Keeley Small-Mid Cap Value Fund 2nd-Quarter Letter

Discussion of markets and holdings

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Jul 30, 2021
Summary
  • For the quarter ended June 30, 2021, the Keeley Small-Mid Cap Value Fund’s net asset value per Class A share rose 4.65%.
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To Our Shareholders,

For the quarter ended June 30, 2021, the Keeley Small-Mid Cap Value Fund’s net asset value (“NAV”) per Class A share rose 4.65% compared with a 5.00% gain for the Russell 2500 Value Index. For the year-to-date period, the Fund gained 22.26% compared to a 22.68% gain for the benchmark.

Commentary

Fueled by the lifting of COVID-related restrictions and ongoing reopening activity, the economy and the stock market advanced further in the second quarter. e economic numbers continued to improve both on an absolute basis and because we are cycling over last year’s downturn. e results might even have been a little better if not for issues in ramping economic activity back up. As companies have worked to get “back to normal,” they have experienced signicant constraints that have slowed progress. We have heardof signicant supply chain problems such as shortages of semiconductors, lumber, shipping containers and other inputs. There has also been a lot of discussion about tightness in the labor market even though unemployment remains above pre-pandemic levels.
Slowly, but surely, these challenges are being met which suggests that the rebound will continue.

Are we all the way back? In some cases, it would appear that we are. If we dene recovery as recouping all the previous losses, stocks (as measured by the S&P 500 Index) had recovered by August 2020. Mid cap and small cap stocks took a little longer but passed their pre-pandemic highs in November 2020. If we dene recovery using earnings, we recovered in the fourth quarter when earnings were up from the prior year. If we use a little tougher denition and dene recovery as being back to where we thought we would be, we are on the verge of recovery now. Earnings expectations for 2021 for the S&P 500 Index are only 3% below where they were at the end of 2019. Estimates for small cap stocks are only 2% below “old” expectations and midcap stock earnings expectations are higher than eighteen months ago.

On the other hand, only 44% of the companies in the Russell 1000 Index have analysts’ estimates for 2021 that exceed where they were before the pandemic. is factor, combined with additional easing of production constraints and a further reduction in unemployment suggests that the recovery has further to run.

As a way of proving that moves within a bull market can take many forms, this quarter’s internals were markedly di erent from the last few quarters. Indeed, unlike the last several quarters where a recovery in economic indicators and increases in earnings expectations led to the outperformance of cyclical, small-cap, and value stocks, this quarter returned to the theme of the last few years which was driven by growth stocks. Beginning with the Fed’s assurances that it was not worried about what it sees as a transitory uptick in in ation, yields on bonds, particularly at the long-end, began to retrace much of the increase we have seen over the last year. is rekindled the move in large-cap growth stocks.

For the quarter, large-cap beat mid-cap which beat small-cap. Growth beat value, except in small-cap where meme-stocks like AMC Entertainment and GameStop lifted the Russell 2000 Value Index. ese moves allowed large-cap growth to close the gap with large-cap value, but value stocks further down the market cap spectrum remain well ahead of small- and mid-cap growth stocks. Within industry sectors, Energy and Real Estate showed strength across market cap segments while Utilities and Consumer Staples were generally laggards. e other sectors were more of a mixed bag depending on style and market cap.

As we look ahead, it is interesting to note that stocks actually look cheaper now than they did at the beginning of the year. While the S&P 500 Index is up 14% year to date, forward earnings estimates are up 21%. Smaller companies have seen an even larger improvement in earnings prospects with forward expectations for the S&P Small Cap 600 Index up 31% and estimates for the S&P Mid Cap 400 Index rising 25% so far this year. is is not to say that valuations have become compelling. Usually, however, when the market makes a big move, stocks become a lot more expensive and this time they have not.

The other factor supporting valuations has been the fall in interest rates. At the beginning of the year, the 10-year US Treasury bond yielded 0.92%, but it moved higher in the rst quarter and ended at 1.74%. But that was about the peak as rates declined throughout the quarter and really fell o late in the quarter to end at 1.45%. Maybe just as importantly, the concern about rising rates, and the potential impact on valuations, has diminished.

So, with the business outlook improving, valuations no worse than they were despite strong gains, and lower rates, what could go wrong? We do not think any new risks have emerged over the last few months and some may have diminished. Investors should continue to watch developments with the COVID pandemic. e emergence of the Delta variant is causing problems in some countries and slowing reopening plans in others. If it worsens, we could see some impact at speci c companies and potentially the market. We will also be watching for signs that the recent increase in in ation is truly transitory. We also want to see the improvement in the employment number. If the relatively muted level of improvement over the last few months is really a matter of incentives, employment gains should pick up. If not, there may be a longer-term skills mismatch that could restrain the recovery. Finally, the change in the direction of interest rates has driven the consensus toward thinking they will fall further. While this could happen, the unanimity of opinion makes us a little nervous.

Even with the market at record highs, we are nding interesting new investments. Healthy capital markets are a prerequisite for some of the types of corporate restructuring activity we seek to invest in. When companies spin o a business, they often allocate some debt to the new company. Banks might be reluctant to allow this in challenging credit markets, but green-light it readily under conditions like we see today.

Six of the Fund’s twelve new investments in the quarter were companies in some stage of a spin-o transaction.

Two of these completed a spinout from a larger company and four should complete their spins over the next year.

We are looking at these situations earlier than we have in the past. Over the years, we have concluded that there are really two trades to be made in the spin-o process. e rst happens before the spin and the second happens after the spin.

One of the reasons for spin-o s is usually to unlock the value that may be hidden because the company being divested is part of a larger, more complicated enterprise. In essence, the sum of the parts may be greater than the whole. In our experience, sum-of the-parts investment theses work best (and sometimes only) when there is a liquidation event. A spin-o is such an event. By investing before the spin-o takes place, we hope to capture the return that accretes as the value of the whole approaches that of the sum-of-the-parts.

The second trade historically works because the stock in the newly independent company is underappreciated by investors at the beginning of its life as a public company. At the very beginning, the stock might be under pressure because of index selling or because the holder does not want to deal with the new position because it may be outside their typical market cap range. Over the longer-term, these companies often bene t from being able to reinvest in their business, from having a management team that is directly incented on the results of the business, or by having a public company currency with which to make acquisitions. e track record of spino companies is outstanding. A lot of people do not realize that companies such as Chipotle Mexican Grill (from McDonald’s), Expedia (Microsoft), Coach (now Tapestry, from Sara Lee), and Moody’s (Dun &and Bradstreet) started their public life as carve-outs and spinoffs.

We are excited about these recent investments and also about the pipeline of additional spin-o opportunities that continues to develop.

Portfolio Review

A four-quarter winning streak came to an end as the Fund slightly lagged its benchmark in the second quarter after four quarters of better than index performance. It was not by much and we are back to work to start a new streak. Because the di erence from the benchmark was not that great, neither Sector Allocation nor Stock Selection detracted much, but they both detracted a little. Within those two factors there were some meaningful moving parts. For example, while overall Sector Allocation accounted for most of the negative variance from benchmark performance, the Fund’s overweight in Energy added signi cantly. is was o set by small negatives (a few basis points) in a bunch of other areas. In Stock Selection, we saw positive relative performance in Industrials and Consumer Discretionary offset by smaller negatives in Information Technology, Energy, and Health Care.

  • The overall Industrials sector did not perform as well as the Russell 2500 Value Index benchmark, but the Fund’s holdings performed better than the sector and better than the overall Index. Covanta, which bene tted from solid earnings, better performance under new management, and some talk that it was looking at strategic alternatives, led the way. It was not the only story as the Fund had four other stocks posting double-digit gains in the quarter.
  • The Fund’s returns in the Consumer Discretionary sector were more concentrated as Kontoor Brands (discussed below) and Aaron’s accounted for most of the Fund’s gains in the sector. As with the Industrials sector, the Fund also bene tted from a lack of problems as the worst performer was only down 5.5%.
  • Two old and one new company led to disappointing relative performance in the Technology sector. e new company was Cognyte and it is discussed later in this report. e long-time holdings were WEX and CDK Global. At WEX, the company reported disappointing rst quarter results and guidance despite rising fuel prices. At CDK, rst quarter results were good, but the outlook was lowered slightly as company revenues continue to face some pandemic-related headwinds.
  • e Fund’s lagging relative performance in the Energy sector was mostly a function of not keeping up. e Energy sector’s 23% gain was the best by any sector, by far. Two of the fund’s three biggest contributors (Oasis and Diamondback, discussed later in this report) were in the Energy sector, but minimal gains in Chesapeake and Texas Paci c Land and small losses in Delek and Diamond S Shipping held back performance.
  • Last quarter, we noted that the Fund only had two Health Care stocks (Ensign and LabCorp). is quarter, we added three more as spino -related activity picked up. us far, these have not contributed to returns as is often the case early in an investment. In addition, Ensign declined slightly in the quarter despite reporting very strong results. It may be facing some headwinds in government reimbursement, but that has typically created excellent acquisition opportunities.

Let’s Talk Stocks

The top three contributors in the quarter were:

Oasis Petroleum (OAS, Financial) (OAS - $100.55 – NASDAQ) is a Williston Basin-centric exploration and production companywith headquarters in Houston, TX. It has really hit the ground running after it emerged from bankruptcy in late 2020. e rise in crude oil prices from roughly $60 to almost $75 during the quarter helped as demand increased as economies globally unlocked from COVID restrictions. Also, Oasis Petroleum announced two separate transactions in the quarter: 1) the acquisition of more acreage in the Williston to improve its scale in the basin and drive more operating e ciencies; and 2) the sale of its acreage in the Permian basin which were unlikely to gain the needed scale. e company also sold down its interest in Oasis Midstream Partners (ticker OMP) in a transaction late in the quarter.

Diamondback Energy (FANG, Financial) (FANG - $93.89 - NASDAQ) is an independent oil and gas exploration and productioncompany with a large footprint in the Permian Basin. e company bene tted from higher oil prices as WTI ran from less than $60 to almost $75 during the quarter due to improved demand fundamentals. In addition, Diamondback Energy has acquired two companies this year in the Permian basin to improve its scale and generate better operating e ciencies and sold its properties in the Williston basin to shore up its balance sheet after the acquisitions.

Kontoor Brands (KTB, Financial) (KTB - $56.41 – NYSE) is the #2 player in the global jeans market behind Levi Strauss & Co.Kontoor’s brands primarily are Lee and Wrangler. Shares continued to rally in the second quarter as the company reported a strong rst quarter and raised its earnings guidance. It saw particular strength from online sales and an added short-term boost from some product shipments being pulled forward due to a software implementation. e shift to casual wear during the pandemic continues to bene t Kontoor, and Kontoor continues to expand its gross margin due to product mix, restructuring e orts, and a competitive environment that has seen little promotional activity.

The three largest detractors in the quarter were:

Air Lease Corporation (AL, Financial) (AL - $41.74 – NYSE) is one of the largest lessors of commercial aircraft in the world.Despite substantial nancial challenges within its airline customer base, Air Lease has maintained decent performance and good collection rates during the pandemic owning to the desirable pro le of its owned eet. Even so, the company had to lower earnings expectations during the second quarter. Some international customers are not bouncing back as quickly as previously expected. Furthermore, both Airbus and Boeing continue to struggle to deliver planes on schedule. is impedes Air Lease’s eet growth. Nevertheless, the company has built ample liquidity and is well-positioned to help nance the rebound in the industry.

Equitable Holdings (EQH, Financial) (EQH - $30.45 – NYSE) is a leading provider of life insurance, annuities, and retirementplans. rough its majority ownership in AllianceBernstein (AB - $xx – NYSE) it also has a sizable presence in the asset management industry. Despite reporting strong rst quarter earnings and closing the sale of a portion of an old variable annuity block, shares underperformed in the quarter. We think that this was mostly due to the fall in interest rates in the second half of the quarter. Over time, lower rates hurt the earnings of life insurers as they reduce reinvestment rates in the companies’ investment portfolios. While EQH is arguably less sensitive to this impact, it shows up in the stocks well before it shows up in earnings.

Cognyte Software (CGNT, Financial) (CGNT - $24.50 – NASDAQ) is a leading provider of security analytics software used bygovernments and corporations to manage information and detect threats. It recently became a standalone public company after it was spun out of Verint Systems in February. During the quarter, it reported solid earnings, although it had previously preannounced these numbers. Forward guidance on revenues was in line with expectations, but EPS was a little light of prior consensus. Given that the company and the analysts are still in the process of getting used to each other, we are not terribly concerned about this, but we will be monitoring progress toward improving profitability closely.

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 con dence and trust.

July 13, 2021

This summary represents the views of the portfolio managers as of 6/30/2021. 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.

Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure