To Our Shareholders,
For the quarter ended March 31, 2024, the Keeley Mid Cap Dividend Value Fund's net asset value (“NAV”) per Class A share rose 9.7%, a bit better than the 8.2% gains by its benchmark, the Russell Mid Cap Value Index.
Commentary
The fourth quarter's outstanding returns were driven by investors concluding that the Fed had finished raising rates and that cuts were right around the corner. This quarter, those expectations took a hit as the timing for the first cut was pushed out to June from March and even that looks more uncertain than it did three months ago. While the bond market suffered from this change in sentiment, the stock market continued to roll. The broad market, as measured by the S&P 500 rose 10.6% while the Russell 2000 index of small cap stocks gained 5.2%.
Other than investors enjoying gains in both periods, the first quarter had little in common with last year's fourth quarter. The domination of the market by Mega cap tech stocks returned after a fourth quarter pause. Artificial intelligence chip producer Nvidia was the best performing stock in the Russell Top 200 index of large cap stocks. e ten largest stocks in that index gained an average of 17.9% compared to the 8.4% increase in the other 190ish stocks. This contrasts with the 8.1% and 12.1% these two cohorts produced in the fourth quarter. Working further down the capitalization spectrum, the Russell Top 200 rose 10.8%, the Russell Midcap index gained 8.6%, and the Russell 2000 produced a respectable 5.2%. After mixed results in the fourth quarter, growth stocks outperformed value stocks in all three capitalization tiers.
We also saw differences in results across non-equity markets. The rise in the yield on the 10-year Treasury from 3.88% at year end to 4.20% led to a 1.3% decline in the Bloomberg US Aggregate bond index. The dollar was stronger in the quarter, compared to weakness last quarter. Commodities were also higher after faltering last quarter.
The economy in the US continues to surprise skeptics, including us. Historically an inverted yield curve and an Institute for Supply Management Purchasing Managers index reading below 50 presaged a recession. These measures crossed into the warning zone late in 2022, yet the US economy continues to grow solidly. Fourth quarter GDP clocked in at an impressive 3.4% and the Atlanta Fed's GDPNow measure predicts 2.8% for the rst quarter. The labor market is less good, but still strong with unemployment under 4% and initial unemployment claims bumping along the bottom. While in ation remains above the Fed's 2% target rate, it has cooled substantially.
- The strong first quarter performance made large cap stocks even more expensive. The Russell Top 200 ended the quarter trading at 21.9 times the next twelve months' earnings, well above the 16.3 average multiple since 1999. This is the 95th percentile of its valuation range, meaning that it has only been more expensive 5% of the time. While the Russell 2000 also trades above its long-term average, 22.8x vs. 20.5x, the relative valuation (R2000 PE/RT200 PE) of 1.04 is in the fifth percentile! While we have been talking about this relative attractiveness for some time, it has been more than twenty years since smaller company stocks were this attractive.
- While the timing of lower of interest rates has disappointed, the Fed continues to signal that it will begin to cut rates this year. Because smaller companies tend to have more variable rate debt, the benefit of lower rates should be seen more in their earnings than those of larger companies. This boost to earnings should help the stocks.
Portfolio Results
The Fund outperformed its benchmark again in the first quarter. The KEELEY Midcap Dividend Value Fund gained 9.0% in the quarter, slightly more than the 8.2% gain in the Russell Midcap Value index. This marks the third consecutive quarter of outperformance.
Stock Selection drove all the outperformance in the quarter. Three factors drive relative performance for the Fund: Dividend vs. non-dividend, Sector Allocation, and Stock Selection. In the first quarter, neither the Fund's focus on dividend-payers nor Sector Allocation had meaningful impacts on the Fund's relative performance. All the outperformance came from better than benchmark Stock Selection.
- We estimate that dividend-payers within the Russell Midcap Value index performed in line with the overall index.
- Sector Allocation (do the sectors the Fund is overweight/underweight outperform/underperform?) did not add or detract meaningfully from relative performance. Slight overweights in the strongly performing Financials and Industrials sectors o set a positive contribution from a slight underweight in the poorly performing Real Estate sector.
- Stock Selection (do the stocks held by the Fund outperform the sectors in which they reside?) contributed positively to relative performance. Selection boosted relative performance meaningfully in six sectors while only Financials was a meaningful detractor. Three of the four remaining sectors were slightly negative. The Fund's holdings in Industrials, Health Care, Communications Services, Energy, and Utilities and made the biggest positive impacts on relative performance.
The details for those who want to dig deeper.
- Industrials – Industrials is the largest sector in the Russell Midcap Value index and was the bestperformer in the first quarter. The Fund's holdings outperformed the high bar set as twelve of the thirteen stocks appreciated. Furthermore, six rose more than 20% and another four gained more than 10%. The performance was led by Allison Transmission, which was the Fund's second-biggest contributor. We discuss it further in the “Let's Talk Stocks” section of this report.
- Health Care – Health Care is a mid-sized sector and lagged the benchmark during the first quarter.Performance by the Fund's holdings exceeded that of the sector and exceeded that of the Russell Midcap Value index. While none of the Fund's Health Care holdings were among the biggest contributors, all seven were up and four were up double digits. Standing out in this sector were Encompass Health, after it reported good earnings, and Organon, which bounced back from a weak fourth quarter.
- Communications Services – The Communications Services sector is the smallest of the eleven sectors inthe index and was the worst performer in the first quarter and one of only two that declined (Real Estate was the other). The two Fund's holdings in this area performed well as both Omnicom and Nexstar Media produced double-digit gains on solid earnings reports.
- Energy – Gains in the price of oil drove good performance in the Energy sector in the first quarter. Thiswas a nice rebound from last quarter's weakness. The Fund's holdings in this sector performed even better. All six of the Fund's stocks were up double digits with the worst performance a 16% gain in the shares of Chesapeake Energy. The biggest contribution in the sector and one of the biggest for the Fund overall came from Diamondback Energy. We will discuss it more later in this report.
- Utilities – While the Utilities sector in the Russell Midcap Value index lagged slightly, it was not as badas one might fear given the rise in interest rates. Furthermore, the Fund's holdings outperformed the sector and were up double digits in the first quarter. Two stocks accounted for most of the positive relative performance: NRG Energy and Southwest Gas. Because NRG was the Fund's biggest contributor, we will discuss it later in this update. Southwest Gas performed well on solid earnings results and the progress toward the separation of its construction services business.
- Financials – Financials are the second largest sector, and they outperformed the overall index. TheFund's tilt towards Bank stocks (as opposed to insurance or capital markets) detracted from relative performance this quarter. Furthermore, the Fund's bank stocks did not perform very well due to a sharp decline in the shares of Columbia Banking. We discuss that stock further in the “Let's Talk Stocks” section of this update.
During the quarter, the Fund bought one new position and completed the sale of two holdings.
Let's Talk Stocks
The top three contributors in the quarter were:
NRG Energy (NRG, Financial) (NRG - $67.69 - NYSE) is one of the largest competitive energy retailers in the U.S. serving over 7.5million residential customers in addition to commercial, industrial, and wholesale customers. It also operates generation plants that produce more than 15 GW of electricity. The company had a strong finish to a transformational year, positioning NRG as one of the top contributors for the second consecutive quarter. NRG's quarterly results were solid, with strong EBITDA growth of 77% as the company continues to benefit from its acquisition of Vivint. is marks the third consecutive quarter of enhanced performance from Vivint, and the company sees regional expansion opportunities. NRG also continues to make progress on its cost reduction goals and has identified incremental growth opportunities, including the potential to build up to 1.5 GW of natural gas- red generation in Texas. NRG maintains its record of rewarding shareholders by increasing the dividend 8% for the fifth consecutive year, along with completing its accelerated share repurchase program.
Allison Transmission Holdings (ALSN, Financial) (ALSN - $81.16 – NYSE) is a market leader in automatic transmission solutionsfor a wide variety of commercial on-highway and off-highway vehicles. The company reported outstanding 4Q23 results that exceeded investor expectations through the strength of its on-highway business in the US. Allison also announced several new business wins in its defense segment and its international off-highway segment. The company was also aggressive in its share repurchase activity in the quarter.
Diamondback Energy (FANG, Financial) (FANG - $198.17 –NASDAQ) is one of the largest independent oil & gas exploration andproduction companies in the Permian Basin of west Texas. During the quarter, the company announced the acquisition of a large private exploration and production company, Endeavor, which significantly increases Diamondback's scale and production capability. With several independent companies being acquired recently by major energy companies (such as Pioneer Natural Resources by Exxon), Diamondback now has the scale to be an attractive acquisition target.
The three largest detractors in the quarter were:
Columbia Banking System (COLB, Financial) (COLB - $19.35 – NASDAQ) is a $50 billion super-community bank operating in thePacific Northwest. It was formed by the merger between Columbia Bank and Umpqua Bank. While the first couple of quarters after the merger were fine, fourth-quarter results were well short of expectations as the company did a poor job managing its expenses to account for rising deposit costs. It also has a significant commercial real estate loan portfolio. The latter has been a hot-button issue for investors since New York Community Bank announced measures to increase its loan loss reserves. During the quarter, management announced additional cost-cutting actions to get expenses where they should be. While it will take time to play out, both Columbia and Umpqua historically managed credit well and we think that CRE in western US markets is very different than in New York City.
Victoria's Secret & Company (VSCO, Financial) (VSCO - $19.38 — NYSE) is an intimate apparel firm and fairly recent spin-offfrom Bath & Body Works that has been progressing through a turnaround plan. In the first quarter, shares significantly underperformed after Victoria's Secret reported in-line fourth-quarter earnings but issued profit guidance that was fully 25% below where the Street had been previously. A once-promising turnaround appears to have stalled as this once-iconic brand continues to struggle to find its way. On the positive side, management is implementing another cost-cutting program and expectations are exceedingly low.
Equity LifeStyle Properties (ELS, Financial) (ELS - $64.40 – NYSE) is a real estate investment trust (REIT) that leases space tocustomers who own manufactured homes and cottages, recreational vehicles, and boats. The company also has a taxable REIT subsidiary that buys, sells, and leases factory-built homes on ELS' sites. In the first quarter, the company reported earnings that were in line with expectations but shares nonetheless lagged the market for several reasons. First, Equity LifeStyle Properties is a defensive company even relative to other REITs and the macroeconomy has shown itself to remain surprisingly robust. Related to that, the company is very interest rate-sensitive, and with rate cuts likely being pushed out, that almost certainly weighed on sentiment. Second, management issued in-line guidance at best for 2024, close to six months ago, and has not chosen to raise it since. Third, the company announced an accounting change and while the change was not material, it nonetheless weighed on the optics of the firm's earnings. Broadly, however, the fundamentals at Equity LifeStyle Properties are little changed, and the company appears to us to be in a position to outperform its guidance as the year progresses.
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.
March 31, 2024
This summary represents the views of the portfolio managers as of 3/31/2024. 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.
