To Our Shareholders,
For the quarter ended March 31, 2023, the Keeley Small Cap Dividend Value Fund’s net asset value (“NAV”) per Class A share fell 0.1% compared with a 0.7% decline in the Russell 2000 Value Index.
Commentary
The first quarter of 2023 ended amidst stock market turbulence over fears that the collapse of a few regional banks would trigger a contagion of systemic deposit out ows. e rapid collapse into Federal Deposit Insurance Corp. FDIC, receivership of SVB Financial Group and Signature Bank, along with the virtual wipe out of First Republic Bank equity holders, has raised concerns over the stability and durability of US community banks as rising interest rates force markdowns of bank bond portfolio holdings.
SVB Financial (Silicon Valley Bank) and Signature Bank were the 16th and 29th largest banks in the US. ey represent the second and third largest bank failures in US history. Each bank had some unusual circumstances, but the fundamental driver of their closure was the loss of con dence by depositors which led to a run on the bank. e FDIC stepped in to guarantee all deposits in these cases and the Fed launched new programs to ensure that banks can access the liquidity they need to accommodate deposit out ows. While bank stocks are o sharply, it appears that conditions are stabilizing.
Rapid deposit out ows into higher yielding securities should ultimately crimp loan growth as smaller banks move toward enhancing liquidity.
Profitability will be pressured given the likelihood that higher deposit insurance and compliance costs will force banks to hold more liquidity on their balance sheets. Fueling out ows are worries over uninsured deposits above the $250,000 threshold. To shore up con dence in the regional bank nancial system, the Fed introduced a new backstop for lenders in need of liquidity. The Fed stood ready to make loans against the par or face value of underwater bonds on bank balance sheets. With some long term bonds, these loans could be as much as 50 percent above market value. U.S. o cials are also studying ways to temporarily expand FDIC coverage to all deposits. Treasury Secretary Yellen told lawmakers in March that regulators would take further steps to protect the banking system. Moreover, the Fed is contemplating tighter capital and liquidity requirements for smaller banks along with more rigorous stress tests.
First quarter market performance was surprisingly good. Despite all the negative headlines, the marketsperformed well in the rst quarter. Stocks, as measured by the S&P 500 were up 7.5%. Large-cap stocks outperformed small-cap stocks and growth stocks beat value stocks. International stocks did nearly as well with the MSCI EAFE up 6.7%. Bonds rebounded a little with the Bloomberg US Aggregate up 2.5%. Commodities were mixed with energy and agricultural commodities mostly falling and metals mixed, but gold gaining 8.8%. Bitcoin was up an astonishing 73%.
And was the opposite of 2022 on several fronts. Big Tech was back and was led by the usual suspects as Nvidia,Meta, and Tesla each rose more than 65%, Microsoft, Apple, and Amazon each gained more than 20%, and Alphabet was the laggard with a 17% gain. Indeed, only one of the thirty stocks in the Technology sector in the Russell Top 200 index was down in the quarter: IBM. Energy stocks, last year’s winners, were down as well. Among smaller stocks, the fall in bank stocks impacted returns. Only ve of the 198 bank stocks in the Russell 2000 were up in the quarter. Looking more broadly we see that the stocks that performed poorly last year performed best in the rst quarter.
We still see value in smaller companies. While the economy continues to advance, growth expectations declinedin the rst quarter as more than 400 basis points of rate increases began to impact activity. is, along with the recent turmoil in the banking sector is driving reductions in earnings estimates. With stock prices up and earnings expectations down, the valuation of the market increased. e P/E multiple on the S&P 500 now stands at 18.2x the next twelve months’ earnings, above the long-term average of 16.3x. Value can still be found in small- and mid-cap stocks which trade in line with or slightly below their long-term averages.
The Fund is well positioned. While the defining attributes of the Fund (small cap, value, and dividends) were allheadwinds last quarter, two of the three were positive factors last year for the rst time in several years. Because these types of shifts tend to play out over several years, we think that the focus on value and dividends will return to being drivers of outperformance. We have been calling for a return to outperformance for small caps for some time, and that has not worked out yet. Nevertheless, the relative valuation of small caps vs. large caps remains at levels that historically presaged outperformance.
Portfolio Results
The Fund fell slightly but outperformed its benchmark by a little. e Keeley Small Cap Dividend Value Fundfell 0.1% in the rst quarter and outperformed its benchmark by 0.6 percentage points. If we look at performance within the quarter, we note that the Fund was behind its benchmark by nearly 100bps in January when the index was up 9.5%. As the market gave ground in February and March, the Fund protected better on the downside. is marked the seventh consecutive quarter of relative outperformance.
Good Stock Selection overcame the headwinds from our dividend focus. When we disaggregate performance,we look at three factors: Dividend vs. non-dividend, Sector Allocation, and Stock Selection. In the rst quarter, Sector Allocation was a small positive, Stock Selection accounted for most of the outperformance, and dividend payers lagged non-dividend payers. We estimate dividend-payers within the Russell 2000 Value index lagged the overall index by more than 200 basis points, although this factor is interwoven into the other two factors.
- Sector Allocation (do the sectors the Fund is overweight/underweight outperform/underperform?) added slightly to relative performance. An overweight position in the good-performing Industrials sector and small underweights in the Health Care and Financials sectors o set small underweights in the Information Technology and Consumer Discretionary sectors.
- Stock Selection (do the stocks held by the Fund outperform the sectors in which they reside?) was the main driver of the Fund’s slight relative outperformance. e Fund meaningfully outperformed in two sectors, meaningfully lagged in two sectors, and was about even (but a little better on balance) in seven sectors. e largest outperformance came in the Health Care and Consumer Discretionary sector while the Fund’s holdings lagged in the Materials and Industrials sectors.
The details for those who want to dig deeper.
- Health Care – Small cap Health Care continued to be a tough place to generate returns in the rstquarter as it was the second worst performing sector behind Financials. Even after a weak performance last year, biotechnology stocks still have not found their footing and declined at a double-digit rate in the quarter. Not owning them accounted for the majority of the Fund’s outperformance in this sector. Relative performance also bene tted from a nice bounce-back in the shares of Embecta, which reported much better results during the quarter.
- Consumer Discretionary – e sector performed well in the quarter, trailing only the InformationTechnology sector. e Fund’s holdings produced even better returns. Encouragingly, the results were broad-based as all seven of the Fund’s holdings appreciated and four were up more than 20% in the quarter. Other than that, they all reported strong earnings during the quarter, there was no uniting theme among the standouts. If you can tie together Jack in the Box, KB Home, Kontoor Brands, and Penske Automotive you are better at nding themes than we are. KB Homes was one of the largest contributors to performance in the quarter and is discussed later in this update.
- Materials – While strong performance by mining shares made Materials one of the better performingsectors of the Russell 2000 Value index, the Fund’s holdings failed to match that. Weakness in the shares of beverage can maker Ardagh Metal Packaging and forest products company Mercer International led the Fund’s holdings to decline compared to a gain for the sector as a whole. In both cases, reported earnings fell short of analysts’ expectations. Furthermore, both companies are working through some disruption that we believe will be temporary but pressure the near-term earnings outlook.
- Industrials – We saw a wide dispersion of investment outcomes in the Industrials sector during the rst quarter. On the one hand, the Fund’s top contributor, ESAB, resided in this sector. We will discuss it later in this update. In addition, four other stocks generated double-digit returns. ese positives were o set by weakness in the shares of Gri on Corporation and TTEC Holdings. At Gri on, a strategic review process has dragged on with no meaningful update or outcome and the business has slowed. TTEC reported better than expected earnings but lowered its outlook.
During the quarter, we added three new positions to the Fund and had one stock merged away for cash.
Let’s Talk Stocks
The top three contributors in the quarter were:
ESAB Corporation (ESAB, Financial) (ESAB - $59.07 - NYSE) is a leading manufacturer of welding equipment for a variety ofindustrial applications and was spun o from Colfax Corporation in April 2022. The company not only reported strong quarterly results which handily beat expectations but also announced it will be adopting the 80/20 operating philosophy to streamline its product portfolio. It will focus on its top 20% of products in its portfolio and rationalize the rest. is philosophy has been deployed in several leading industrial companies to great success.
Kontoor Brands (KTB, Financial) (KTB - $48.39 – NYSE) manufactures and markets jeans through the Lee and Wrangler brands.Kontoor rallied during the rst quarter after reporting strong fourth-quarter 2022 results and guiding to sales and earnings for 2023 to be well ahead of then consensus expectations. e company's strength in the fourth quarter came from sales to the U.S. wholesale channel, including department stores but also mass retailers, where Kontoor gained market share. In addition, Kontoor saw particular strength during the fourth quarter from selling to Western retailers, which have been more resilient than other retailers. Despite potential macroeconomic challenges in 2023, Kontoor expects to generate low-single-digit revenue growth from sales to the U.S. and later in the year to China as it recovers from COVID-19 lockdowns and restrictions. Margin expansion from sales in the digital and international channels should drive earnings growth that exceeds sales growth.
KB Home (KBH, Financial) (KBH - $40.18 – NYSE) is one of the nation’s leading homebuilders. Its shares rose during the rstquarter due to a positive shift in sentiment towards the homebuilding industry. Much of this was due to an improving backdrop for home sales as mortgage rates moderated and employment remained strong. Just as importantly, KB reported impressive quarterly earnings with EPS exceeding consensus expectations. While revenues declined slightly from a year ago, gross margins increased on better building costs and higher average selling prices. Management further noted a strong monthly sequential improvement in orders throughout the quarter which carried over into March. e company remains active with share repurchases below book value and has bought back almost 12% of its shares outstanding over the past two years. During its earnings call, management expressed cautious optimism for the upcoming spring selling season.
The three largest detractors in the quarter were community banks.
Columbia Banking System (COLB, Financial) (COLB - $21.42 — NASDAQ), Independent Bank Group (IBTX, Financial) (IBTX - $46.35 - NASDAQ), and Pacific Premier Bancorp (PPBI, Financial) (PPBI - $24.02 - NASDAQ) led the list of detractors, but all ten of thebottom ten were community banks. Interestingly, the Fund’s bank stock holdings actually outperformed those in its benchmark, the Russell 2000 Value index. e sharp drop in bank shares came after the surprising failures of SVB Financial (Silicon Valley Bank) and Signature Bank in mid-March. Shares fell on concerns that the deposit runs experienced by SVB and Signature would spread more broadly. While banks are struggling, and will continue to struggle, with rising deposit costs, none of the banks held in the Fund is in the venture deposits or venture lending businesses that led to the run at SVB, and none is active in the crypto markets that were a source of volatility for Signature. e Fund holds banks that are generally more deposit-rich, better funded, and have better histories of managing credit conditions than the average bank. Columbia is particularly impressive on these three attributes. Our biggest concern arising from these recent events is that it leads banks to rein in lending which could have broader negative economic impacts. is, in turn, could lead to rising credit costs which would further reduce earnings expectations.
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 3/31/23. 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.
