To Our Shareholders,
For the quarter ended December 31, 2022, the Keeley Small-Mid Cap Value Fund’s net asset value (“NAV”) per Class A share rose 13.1% compared with a 9.2% increase in the Russell 2500 Value Index. e strong fourth quarter absolute and relative performance led the Fund to slightly outperform its benchmark for the full calendar year -12.9% vs. -13.1% for the index.
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 mean lower values. e 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. e 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%. ese 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-Mid Cap 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 2500 trades at 92% of the P/E of the Russell Top 200 index compared to an average since 1999 of 114%. Furthermore, value stocks in the capitalization range appear cheap relative to growth stocks. e current relative P/E is 0.59x compared to a historical average of 0.64x.
- About 57% of the assets of the Fund are invested in companies that were/are engaged in a spin-o transaction. Historically, spin-o s performed very well in the years after the transaction. at has not been the case for the last several years as investors sought simpler stories. With rates up and the willingness to discount out to in nity down, we expect investors to focus on companies with the ability to manufacture earnings growth through internal actions.
- Finally, the characteristics of the Fund are attractive. With a weighted average Price/2023 Earnings (P/FFO for REITs) of only 10.4x, the Fund appears materially cheaper than the 15.0x of its benchmark, the Russell 2500 Value index. Furthermore, ROA and ROE are better for the Fund than the index.
Portfolio Results
Almost all the relative performance came from Stock Selection. We disaggregate relative performance into two factors: Sector Allocation and Stock Selection. In the fourth quarter, Sector Allocation had minimal impact overall and Stock Selection drove the Fund’s outperformance.
- Sector Allocation (do the sectors where the Fund is overweight/underweight outperform/underperform?) provided little net impact to relative performance. e slight bene ts from an overweight in Energy and an underweight in Technology were offset by small negatives elsewhere.
- Stock Selection (do the stocks held by the Fund outperform the sectors in which they reside?) drove the Fund’s relative outperformance. Selection added value in seven sectors, detracted in two and was a push in the other two. The largest outperformance came in the Industrials, Consumer Discretionary, Technology, Real Estate, and Consumer Staples sectors. Holdings in the Utilities and Financials sectors detracted from relative performance.
The details for those who want to dig deeper.
- Industrials – The Industrials sector was the third best performing sector in the Russell 2500 Value index and the Fund’s holdings performed even better. We saw a very wide distribution of returns within this sector as it included both the Fund’s best-performing stock and worst-performing stock. Interestingly, both were involved in acquisitions. Altra Industrial Motion (the top performer) was the target of an acquisition bid while Chart Industries (the biggest detractor) was a buyer. Both companies are discussed in the “Let’s Talk Stocks” section of this commentary.
- Consumer Discretionary – This sector ranked as second best for both the index and the Fund, but the Fund’s holdings signi cantly outperformed the sector. Outperformance was broad-based as all eight of the Fund’s holdings were up double-digits and seven of the eight outperformed the sector. Retail-oriented stocks PVH, Bath & Body Works, and Victoria’s Secret led the gains.
- Technology – Technology was the worst-performing sector in the Russell 2500 Value index which made it easy for the Fund’s holdings to outperform. And that they did with performance that even exceeded the overall index. Four of the Fund’s six holdings advanced more than 10% in the quarter with particularly strong performance from WEX, Inc.
- Real Estate – The performance of Real Estate stocks lagged the overall market, but the Fund’s holdings performed better than the overall market. A strong bounce back by Howard Hughes drove much of the outperformance, but the Fund also bene tted from good gains at Gaming and Leisure Properties and Lamar Advertising.
- Consumer Staples – Consumer Staples ranks as one of the smaller sectors in the index and the Fund holds only four stocks in the sector. Nonetheless, all four stocks advanced in the quarter, three by more than the sector’s 11% return. Most of the gains, however, arose from a more than 50% increase in the shares of Spectrum Brands. We discuss this stock later in this report.
- Utilities – The Utilities sector represents only about 4% of the benchmark and the Fund holds only three stocks in the sector. A 15% drop in one of them (NRG Energy) and lackluster returns in the other two led to negative relative performance in the sector for the Fund. We talk about NRG later in this update.
- Financials – The Financials sector failed to keep up with the strong gain in the index and the Fund’s holdings lagged the sector. Most of the shortfall came from the decline in the shares of Popular Inc. which we discuss later in this report, but the Fund’s other holdings in bank stocks were nothing to write home about either.
During the quarter, we added two new positions and sold five holdings out of the Fund.
Let’s Talk Stocks
The top three contributors in the quarter were:
Altra Industrial Motion (AIMC, Financial) (AIMC - $59.75 – NASDAQ) is a provider of material handling solutions for a widevariety of industrial customers. On October 27, Altra announced that it agreed to be acquired by Regal Rexnord Corporation for $62 a share in cash which represented a 54% premium to the prior day’s closing price. The deal is expected to close in the rst half of 2023.
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.
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.
The three largest detractors in the quarter were:
Chart Industries (GTLS, Financial) (GTLS - $115.23 — NYSE) provides equipment to industrial and energy customers for thepurpose of converting gas to liquids. On November 9, the company announced an agreement to acquire Howden, a manufacturer of gas handling equipment, for $4.4 billion in cash and preferred stock. Despite being accretive to earnings, the deal was poorly received by investors. e size of the deal, the quality of the target, and the multiple paid all weighed on investors’ assessment of the transaction. In addition, management did not do a good job explaining the need for its departure from its previously successful bolt-on strategy and why Howden was worth more than twice what private equity acquired the company for three years ago. e increase in leverage at a time when the economy looks shakier and nancing costs have increased was an additional negative.
NRG Energy (NRG, Financial) (NRG - $31.82 - NYSE) is one of the largest competitive energy retailers in the U.S. serving over vemillion customers supported by 18 gigawatts of conventional generation. In early December, shares of NRG fell 15% when the company announced the acquisition of Vivint Smart Home (VVNT-NYSE) for $12 per share. Investors did not see the bene ts of this deal as the lack of clearly de ned growth objectives and the incremental debt associated with the acquisition could negatively impact the attractive capital return policy of the company. While investors generally like Vivint’s recurring revenue subscription model, they are not yet sold on the cross-selling opportunities into NRG’s legacy utility customer base. Furthermore, investors remain skeptical of the competitive nature of the home security market. Finally, this transaction further complicates an already complicated story as the company diversi es away from its IPP (Independent Power Producer) roots.
Popular Inc. (BPOP, Financial) (BPOP - $66.32 – NASDAQ) is a bank holding company comprised of the largest bank on the islandof Puerto Rico and some US operations. Its shares fell after the company reported slightly disappointing third quarter earnings and outlined a few headwinds that will impact 2023 results. While rising rates help its interest income, deposit costs are starting to pinch earnings. Furthermore, lower noninterest revenue and rising employment costs will also pressure pro tability.
Conclusion
In conclusion, thank you for your investment in the KEELEY Small-Mid Cap Value Fund. We will continue to work hard to earn your confidence and trust.
This summary represents the views of the portfolio managers as of 12/31/2022. 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.
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