In the fourth calendar quarter of 2015, the KEELEY Mid Cap Dividend Value Fund (KMDVX, Financial) rose 1.28 percent compared to a 3.12 percent increase for the Russell Mid Cap Value Index. After a challenging third quarter, equity markets rebounded to post positive gains in the fourth quarter. However, many of the factors that weighed on markets throughout 2015 remain, and will most likely play a key role in 2016. The volatility in energy prices continued, and the situation may become even more volatile as companies succumb to the pressure of sustained low energy prices. China’s slowing growth is also having a spillover effect on the global economy and has placed additional pressure on the beleaguered energy sector. The decision by the Federal Reserve to finally end their run of monetary excess was welcomed by the markets, and we hope the decision will allow investors to finally place greater focus on company fundamentals going forward. One bright spot in recent years has been the U.S. consumer. Many factors point to continued momentum from the consumer, as employment growth, strength in housing, improving balance sheets, and an uptick in consumer confidence were all positive elements in the fourth quarter. Although the Keeley Mid Cap Dividend Value Fund posted a positive absolute return during the quarter, we trailed the benchmark. Despite some positive data points for the consumer, the consumer discretionary sector lagged, barely producing a positive result in the fourth quarter. Our overweight to the consumer discretionary sector had a negative impact, but we fortunately offset that negative with good stock selection and consumer discretionary made a positive contribution overall. The largest detractor during the quarter was our stock selection within financials. Technology, which was the best performing sector during the quarter, was our second largest detractor, where our stock selection had a negative impact. Energy continued to lag and was the only sector in the Russell Mid Cap Value Index to produce a negative return. We benefited from an underweight position, but stock selection caused a net detraction for the quarter.
The Fund’s top performing position was Autoliv Inc. (ALV, Financial) which climbed over 14 percent and added 25 basis points of return to the Fund during the quarter. The company reported better than expected results. Sales were strong across the board as active safety continues to perform well. The company also looks to gain additional market share in the airbag market given the recent struggles of their main competitor.
The Fund’s second largest contributor was EPR Properties (EPR, Financial) which increased over 13 percent and added 24 basis points of performance during the quarter. The specialty Real Estate Investment Trust (REIT) reported third quarter adjusted funds from operations (FFO) that exceeded expectations with a 10 percent increase in revenue from the prior year quarter. The company also raised guidance for the full year.
The largest detractor was Ryder Systems (R, Financial) which fell over 23 percent and detracted 34 basis from our results during the quarter. The company reported disappointing earnings results as they were negatively impacted by execution issues which led to lower utilization and maintenance inefficiencies. A decrease in used vehicle pricing also weighed on the stock.
The second largest detractor was HollyFrontier Corporation (HFC, Financial) which fell over 18 percent and cost the Fund 24 basis points in performance during the fourth quarter. The company was a solid performer leading up to the quarter. Although earnings results were reported as expected, given the decline in spreads, profit margins may decline along with unplanned maintenance downtime.
Going forward, we generally feel the same about the market as we did a year ago. Namely, we think the market will be pretty flat this year. When we look at the drivers, earnings and valuation, neither look all that compelling. The S&P 500 Index trades at 16.3x next twelve months earnings (NTM EPS). That is a little above its average since 1999 of 15.8x. As a result, multiple expansion could go either way.
Unfortunately, the P/E is based on EPS expectations that still look a little too high. Consensus has S&P 500 EPS growing 8 percent in 2016. That is a pretty big pick-up from the flat earnings in 2015, so it will probably come down. In fact, most years earnings expectations do come down throughout the year. Last year at this time, analysts forecast EPS growth of 9 percent for the S&P 500 Index so the decline in expectations was more severe than usual. In order to get comfortable with the idea that EPS won’t really disappoint, we have to be able to support the idea that earnings will grow at about 5 percent this year. Where will that come from?
The first factor that should not impact earnings expectations as much in 2016 as in 2015 is energy. Roughly 56 percent of the decline in earnings expectations for the S&P 500 (from 9% growth expected at the beginning of the year to flat results expected now) came from falling expectations for earnings from energy companies. While earnings will be probably be lower for the sector in 2016 (and could go negative), they only represent 4 percent of S&P 500 Index earnings so the impact is likely to be less. In the S&P 600, declines in energy earnings accounted for 29 percent of downward revision and the sector is now expected to lose money.
The other factor that was a headwind for earnings in 2015 that will probably not have as big an impact in 2016 is currency. Since mid-year 2014 the Euro has fallen 21 percent against the dollar. Some currencies have done better, but depending on how much revenue a company was getting from overseas sales, this could have been a 5%-7% impact on revenues and a drag on earnings as well. With FX flattening out in the second half of 2015 this looks like it will not be as big a drag in 2016. On the other hand, global economic growth looks like it is slowing on balance. In the US, growth seems to be slowing, but remains positive. China is still looking for a bottom on its growth rate and 2016 will likely be slower than 2015. On the other side of the ledger, Europe may improve.
In summary, the market (as measured by the S&P 500) looks reasonably priced at year end and has become more attractive from a valuation standpoint since then. Small-cap is more attractive than large and is more attractive on a relative basis than it has been for almost all of the last ten years. Additionally, value is more attractive relative to growth. And lastly, earnings expectations are too high (as usual this time of year), but some of last year’s headwinds should not have as great an impact going forward. On the other hand, economic growth looks a little harder to come by this year and the stock market swoon at the start of the year probably will not help. Although this could potentially be a challenging time for equity investors in the short-term, the Fund has historically performed well in these environments and we are pleased to see valuations come down in our universe of stocks. We expect any enhanced volatility coupled with better valuations will provide some attractive opportunities in the future. Thank you for your support of the Mid Cap Dividend Value Fund.
