To Our Shareholders:
For the quarter ended March 31, 2018, the KEELEY ALL Cap Value Fund’s net asset value (“NAV”) per Class A share declined 1.51% versus a loss of 2.82% for the Russell 3000 Value Index
Commentary
The first quarter of the new year can be characterized as an eruption of market turbulence. Exiting the prior year on an ebullient note, the market rally continued into January, propelled by strong corporate earnings, corporate tax cuts, and a weakening dollar that supported exports. Following an extended period of rising markets, driven by global quantitative easing, the quarter saw a return of volatility, with sharp declines in February and March. Two threats to the story of synchronized global recovery caused volatility indexes to surge: trade wars and inflation. Another cause of market turbulence has been the shift of fund flows to computer driven passive investing. Exchange traded funds accounted for as much as forty percent (40%) of total stock trading on market decline days. Against this backdrop, we believe that stock pickers are entering an environment where they can demonstrate their ability to add value. This is evidenced by the primary driver of the Fund’s outperformance this quarter being stock selection.
As tariffs on a list of over 1,300 targeted goods was released for public review, China proposed to reciprocate in like-kind. The many twenty-five percent (25%) levies now bandied about threaten disruption to industrial production levels and the injection of inflation into the economic system. Markets tumbled and gyrated as investors attempted to gauge the potential negative impacts, forecasting which businesses were most at risk and wagering on the likelihood that coming negotiations could pacify the growing hostility over international trade. Small cap stocks, which generate approximately nineteen percent (19%) of their revenue from overseas, had their best January performance since 2013. This held steady in March, while larger multinationals, with approximately thirty-nine percent (39%) overseas exposure, stumbled given their greater sensitivity to trade and protectionism.
While consumers rode high in February, marking the highest consumer confidence levels in eighteen years and the lowest unemployment levels in seventeen years, the Federal Reserve’s ‘curious case of the missing inflation’ (2017) appeared to receive a new designation of ‘case closed.’ Wage growth accelerated in January to two point nine percent (2.9%), the strongest gain since mid-2009, and the Consumer Price Index (CPI) topped analyst estimates, holding to an above two percent (2%) trend. Incoming Federal Reserve chairman Jerome Powell concurred that “inflation is moving up to target.” Yields on the US two-year to ten-year treasury notes began a sharp, upward move as inflation fears and higher rates were both incorporated into market outlooks. Generally, economists expect four Federal Reserve interest-rate hikes in 2018 and four more in 2019. Recessions tend to occur when there is an over-tightening of monetary policy, which we do not envision in the near term. Broadly considered, the global economy continues to demonstrate the first synchronized economic expansion in many years, supported by stabilized commodity prices and steadily climbing industrial output. Much of the same is reflected domestically, yet with added drivers such as recently enacted corporate tax reform.
The current bull market marked its ninth anniversary in March. While some valuations appear stretched, many companies have been left behind, as value stocks have underperformed growth stocks for the past decade. Given the outlook for an improving economy, accompanied by near record low unemployment, we remain constructive on the outlook for continued market gains, as we seek to uncover the mispriced equities of companies selling at a discount to intrinsic value. At Keeley Teton, we focus on underfollowed and misunderstood companies that are implementing restructuring changes to close that discount. We employ fundamental research and bottom-up analysis to identify potential catalysts that could ultimately unlock this value.
For our portfolios, a major historical performance driver has been merger and acquisition activity. Global deal making year-to-date has crossed the $1 trillion mark, the fastest it has reached that level, as a wave of consolidation spreads across the U.S. and activity in the UK, China, Germany and Japan accelerates. Buoyed by quickening economic growth, tax cuts, and strong business confidence, boardrooms are reassessing the capital they can plough into acquisitions. Deal making is up more than fifty percent (50%) from a year ago and twelve percent (12%) percent from the same point in 2007, the high-water mark for mergers and acquisitions, according to Dealogic. Also, according to Thomson Reuters, a record $1 trillion of cash was pledged toward private equity funds last year in search of higher returns. In many cases, institutional investors are turning to active microcap equity as a proxy for private equity. Small cap companies are increasingly being acquired by larger corporations challenged by anemic organic top line growth. In the Fund, we had one company acquired in the quarter (CSRA, Financial) and two more (SHPG, ABC) are rumored to be targets. The government information technology space continues to consolidate and recently spun-off CSRA (CSRA) was acquired by larger competitor, General Dynamics (GD) at a thirty-eight percent (38%) premium.
In the first quarter of 2018, the Fund’s performance was driven by strong stock selection in Energy, Technology and Real Estate. Delek (DK, up 17%) benefitted from strong refining margins given widening oil price differentials as well as the accretive acquisition of Alon Energy. Additionally, the Fund was slightly underweight Energy, one of the worst performing sectors (down 6%) in the index. Performance in the Technology sector was strong buoyed by General Dynamics offer to buy CSRA (up 38%) as well strong results from Intel (INTC, up 13%). The Fund’s stock selection in Real Estate was particularly strong in the first quarter. On average the Fund’s real estate holdings were up approximately three point five percent (3.5%) versus a seven percent (7%) decline for the index. Howard Hughes (HHC, up 6%) was the Fund’s best contributor in this sector.
On the negative side, stock selection in Industrials and Consumer Discretionary detracted from performance. Macro concerns, which we believe are unfounded, impacted Air Lease (AL, Financial) – down eleven percent (11%) due to the negative prospects of a trade war, Nexstar Media (NXST) – down fifteen percent (15%) on weaker ad spend, and Visteon (VC, Financial) – down eleven percent (11%) on slower adoption of autonomous vehicles given recent accident reports. On the consumer side, Del Taco (TACO, Financial) – down fifteen percent (15%) retrenched as it appears future California wage inflation will mask margin improvement, despite having some of the best same store sales growth in the industry.
The top contributors in the quarter were:
CSRA, Inc. (CSRA, Financial) is a provider of information technology solutions and services to the Defense and Intelligence, and Civil agencies of the US Government. The company was the government services arm of Computer Sciences and was spun off in November 2015. As a pure play government IT contractor, the company eventually caught the attention of General Dynamics which acquired CSRA at a thirty-two percent (32%) premium.
Intel Corp. (INTC, Financial) engages in the design, manufacture, and sale of computer, networking, and communications platforms that power the cloud and the connected world. The company has been in the process of transforming its business away from its mature, slower growing personal computer (PC) exposure to higher growth data center, communications and memory markets. After several lackluster quarters, Intel posted a second consecutive quarter of strength, led by server growth in Data Centers.
Zoetis (ZTS, Financial) is an animal health company that was a spinoff from Pfizer. The company reported very strong quarterly earnings and issued solid 2018 guidance that was higher than Wall Street estimates. Zoetis remains well positioned to continue to increase share in the livestock and companion animal markets while being insulated from the drug pricing and healthcare reform issues pressuring the human pharmaceutical companies.
The three largest detractors in the quarter were:
Air Lease Corporation (AL, Financial) is a leading aircraft leasing company that currently owns and manages a fleet of 253 aircraft. Industry-wide change is being driven by increasing air travel demand from the rising middle-class population in international markets. This has led Air Lease to more than double its owned fleet within five years. Despite continued strong operating performance, the stock was weak due to general fears regarding the impact of tariffs on aircraft demand. Although Boeing was listed as a US company subject to Chinese tariffs, the tariffs were specific to very few models, and even if the tariffs became broader, it would tilt more Chinese airlines to lease rather than purchase which would be beneficial to aircraft lessors like Air Lease. We continue to believe the stock is attractive trading at book value.
Visteon Corporation (VC, Financial) is an original equipment supplier historically focused on developing electronic clusters and cockpits for light passenger vehicles. In June 2015, the company appointed a new CEO from Harman who is transforming the company into a leader in autonomous driving systems and software (ADAS). More recently, accidents involving fully autonomous vehicles have been in the news. This has created a pullback in many of the stocks that supply ADAS to the OEM’s. This may slow adoption over the short term, but we continue to be bullish on their positioning for the future.
Del Taco Restaurants, Inc. (TACO, Financial) engages in developing, franchising, owning, and operating Del Taco quick-service Mexican-American restaurants. The stock sold off last quarter on concerns regarding future margin headwinds stemming from both food and labor inflation. These concerns were proven correct as the company slightly missed fourth quarter 2017 earnings and lowered its 2018 guidance. In addition, the industry continues to fight for market share by pushing “value bundles” led by the larger brands such as McDonalds. We continue to believe the company is well positioned with its unique “fresh” menu offerings and has ample growth opportunities outside its core West Coast roots.
Conclusion
In conclusion, we thank you for investing alongside us in the KEELEY All Cap Value Fund. We will continue to work hard to justify your confidence and trust.
KEELEY All Cap Value Fund Standardized Performance Information
The performance reflected herein is for the Class A shares without load. "Without load" does not reflect the deduction of the maximum 4.50% sales fee (load), which reduces the performance quoted. Past performance does not guarantee future results. The performance data quoted represents past performance and current returns may be lower or higher. The investment return and principal will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. Most current performance data may be obtained at www.KeeleyFunds.com.
The Fund's adviser has contractually agreed to waive a portion of its management fee or reimburse the Fund if total ordinary operating expenses during the current fiscal year as a percentage of the Fund's average net assets exceed 1.39% for Class A Shares and 1.14% for Class I Shares. The waiver excludes expenses related to taxes, interest charges, dividend expenses incurred on securities that a Fund sells short, litigation and other extraordinary expenses, brokerage commissions and other charges relating to the purchase and sale of portfolio securities. The waiver is in effect through February 28, 2019.
This summary represents the views of the portfolio managers as of 03/31/18. 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.
