To Our Shareholders,
For the quarter ended December 31, 2022, the Keeley Small Cap Dividend Value Fund’s net asset value (“NAV”) er Class A share increased 13.9% compared with an 8.4% increase in the Russell 2000 Value Index. is marked the Fund’s sixth consecutive quarter of outperformance and was the Fund’s second-best quarter of relative performance since its 2009 inception. For the full calendar year, the Fund declined 5.8%, outperforming the 14.5% fall in the benchmark by 8.7 percentage points.
Commentary
Even with a strong fourth quarter rebound most investors are glad that 2022 is over. e S&P 500 was down 18% and the Russell 2000 fell a little more than 20%. International stocks did a little better as the EAFE declined only 16% in dollar terms. Unlike previous downturns over the last couple decades, bonds did not provide a safe haven as the Bloomberg Aggregate declined 13%. Commodities fared a little better as energy-related commodities were all up, metals were mixed, and agricultural commodities were mostly higher.
Starting in March, the U.S. Federal Reserve raised the federal funds rate at seven consecutive meetings with a total increase of 4.25%. e stock market fell as interest rates are a key variable in valuing assets and higher rates ean
lower values. The multiple on the S&P 500 fell 4.8 points from 21.5x at the beginning of the year to 16.7x at the end. In smaller stocks, the Russell 2000 saw its P/E contract from 23.5 to 19.1. The Russell 2000 Growth index declined 26.4% in 2022 compared with the 14.5% fall in the Russell 2000 Value.
The 400 basis points of increases and nine months of time elapsed since the beginning of the rate raising cycle seem to be starting to impact the in ation numbers. While it is hard to make much of a month or two of data, the year/year rate of core inflation slowed from 6.6% in September to 6.3% in October, and 6.0% in November. The December reading is expected to fall further to 5.7%. These numbers remain well above the Fed’s 2% target rate, but the trend looks favorable.
Global central banks have embarked on a concerted e ort to combat in ation through restrictive monetary policies. As a result, the global stock of negative yielding bonds has dwindled to zero after last month’s policy shift by the Bank of Japan. e market value of debt trading at yields below zero approached $18 trillion in late 2020 as central banks slashed rates and launched huge bond buying through massive “quantitative easing” programs in the wake of the COVID-19 pandemic. is past year marked an end to the era of easy money. e shift to monetary tightening remains a major headwind for equity markets in 2023. A rapidly slowing economy and declining in ation could force the Fed to pivot toward monetary easing sooner than expected, a potential catalyst for a rebound in global markets.
Meanwhile, the economy and markets seem well positioned to absorb a slowdown. Stimulus money granted during the pandemic bolstered the balance sheets of individuals and businesses. While much of this has burned o or been absorbed by in ation, people and the companies they work for appear to be in a healthier position. Second, many of the excesses (negative interest rates, SPACs, pro tless innovation) created in the bull market leading up to last year’s downturn appear to have at least partly unwound already. Finally, valuations appear more reasonable. While large cap stocks trade above their long-term averages, small- and mid-cap stocks trade well below the averages since 1999.
Several factors make us optimistic that the Small Cap Dividend Value Fund can continue to deliver good relative performance in the periods ahead.
- Small caps remain attractive. After several years of underperforming their larger peers, the relative valuation for small caps is attractive. e Russell 2000 trades at 111% of the P/E of the Russell Top 200 index compared to an average since 1999 of 129%. While this is up from mid-year 2022, you have to go back to 2003 to see this metric this attractive.
- Dividend payers seem to be coming back into favor. After lagging non-dividend payers badly from 2019 through the middle of 2021, dividend payers have been outperforming.
- Finally, the characteristics of the Fund are attractive. With a weighted average Price/2023 Earnings (P/FFO for REITs) of only 10.6x, the Fund appears materially cheaper than the 15.3x for its benchmark, the Russell 2000 Value index. Furthermore, ROA, ROE, and expected growth rate are better for the Fund than the index. Finally, 76% of the holdings in the Fund raised their dividend over the last year and 77% have a payout ratio below 50%.
Portfolio Results
All three pillars of performance contributed. When we disaggregate performance, we look at three factors: Dividend vs. non-dividend, Sector Allocation, and Stock Selection. In the fourth quarter, all three factors contributed to the Fund’s outperformance.
- We estimate dividend-payers within the Russell 2000 Value index outperformed the overall index by about 300 basis points, although this factor is interwoven into the other two factors.
- Sector Allocation (do the sectors where the Fund is overweight/underweight outperform/underperform?) added to relative performance with the largest positive impacts arising from the Fund’s underweight in the Health Care sector and overweight in the Industrials sector.
- Stock Selection (do the stocks held by the Fund outperform the sectors in which they reside?) accounted for the vast majority of the Fund’s relative outperformance. e Fund meaningfully outperformed in ve sectors, meaningfully lagged in one sector, and was about even in ve sectors. e largest outperformance came in the Industrials, Consumer Staples, Health Care, and Energy sectors and only the Financials sector lagged.
The details for those who want to dig deeper.
- Industrials – is sector ranked third within the eleven sectors in the benchmark with a strong performance in the quarter. e Fund’s holdings, however, appreciated far more and accounted for about half of the Fund’s relative outperformance. All twelve of the Fund’s holdings during the quarter appreciated and seven stocks rose more than 20%. Maxar Technologies led the group as it rose more than 175% in the quarter after it agreed to be acquired. It is discussed later in this update.
- Consumer Staples – e Consumer Staples sector lagged the Russell 2000 Value index slightly, but the Fund’s holdings performed very well to make it the best performing sector in the Fund with a gain of more than 35%. We would caution that it is a small sector and the Fund only owned three stocks. Nonetheless, all three gained more than 25% in the quarter with the more than 50% rise in Spectrum Brands being the stand-out. It was one of the Fund’s top three contributors and is discussed later in this report.
- Health Care – Stocks in the index in the Health Care sector fell during the fourth quarter making it the worst performing of the eleven sectors. e Fund’s holdings, on the other hand, appreciated nearly as much as the overall index. While the Fund had a few disappointments (Embecta and Perrigo), long-time holdings Ensign Group and Chemed appreciated 15%-20% in the quarter which drove the strong relative performance. e Fund also bene tted from not owning any stocks in the biotechnology industry. None pay dividends and therefore are not appropriate for this strategy.
- Energy – Despite fourth quarter declines in energy commodities, energy equities were the second best performing sector in the Russell 2000 Value index. e Fund’s tilt toward energy service companies rather than exploration and production stocks enabled it to outperform within the sector and add to overall relative performance. Four of the Fund’s ve Energy holdings were service companies and three of those appreciated more than 30%. TechnipFMC was the third largest contributor to Fund performance and we discuss reasons for its rise later in this update.
- Financials – The Financials sector performed slightly worse than the overall index and the Fund’s holdings performed slightly worse than that. We saw a wide dispersion of returns within the twenty-two Financials holdings. Eight stocks were up double-digits, but ve declined. Most of the underperformance came in the Fund’s holdings in Banks and Insurance companies. In fact, the Fund’s biggest detractor was a bank, First Foundation, which is discussed in the next section of this report.
During the quarter, we added four new positions to the Fund and sold four holdings.
Let’s Talk Stocks
The top three contributors in the quarter were:
Maxar Technologies (MAXR, Financial) (MAXR - $51.74 – NYSE) is a leading provider of satellite imagery to governments andcommercial customers worldwide. It also builds satellites and other space infrastructure for government and commercial customers. Maxar shares advanced more than 175% in the third quarter after the company agreed to be acquired by a private equity group led by Advent International for $53 per share in cash.
Spectrum Brands Holdings (SPB, Financial) (SPB - $60.92 – NYSE) is a diversi ed manufacturer of various consumer productsoperating 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. Near the end of the second quarter, the proposed sale of the company’s Hardware and Home Improvement business (HHI) to competitor ASSA ABLOY had been blocked by the US DOJ based on antitrust grounds. In early December, ASSA ABLOY announced it would sell its residential hardware business to Fortune Brands. is should be enough to clear regulatory hurdles to acquire HHI. Spectrum Brands plans on using the expected net proceeds of $3.5 billion to reduce its debt which should improve its valuation. To put that number in perspective, Spectrum has debt of $3.1 billion and a market cap of only about $2.6 billion.
TechnipFMC plc (FTI, Financial) (FTI - $12.19 - NYSE) is a manufacturer of oil eld equipment for both o shore and onshoreapplications. When reporting third-quarter results, the company indicated that it expects strong results ahead. Management sees the potential for signi cant order growth in its subsea segment with total orders expected to approximate $9 billion over the next ve quarters compared to $6.7 billion in orders recorded in 2021. e company also expects to hit its long term 15% margin target in its subsea segment prior to its old 2025 target.
The three largest detractors in the quarter were:
First Foundation (FFWM, Financial) (FFWM - $14.33 — NASDAQ) is a bank holding company with banking and wealthmanagement operations in California, Texas, and Florida. Rising funding costs and higher expenses associated with customer accounts led to a large shortfall vs. expectations in First Foundation’s third quarter earnings. ese factors likely continue to pressure earnings in early 2023. In addition, the resignation of the company’s President and the Chief Financial O cer’s move to a competitor also spooked investors.
National Storage Affiliates (NSA, Financial) (NSA - $36.12 - NYSE) is a real estate investment trust (REIT) that owns and acquiresself-storage facilities across the U.S., mostly in secondary and tertiary markets. Fueled by strong occupancy growth, NSA performed well early in the pandemic compared to other self-storage REITs as its occupancy rate closed the gap it had with larger peers. However, in the fourth quarter, NSA's pro t growth decelerated, as expenses were higher and occupancy declined because rate increases nally began to crimp demand. at sparked investor fears of heightened promotional activity as a way to drive customer demand. Also, NSA is dealing with excess self-storage supply in the Portland, Oregon area, which is 9% of NSA's revenues. Despite these temporary headwinds, NSA is a solid operator that should continue making acquisitions and should see fundamentals improve as its markets absorb new supply.
Embecta Corporation (EMBC, Financial) (EMBC - $25.29 — NASDAQ) is a diabetes equipment business that Becton Dickinson(BDX) spun o in April 2022. Embecta produces pen needles, insulin syringes and other products. During the fourth quarter, Embecta reported earnings in line with expectations, but guided to earnings in 2023 that were below analyst expectations. Two factors create headwinds in 2023. First, some dynamics that have been known, such as incremental public company costs and higher supply chain and material costs. Second, Embecta plans to spend more on research and development. Embecta has had a rough rst nine months as a public company, mostly in communicating reasonable targets. Nevertheless, it is a pretty good business and a cheap stock and has some opportunities in new products that could drive more excitement about its prospects.
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 confidence and trust.
This summary represents the views of the portfolio managers as of 12/31/22. 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.
