To Our Shareholders,
For the quarter ended September 30, 2022, the Keeley Small-Mid Cap Value Fund’s net asset value (“NAV”) per Class A share declined 5.2% compared with a 4.5% fall in the Russell 2500 Value Index. For the year-to-date, the Fund has declined 23.0%, a little more than the 20.4% fall in the benchmark.
Commentary
After a very strong start, the market rolled over in August and fell further in September to end down for the quarter. At the end of the quarter, the market was testing the June lows. During the quarter, stocks declined less than bonds, small caps outperformed large caps, stocks of unprofitable companies did better than companies that make money, and non-dividend-payers outperformed dividend payers. Within the fixed income markets, high yield bonds outperformed Treasuries. In all these cases, riskier assets outperformed less risky assets.
According to the Federal Reserve Board’s Summary of Economic Projections the governors expect the Fed Funds rate to end between 4.25% and 4.50% this year and 4.50% and 4.75% next year. While there are a lot of paths to get there, the Fed has been aggressive in boosting rates in 75bps increments thus far. If they stay on this path, we should expect a couple more hikes this year of similar size and maybe a little more next year. The goal of this rate hiking program is to slow demand in order to reduce inflation and prevent inflationary expectations from becoming entrenched.
Unfortunately, many of the current drivers of inflation may not be responsive to monetary policy unless rates move high enough to cause a recession. After all, higher rates don’t end the war in Ukraine which might increase the supply of Russian oil and gas. They also do not remove the bottlenecks to the export of grain from Russia and Ukraine which would reduce food inflation. On the positive side, much of the rate of price increase has been driven by these and other transient factors. Even if those factors do not reverse, their impact will eventually work its way through supply chains and later be anniversaried. This should begin to happen early next year. In addition, many commodity prices have begun to retreat. Crude oil was off more than 20% in the third quarter and will be down on a year-over-year basis by the end of January if prices stay at this level. Metals and some agricultural commodities also declined in the third quarter. Finally, job openings have trended lower over the past several months suggesting labor market tightness may be easing. With signs pointing to a slowdown in the economy, it seems increasingly possible to us that the Fed may have to pause its rate increase campaign and assess the impact of increases thus far on the economy and inflation sometime in the first half of next year.
We think that the conditions as they stand today, however, create the potential for better outcomes than we have seen in the past. First, unemployment is very low and job openings are very high. This might mean that employees furloughed from one position can find new jobs quickly. Second, there are few obvious signs of excesses that need to be unwound, unlike during the popping of the Housing Bubble in 2008 or the Internet Bubble in 2000. This leaves the financial system in better condition to support the economy. In addition, household liquidity is still relatively strong.
Through the first nine months, the S&P 500 declined nearly 25%. With forward earnings estimates up slightly, the index’s P/E ratio contracted from 21.5x at year-end to 15.2x on September 30. This puts it below the 16.2x average since 1999. While this is not far from the lows in September 2002 (14.7x), it is well above the lows in 2009 (10.7x).
We think conditions look more like the early 2000 bear market, rather than the 2008 financial crisis . At this point, much of the valuation contraction has already occurred. Earnings expectations likely have to come down, but they already have in many sectors. Indeed, if not for commodity-driven upward revisions in Energy sector earnings, estimates for the S&P 500 would be about 5% lower than at the beginning of the year.
More importantly to the small- and mid-cap strategies we manage is that valuations for small caps and mid caps relative to large caps are unusually favorable. e forward P/E ratio for the S&P Small Cap index was 10.4x at quarter end making the relative multiple (S&P Small Cap/S&P 500) only 0.68. This is the lowest it has been since March 2001! Small caps outperformed for years after that time.
We believe the outlook for positive returns in stocks is good. While the economy will likely be in worse shape, we think that the outlook for inflation will be better in six months.
Portfolio Results
The Fund lagged its benchmark, the Russell 2500 Value index, slightly during the quarter. When we disaggregate relative performance into its components, Sector Allocation and Stock Selection, we nd that the Allocation e ect was positive while the Selection e ect was negative. e majority of the positive Allocation e ect came from the Fund’s overweight stance in the Energy market with an underweighting in the Real Estate sector also helping a little. Within Stock Selection, more than all of the relative performance lag was accounted for by the Technology and Health Care sectors. e Fund’s holdings in the Industrials and Consumer Staples sectors also declined more than those in the index. e Selection impact was meaningfully positive in the Energy and Real Estate sectors and slightly positive in Consumer Discretionary and Communication Services.
- After a good showing last quarter, the Fund’s Technology holdings detracted this quarter. Double-digit declines in TD Synnex, WEX, Vontier, and Verint Systems hurt performance. Interestingly, the first three companies reported good results and raised or reaffirmed guidance in the quarter.
- The Fund’s underperformance in Health Care was due in part to what is owned and in part to what it did not own. It did not own biotechnology stocks which were the best performing sub-sector in Health Care. There is not usually much restructuring in that industry. More important was the disappointing performance in Bausch Health, Organon, and ZimVie. Bausch fell as it received some adverse rulings in a patent trial. The other two were among the Fund’s biggest detractors and are covered in the Let’s Talk Stocks section of this report.
- Interestingly, Industrials was the second best-performing sector within the benchmark in the third quarter. The Fund’s holdings declined a little more than the index. While the resuscitated takeover of Nielsen was a bright spot for the Fund, performance was hurt by the performance of recent spin-offs ESAB and GXO. So far, the companies are performing well, but investors worry that both companies’ large operations in Europe may drag down results in the future.
- Consumer Staples is a relatively small sector and the Fund holds only four stocks in it. Unfortunately, one of these, Spectrum Brands, saw a steep drop in its share price during the quarter after a divestiture ran into a regulatory snag. As it was the Fund’s biggest detractor, Spectrum is discussed further in the next section of this update.
- Energy was the best-performing sector within the benchmark and was the only one in positive territory in the third quarter. The Fund’s holdings performed even better and were up nearly 30%. All of the Fund’s top three contributors came from the Energy sector and are discussed in the Let’s Talk Stocks section of this report. Performance was led by International Seaways, which was the Fund’s biggest contributor for the second quarter in a row.
- Real Estate was the worst performing sector within the Russell 2500 Value index. Rising interest rates and the view by some investors that REITs are just a bond proxy seems to have overwhelmed the view that real estate is an inflation hedge, at least in the third quarter. While six of the seven stocks were down in the quarter, only one (Howard Hughes Corporation) declined more than the overall sector in the index.
- This year has been a difficult one for Consumer Discretionary stocks and the sector continued to lag in the third quarter. The Fund’s holdings saw a wide dispersion of returns. Rebounds in Bath & Body Works and Victoria’s Secret were enough to offset drops in Aaron’s and PVH. The former fell on concerns about the health of the lower income consumer while the latter fell on worries about the European consumer.
- Communication Services was the second worst sector in the index as it is where you find media and internet companies in addition to traditional communications companies. The Fund holds only two stocks in this small sector and one of them, Nexstar Media, rose in the quarter leading to outperformance for the Fund in this sector.
During the quarter, we sold five positions out of the Fund.
Let’s Talk Stocks
The top three contributors in the quarter were:
International Seaways (INSW, Financial) (INSW - $35.13 – NYSE) is a shipping company focused on crude and product tankersworldwide. The company reported its first profitable quarter since the third quarter of 2020 driven by a recovery in shipping rates from the negative impacts from the pandemic that reduced global oil demand. The current geopolitical backdrop along with the continued conflict between Russia and Ukraine likely provide tailwinds to crude shipping rates globally. In early September, takeover speculation pushed the stock higher when large shareholder Famatown Finance Limited (a company indirectly controlled by the trusts of shipping magnate John Fredriksen) issued a press release stating that Famatown and its representatives presented to the management team of International Seaways and requested the addition of two representatives to the Board of Directors.
Chord Energy Corporation (CHRD, Financial) (CHRD - $136.77 – NASDAQ) is an exploration and production company withacreage located in the Williston Basin in North Dakota. The newly formed company is a merger of Oasis Petroleum and Whiting Petroleum. It reported a strong inaugural quarter and a favorable return of free cash flow framework for shareholders. The company will return 75% of free cash flow if its leverage ratio remains below 0.5x and will return 50% of free cash flow if leverage remains below 1.0x. The company expects to return free cash flow to shareholders in the form of base and variable dividends and share repurchases.
TechnipFMC plc (FTI, Financial) (FTI - $8.46 — NYSE) provides equipment used in both offshore and onshore oil & gasdevelopment. Several pieces of good news drove the shares higher in the quarter despite weakness in the price of crude oil. Most importantly, the company reported sharp increases in order activity in both its Subsea and Surface segments which serve offshore and onshore applications, respectively. Technip FMC also sold down its remaining stake in Technip Energies, its legacy engineering and construction company that was partially spun off in 2021. This improved its balance sheet. Finally, the company announced a new $400 million share repurchase authorization along with second quarter results.
The three largest detractors in the quarter were:
Spectrum Brands Holdings (SPB, Financial) (SPB - $39.03 – NYSE) is a diversified manufacturer of consumer products operating in four segments including Home & Garden, Global Pet Care, Home & Personal Care, and Hardware & Home Improvement. It sells leading brands such as Cutter bug spray, George Foreman grills, and KwikSet locks. The stock fell sharply after the US Department of Justice sued the company to stop the sale of its Hardware & Home Improvement business to ASSA ABLOY on antitrust grounds. Both Spectrum Brands and ASSA ABLOY have stated that they are committed to closing the deal and will ght this lawsuit in court. A completed deal would substantially reduce debt at Spectrum and likely lead to significant return of capital to shareholders. Should the companies be unsuccessful in litigation, Spectrum would receive a $350 million breakup fee and would likely try to find another buyer.
Organon & Co. (OGN, Financial) (OGN - $23.40 - NYSE) was spun-off by drugmaker Merck & Co. (MRK) as an independentcompany in 2021. While the company makes drugs focused on a range of areas, it has a special focus on producing drugs devoted to women's health, including contraceptives Nexplanon and NuvaRing. During the third quarter, Organon reported solid and largely uneventful earnings. Its shares were pressured in the quarter by investor fears about impact rising interest rates (floating-rate debt represents about 40% of Organon's debt) and the strong dollar (about 75% of the company's sales come from outside the US) on earnings.
ZimVie Inc. (ZIMV, Financial) (ZIMV - $9.87 – NASDAQ) develops, manufactures, and markets medical devices and surgicalinstruments. It was spun-off by Zimmer Biomet (ZBH) in February 2022. The company operates in two markets: spinal surgery solutions and dental implants and related biomaterials. During the third quarter of 2022, ZimVie reported earnings in line with expectations but reduced forward guidance due to foreign currency concerns -- overseas sales are 25% of total revenues -- and due to macroeconomic issues in Europe. The lower guidance pressured shares, and the stocks of medical technology firms did not perform well in the third quarter in general. In addition, the stock may be suffering a little from a lack of Wall Street interest as very few Wall Street analysts have begun following ZimVie. While management suggested on its most recent earnings conference call that its current earnings guidance is conservative, we think ZimVie must provide investors more information about its product pipeline in order to generate more investor enthusiasm.
This summary represents the views of the portfolio managers as of 9/30/2022. 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.
