To Our Shareholders,
For the quarter ended March 31, 2023, the Keeley Mid Cap Dividend Value Fund’s net asset value (“NAV”) per Class A share rose 0.9% compared to the 1.3% increase in the Russell Mid Cap 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 de ning attributes of the Fund (midcap, 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 smaller companies for some time, and that has not worked out yet. When we look at relative valuations across size (Small, Mid, Large) and style (Value, Core, Growth), midcap value looks most attractive. e Russell Midcap index trades at 86% of the Russell Top 200 compared with a long-term average of 104%. e Russell Midcap Value index trades at 60% of the valuation of the Russell Midcap Growth index compared with a long-term average of 70%. is “double discount” should close over time.
Portfolio Results
The Fund slightly lagged its benchmark in the rst quarter. e KEELEY Midcap Dividend Value Fund gained0.9% in the quarter, about 50bps behind its benchmark the Russell Midcap Value index. is broke a streak of four consecutive quarters of outperformance.
Only one of the three key drivers added to relative performance. When we disaggregate performance, we look atthree factors: Dividend vs. non-dividend, Sector Allocation, and Stock Selection. In the rst quarter, mixed Stock Selection and the underperformance of dividend payers o set a slight positive from Sector Allocation. It is worth noting that sometimes when the aggregate di erence is relatively small (as it was this quarter), it is because large moves positively and negatively o set each other. Other times it is small moves. is time it was the latter which makes analyzing performance a little less meaningful.
- We estimate dividend-payers within the Russell Midcap Value index lagged the overall index by more than 100 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 a little to relative performance. e main driver of this was the Fund’s slight underweight stance in the Financials sector. It was the worst-performing of the eleven sectors.
- Stock Selection (do the stocks held by the Fund outperform the sectors in which they reside?) drove most of the Fund’s underperformance. It did not outperform meaningfully in any sectors, although was nominally better than the benchmark in six of eleven sectors. It lagged in a meaningful way in three sectors and was nominally behind the index in two. Materials, Financials, and Health Care detracted the most, although none accounted for even 50bps of underperformance in Stock Selection.
The details for those who want to dig deeper.
- Materials – While the overall sector performed better than the market, the Fund’s holdings fell a little We attribute most of the underperformance to weakness in the shares of Ardagh Metal Packaging and RPM International, which were each down more than 10%. In both cases, the outlook provided by the company when it reported earnings fell short of expectations. In RPM’s case, demand softened and the company started taking steps to reduce inventory. For Ardagh, beverage can volumes look like they will grow more slowly than the company previously anticipated. O setting some of this weakness was a nice gain in the shares of relatively newer holding Cabot Corporation, which reported good results in an improving pricing environment.
- Financials – The Financials sector was the worst-performing sector in the index and was one of onlythree to decline during the quarter. e Fund’s holdings declined more than the sector within the index. e main reason was that the Fund held a heavier weight in banks rather than other sub-sectors within Financials. While the Fund’s bank stocks outperformed the bank stocks within the benchmark, they did not outperform other Financial sub-sectors. e steep drawdowns in bank stocks led them to be the two biggest detractors and ve of the ten largest detractors to the Fund’s relative performance. We discuss Comerica and Columbia Banking later in this report.
- Health Care – e Health Care sector was relatively at in the quarter compared to the slight gain in the overall benchmark. e Fund’s holdings turned in a mixed performance but were down in aggregate. On the positive side, Embecta bounced back after being one of the biggest detractors last quarter. Better than expected earnings drove a solid gain in the shares. On the other side of the ledger, a double-digit decline in Organon and near double digit drops in Universal Health and Encompass more than o set the positives. All three companies provided cautious 2023 guidance during the quarter.
During the quarter, the Fund added two new positions, sold one holding, and swapped one stock for another in a merger.
Let’s Talk Stocks
The top three contributors in the quarter were:
Jabil Inc. (JBL, Financial) (JBL - $88.16 – NYSE) is one of the leading contract manufacturers in the world. In addition to serving the electronics industry, it has signi cant business manufacturing medical, industrial, and automotive components. The company executed very well over the last year as it was able to meet or exceed its guidance despite disruption in supply chains. at continued again this quarter and Jabil reported results that exceeded analysts’ estimates and raised forward guidance a little. Supply chains appear to be normalizing, but the demand outlook appears a little more uncertain. Nevertheless, with its diverse customer base and its exposure to some secular growth industries for electronics (autos, health care, and renewable energy), Jabil appears well-positioned to continue to grow.
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.
Skyworks Solutions (SWKS, Financial) (SWKS - $117.98 - NASDAQ) is one of the leading suppliers of RF (radio frequency)semiconductors used in communications. In particular, its chips are key enablers of wireless communications and advances in that eld create additional content opportunities in cell phones, other endpoints, and wireless infrastructure. e stock’s gain in the quarter probably had more to do with increased optimism about a second half rebound in the market for technology products than any company-speci c developments. e company reported earnings that were in line with expectations and o ered guidance that was a little below prior consensus. at seems to have been enough for the stock of a company that leads its industry sector, has outstanding customers, a good secular growth story and trades at a single-digit multiple.
The three largest detractors in the quarter were:
Comerica Incorporated (CMA, Financial) (CMA - $43.42 - NYSE) is a commercially-focused bank headquartered in Dallas, TXwith signi cant operations in Texas, California, and Michigan. e rst quarter, and particularly March, was a tough period for community bank stocks. From the time SVB Financial (Silicon Valley Bank) announced it would try to raise capital (March 8th) until the end of the quarter, the KBW Regional Bank index fell 17%. Comerica was caught up in this and its stock was impacted more because it is also in the venture lending and deposit-taking business that was the source of much of the stress for SVB. e big di erence between the two banks is that these deposits make up only about 10% of Comerica’s deposits whereas they were the vast majority of SVB’s. With more than half of their deposits in non-interest-bearing accounts, Comerica has had one of the lowest cost of deposits in the banking industry. With more money moving to higher-yielding alternatives, Comerica’s funding costs will likely rise, but we think it will maintain a cost advantage.
Columbia Banking System (COLB, Financial) (COLB - $21.42 — NASDAQ) recently merged with Umpqua Bank to become thelargest community bank in the northwestern United States. Headquartered in Tacoma, Washington and Portland, Oregon, Columbia serves clients in Washington, Oregon, California, and Idaho. It shares fell on the same concerns as those that impacted Comerica, stability and cost of deposits. We believe Columbia is well-positioned in this environment. Like Comerica, its deposit base is one of the best among community banks in the country. In addition, because it recently completed the large Umpqua merger, its balance sheet has been “marked to market”. As such, investors should have a higher degree of con dence in the underlying values.
Chesapeake Energy (CHK, Financial) (CHK - $76.04 — NASDAQ) is a natural gas-focused exploration and production companywith acreage primarily in the Marcellus Shale in Pennsylvania and the Haynesville Basin in Texas. During the quarter, the company suffered from lower natural gas prices primarily driven by a mild winter and an operational shutdown at a local lique ed natural gas (LNG) export terminal in Louisiana due to damage from a re. e LNG customer has since restarted operations and volumes are expected to reaccelerate. Another positive is that Chesapeake sold o non-core acreage in south Texas to reallocate capital to its core operations in southwest Pennsylvania and east Texas.
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 confidence and trust.
This summary represents the views of the portfolio managers as of 3/31/2023. 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.
