection added to value, while Sector Allocation was a very slight detractor. Within Sector Allocation, performance was helped by a slight overweight in Energy and a slight underweight in Communications Services. Energy was the best performing sector while Communications Services was the worst. These benefits were offset by an underweight in Health Care and an overweight in Industrials. The Health Care underweight is due to the lack of ownership in biotechnology stocks. These represent half the weight of the Health Care sector within the index and rose on an absolute basis in the quarter. None of them pay dividends. Within Stock Selection, positive relative contribution from Consumer Discretionary, Energy, Communications Services, and Financials was partly offset by detractors in Technology, Health Care and Industrials. The Fund’s holdings outperformed the benchmark in four sectors, underperformed in four sectors, and were about the same in three.
- The Fund’s holdings in the Consumer Discretionary sector eked out a small gain compared to the loss in the sector within the benchmark. Five of the Fund’s nine holdings advanced during the quarter. Jack in the Box led the gainers as strong second quarter earnings were enough to o set some adverse regulatory developments. The worst performers were Aaron’s and Standard Motor Products which are two of the Fund’s smallest holdings.
- The Fund’s more than 20% gain in its Energy holdings exceeded the 8% gain for the sector. Two Energy holdings, International Seaways and Chord Energy, were the Fund’s two biggest contributors to performance this quarter and are discussed at more length later in this report.
- The Communications Services sector was the worst-performing sector within the benchmark with a nearly 15% decline. The Fund’s lone holding, Nexstar Media Group, however posted a slight gain as it reported a strong quarter and announced a sizable acquisition.
- We saw a wide dispersion of returns between the twenty-three stocks the Fund holds in the Financials sector, but in aggregate they outperformed those in the benchmark. Small banks South Plains Financial and Timberland Bancorp led the way with double-digit positive returns on solid earnings results. The detractors were a mix of capital markets companies like BrightSphere Investment Group and Virtu Financial as well as a couple banks (Provident Financial and First Foundation).
- The Fund’s holdings in Information Technology lagged the performance of the benchmark’s by the most of any sector. The Fund has only three holdings in the sector, so one position can impact these results. This quarter, the sharp drop in the shares of TTEC accounted for most of the sector’s underperformance. It was one of the Fund’s biggest detractors and is discussed later in this report.
- While the Fund’s holdings in Health Care rose in the quarter, they lagged the returns of the overall Health Care sector within the index. is was mostly due to the lack of holdings within the biotechnology industry. While that industry had a good quarter, the Fund’s lack of ownership in that area has been a significant positive on a year-to-date basis.
- Stocks in the Industrials sector declined more than those of the Russell 2000 Value index and the Fund’s holdings declined a little more than the index, on average. While Regal Rexnord and Griffon performed well on strong earnings and a strategic review, respectively, 20% plus declines in ESAB, Maxar, Primoris, and Spirit AeroSystems more than offset those gains. Primoris was one of the Fund’s biggest detractors and is discussed later in this letter.
During the quarter, we added one new position to the Fund and sold six holdings.
Let’s Talk Stocks
The top three contributors in the quarter were:
International Seaways (INSW, Financial) (INSW - $35.13 – NYSE) is a shipping company focused on crude and product tankersworldwide. The company reported its first profitable quarter since the third quarter of 2020 driven by a recovery in shipping rates from the negative impacts from the pandemic that reduced global oil demand. The current geopolitical backdrop along with the continued conflict between Russia and Ukraine likely provide tailwinds to crude shipping rates globally. In early September, takeover speculation pushed the stock higher when large shareholder Famatown Finance Limited (a company indirectly controlled by the trusts of shipping magnate John Fredriksen) issued a press release stating that Famatown and its representatives presented to the management team of International Seaways and requested the addition of two representatives to the Board of Directors.
Chord Energy Corporation (CHRD, Financial) (CHRD - $136.77 – NASDAQ) is an exploration and production company withacreage located in the Williston Basin in North Dakota. The newly formed company is a merger of Oasis Petroleum and Whiting Petroleum. It reported a strong inaugural quarter and a favorable return of free cash flow framework for shareholders. The company will return 75% of free cash flow if its leverage ratio remains below 0.5x and will return 50% of free cash flow if leverage remains below 1.0x. The company expects to return free cash flow to shareholders in the form of base and variable dividends and share repurchases.
Winnebago Industries (WGO, Financial) (WGO - $53.21 - NYSE) is a leading manufacturer of towable and motorized recreationalvehicles. Winnebago continued to report very strong quarterly results with another record during the quarter. On a year-over-year basis, the company grew revenues 52%, increased gross margins by 100 basis points, and increased earnings per share 84%, aided by $70 million of share repurchases. However, management noted on the quarterly conference call that a moderation in results is likely as record backlogs start to decline and dealer inventories normalize.
The three largest detractors in the quarter were:
Spectrum Brands Holdings (SPB, Financial) (SPB - $39.03 – NYSE) is a diversified manufacturer of consumer products operating in four segments including Home & Garden, Global Pet Care, Home & Personal Care, and Hardware & Home Improvement. It sells leading brands such as Cutter bug spray, George Foreman grills, and KwikSet locks. The stock fell sharply after the US Department of Justice sued the company to stop the sale of its Hardware & Home Improvement business to ASSA ABLOY on antitrust grounds. Both Spectrum Brands and ASSA ABLOY have stated that they are committed to closing the deal and will ght this lawsuit in court. A completed deal would substantially reduce debt at Spectrum and likely lead to significant return of capital to shareholders. Should the companies be unsuccessful in litigation, Spectrum would receive a $350 million breakup fee and would likely try to find another buyer.
Primoris Services (PRIM, Financial) (PRIM - $16.25 - NASDAQ) is a diversified engineering and construction company focused onthe construction of pipelines, utility-scale transmission and distribution systems, telecom, and heavy civil projects. Primoris reported disappointing earnings despite posting record revenues in the quarter. The main drivers of this miss were much higher fuel and labor costs within its Utility segment and worse than expected performance within its Pipeline segment. The Pipeline segment performance was expected to underperform but the 50% decline in revenue year-over-year and the corresponding margin collapse was worse than expected and was mostly driven by large project close-outs last year that did not repeat. Total company backlog stands at a record of $4.6 billion and the outlook for the Utility and Renewable segments remains robust.
TTEC Holdings (TTEC, Financial) (TTEC - $44.31 - NASDAQ) supplies outsourced customer care services to large companies andgovernments. It uses call centers as well as electronic contact centers to help its clients serve their customers. The stock fell sharply after the company announced second quarter earnings that were in line with expectations but reduced its forward outlook significantly. Two factors led to the downgrade in guidance. First, bookings were a little slower than expected and the transition from contract win to revenues is taking longer than expected. Second, the impact on profitability from the run-off of pandemic-related “surge” work is higher than previously understood.
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.
This summary represents the views of the portfolio managers as of 9/30/22. 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.
