To Our Shareholders,
For the quarter ended September 30, 2022, the Keeley Mid Cap Dividend Value Fund’s net asset value (“NAV”) per Class A share fell 3.8% compared to the 4.9% decline in the Russell Mid Cap Value Index. is marked the third consecutive quarter of relative outperformance and brought year-to-date returns to -16.2% versus a 20.4% decline in the benchmark
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
In a strange and volatile quarter, the Fund outperformed its benchmark, the Russell Midcap Value index. is marks the third straight quarter of outperformance. It is even more encouraging in that the Fund outperformed even while dividend-paying stocks within the Russell Midcap Value index lagged their non-dividend-paying peers. We have talked about the three main drivers of relative performance for the Fund as being dividend vs. non-dividend, Sector Allocation, and Stock Selection. is quarter, the rst was a headwind, the second was a slight positive, and the third added to relative performance.
As noted, Sector Allocation added a little, but none of the sectors added much individually. The contribution from Stock Selection was broad-based with the Fund’s holdings in eight of eleven sectors contributing to outperformance, two sectors detracting and one being a push. The most noteworthy outperformance came in the Financials and Energy sectors while the Fund lagged in the Industrials and Utilities sectors.
- The biggest contribution to relative outperformance came in the Financials sector as the Fund’s holdings were up a touch while the sector was down (less than the benchmark). No single stock accounted for the better performance as eight of thirteen stocks gained in the quarter, although none were up double-digits. e biggest detractor was Virtu which fell on lower retail investor participation.
- The Energy sector was the second-best performer in the index and trailed only the Industrials sector during the quarter. Interestingly all sectors were down within the Russell Midcap Value index. e Fund’s Energy holdings, however, were up led by double-digit gains in Chesapeake Energy and Devon Energy. Relatively high commodity prices and signs that the industry remains disciplined contributed to the good stock performance. Chesapeake was one of the Fund’s best-performing investments in the quarter and is discussed in the Let’s Talk Stocks section of this report.
- As noted, the performance in the Industrials sector was best within the index. e Fund’s holdings performed slightly worse leading to a slight drag on relative performance. A double-digit gain in shares of Timken after strong earnings was not enough to overcome double-digit declines in Allison Transmission and Oshkosh Corporation. e latter two fell after providing disappointing guidance. e former is seeing higher investment spending while the latter continues to struggle with supply chain bottlenecks.
- You would normally expect Utilities stocks to outperform in a choppy market, but that did not happen this quarter. The Fund’s holdings performed slightly worse due to the underperformance in Exelon (discussed in more detail later in this report) and UGI Corporation. e latter has large European propane distribution operations that could be vulnerable to supply issues in light of the situation on continental Europe.
During the quarter, the Fund added only one new position during the quarter with the spin-off of Enhabit from Encompass Healthcare, but it was sold before quarter end after it announced disappointing guidance. Tge Fund sold two additional holdings and the cash acquisition of CDK Global closed in the third quarter.
Let’s Talk Stocks
The top three contributors in the quarter were:
Chesapeake Energy (CHK, Financial) (CHK - $94.21 – NASDAQ) is a natural gas-focused exploration and production companywith acreage primarily in the Marcellus shale in Pennsylvania and the Haynesville Basin in Texas. Most of the strength in the stock was due to elevated natural gas prices during the quarter which should drive strong earnings. Chesapeake also announced it would be selling its non-core Eagle Ford shale acreage in south Texas. With the proceeds from a sale of this acreage, the company is expected to repurchase shares after e ectively doubling its authorization.
Jabil Inc. (JBL, Financial) (JBL - $57.71 – NYSE) is one of the leading contract manufacturers in the world. In addition to servingthe electronics industry, it has signi cant business manufacturing medical, industrial, and automotive components. While no one piece of news or company development accounts for the outperformance in the shares of Jabil, it has continued to report earnings results that exceed expectations and raise its guidance over the last several quarters. is impresses us in light of the signi cant headwinds that include a slowing economy, electronic component shortages, tight labor markets, and COVID lockdowns in key markets such as China. Perhaps this operational performance is nally starting to be recognized in the stock?
Quanta Services (PWR, Financial) (PWR - $127.39 - NYSE) is a specialty contractor in the electrical power, oil and gas, andcommunication industries. e stock rose after the company reported another record quarter for revenues which exceeded $4 billion for the rst time. Quanta achieved double-digit growth in EBITDA and EPS during the quarter and reported record backlog of $19.9 billion. e outlook for Quanta remains robust as its customers continue to modernize utility infrastructure to support initiatives that move towards a reduced carbon environment.
The three largest detractors in the quarter were:
Organon & Co. (OGN, Financial) (OGN - $23.40 - NYSE) was spun-o by drugmaker Merck & Co. (MRK) as an independentcompany in 2021. While the company makes drugs focused on a range of areas, it has a special focus on producing drugs devoted to women's health, including contraceptives Nexplanon and NuvaRing. During the third quarter, Organon reported solid and largely uneventful earnings. Its shares were pressured in the quarter by investor fears about impact rising interest rates ( oating-rate debt represents about 40% of Organon's debt) and the strong dollar (about 75% of the company's sales come from outside the US) on earnings.
Exelon Corporation (EXC, Financial) (EXC - $37.46 – NASDAQ) is a pure-play electric transmission and distribution utilitycompany that separated its power generation assets into a new company, Constellation Energy (CEG), through a tax-free spino in February 2022. Exelon has operations in the Midwest, Mid Atlantic, and New York regions. e company reported a mixed quarter with revenues exceeding expectations while EPS was a few pennies o . e miss was attributable to weather and the timing of certain expenses. More importantly, management touched on the potential negative impact from the In ation Reduction Act passed by Congress. Provisions in the law could increase taxes paid by Exelon potentially reducing the amount available to be invested in support of the Act. is was a surprise to the market and reduces the potential earnings bene t from the law.
Ardagh Metal Packaging (AMBP, Financial) (AMBP - $4.84 - NYSE) is a leading manufacturer of metal beverage cans withoperations in Europe, Brazil, and the United States. Ardagh reported results that exceeded analysts’ expectations even as the company faces signi cant foreign exchange and in ationary headwinds in Europe. e current environment in Europe creates uncertainty for Ardagh with respect to raw material availability and energy supply. Additionally, management noted that the demand outlook is uncertain near-term as the elevated in ationary and cost environment may cause the consumer to pause for a period of time.
Conclusion
In conclusion, thank you for your investment in the KEELEY Mid Cap Dividend Value Fund. We will continue to work hard to justify your confidence and trust.
This summary represents the views of the portfolio managers as of 9/30/2022. 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.
