Keeley Mid Cap Dividend Value Fund

Discussion of markets and holdings

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Jul 30, 2021
Summary
  • For the quarter ended June 30, 2021, the Keeley Mid Cap Dividend Value Fund’s net asset value per Class A share rose 3.94%.
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To Our Shareholders,

For the quarter ended June 30, 2021, the Keeley Mid Cap Dividend Value Fund’s net asset value (“NAV”) per Class A share rose 3.94% compared with a 5.66% % gain for the Russell Mid Cap Value Index. For the year-to-date period, the Fund has advanced 18.11% compared to a 19.45% 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 signi cant constraints that have slowed progress. We have heard of signi cant supply chain problems such as shortages of semiconductors, lumber, shipping containers and other inputs. ere 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 de ne recovery as recouping all the previous losses, stocks (as measured by the S&P 500 Index) recovered by August 2020. Mid cap and small cap stocks took a little longer to recover but passed their pre-pandemic highs in November 2020. If we de ne recovery using earnings, we recovered in the fourth quarter when earnings were up from the prior year. If we use a little tougher de nition and de ne 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 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 look cheaper now than they did at the beginning of the year. While the S&P 500 Index is up 15% year to date, forward earnings estimates are up 21%. Mid caps have seen an even larger improvement in earnings prospects with forward expectations for the S&P 400 Index are up 25%. 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 improvement in the employment numbers. 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.

Portfolio Results

The drivers of relative performance in a portfolio can be disaggregated into Sector Allocation and Stock Selection. e Fund generally sees more impact from stock selection, and this was true this quarter as well. Sector allocation had a slight impact on overall relative performance and underweights and overweights in some sectors did not have signi cant impacts either. erefore, the Fund’s lagging relative performance was driven by Stock Selection and that impact was mostly felt in four segments. e Fund saw a bene t from Stock Selection in the Utilities sector while stocks in the Financials, Consumer Discretionary, and Industrials sectors lagged their benchmarks.

  • The Utilities sector was the only sector that saw a decline in the quarter, but the Fund’s holdings there were able to generate a gain. is was broad-based as six of the Fund’s holdings appreciated in the quarter led by a strong gain in the shares of UGI Corporation.
  • The Financials sector was the biggest detractor for the Fund. Its holdings tend to be sensitive to interest rates: they rise when rates rise and fall when rates fall. e second half of the quarter swoon in bond yields pressured the share prices of the Fund’s holdings in life insurance companies (Equitable Holdings, and Reinsurance Group of America) as well as those of banks such as Synovus and Prosperity. Interestingly, this sector also contained the Fund’s biggest contributor, Discover Financial.
  • While falling rates hurt the Financials sector, they do not appear to have helped the interest-sensitive housing sector. We saw shares of homebuilder KB Home decline and it ended up as one of the Fund’s worst performers. It is discussed below. Marriott Vacations also contributed to the Consumer Discretionary sector’s disappointment despite reporting strong earnings and preannouncing strong second quarter sales toward the end of the quarter.
  • Industrials was the third worst sector in the Fund from a relative performance standpoint. Declines in BWX Technologies (discussed below) and GrafTech International (due to a secondary from its private equity owner) o set double-digit gains in new holding Acuity Brands and old holding nVent Electric.

During the quarter, the Fund added ve new positions and sold four positions, one due to a merger.

Let’s Talk Stocks

The top three contributors in the quarter were:

Discover Financial Services (DFS, Financial) (DFS - $118.29 – NYSE) is the nancial holding company that o ers the Discovercredit card, operates the on-line Discover Bank, and provides student loans. Shares responded favorably to strong rst quarter earnings results. ese were mostly driven by the company’s ability to reserve some of the enormous credit reserves it built up in 2020. us far, lenders have seen much better credit performance in this economic slowdown because of the government’s massive stimulus programs. With those scheduled to taper o in the coming quarters, Discover is well positioned to grow its loan balances while maintaining very healthy capital and reserves. Some of this is likely to come back to shareholders in the form of dividends and share buybacks.

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.

NortonLifeLock Inc. (NLOK, Financial) (NLOK - $27.22 - NASDAQ) is one of the largest providers of consumer online securitysoftware and services. Since selling its enterprise software business in 2019, the company has been rationalizing costs, streamlining its product o erings, and investing in new areas. e results of these e orts have been building for the last several quarters in strong pro tability and accelerating internal growth. ey really seemed to come together in the rst quarter results and the company was able to raise longer-term expectations as well.

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.

KB Home (KBH, Financial) (KBH - $40.72 – NYSE), one of the nation’s leading homebuilders saw its stock sell-o in the quarter asconcerns increased about the impact on demand from higher home prices and the impact of raw material and labor cost in ation on pro tability. e Company’s fundamentals tell a di erent story as KB Home reported a very strong quarter ( scal 2Q-2021) with revenue growth of 58% year-over-year, margin expansion, EPS growth that exceeded consensus estimates, net new orders up 145%, and ending backlog increasing 98%. Management commented that net new orders were the Company’s highest second-quarter level in 14 years. e medium-term outlook for home builders remains attractive supported by low mortgage rates, accelerating economic activity, and favorable demographic trends with Millennials/Gen Z entering the household formation phase. Additionally, KB Home’s valuation (P/E and EV/EBITDA) remains attractive trading towards the low-end of the historical valuation range.

BWX Technologies (BWXT, Financial) (BWXT - $58.12 – NYSE) provides nuclear components and products to the U.S. Navy andthe Canadian nuclear power markets, environmental site restoration services, and medical isotopes. e company’s stock came under pressure in the quarter due to concerns about potential changes to funding for the Navy’s shipbuilding program given the change in administration and the longer-than-expected roll-out of the moly-99 isotope initiative. From a fundamental basis, the stock remains attractive as the company is nearing an end to an elevated capex cycle that supported the growth of the Navy’s shipbuilding needs. is should lead to accelerating free-cash- ow generation that could be used for share repurchases and dividend increases. Additionally, the company has a couple of longer-term revenue opportunities with the commercialization of the medical isotope business and the potential for microreactors and fuel for use by various governmental bodies (DoD, DoE, and NASA).

Conclusion

In conclusion, thank you for your investment in the KEELEY Mid Cap Dividend Value Fund. We will continue to work hard to justify your con dence and trust.

July 13, 2021

This summary represents the views of the portfolio managers as of 6/30/21. 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