To Our Shareholders,
For the quarter ended December 31, 2023, the Keeley Mid Cap Dividend Value Fund's net asset value (“NAV”) per Class A share rose 12.3%, a touch better than the 12.1% gain in its benchmark the Russell Mid Cap Value Index. For the full year, the Fund produced a total return of 12.4%, slightly behind the benchmark's 12.7%.
Commentary
After a difficult 2022 and a choppy first nine months, stocks ended 2023 on a strong note. Growing investor confidence that the Fed is done raising rates for this cycle drove prices of almost all assets higher. Falling rates lifted the bond market, as measured by the Bloomberg Aggregate, to its best quarterly performance since the third quarter of 1982! Its 6.2% return, however, paled in comparison to the double-digit gains produced by the equity market.
Stock markets experienced broad-based strength. Fourthquarter equity returns ranged from good to outstanding. On the good end were the 5% gains in international stocks, while US stocks appreciated more sharply with the S&P 500 up 11.7%. Small caps performed even better with the Russell 2000 up 14.0%. Style favored growth for large and mid-caps, but value for small caps.
Interest sensitive sectors performed well. Ten of the eleven sectors gainedground in the quarter with only Energy in the red. Interestingly, Real Estate and Financials were two of the better performing sectors across market cap ranges. Surprisingly, Utilities lagged the strong move in equities despite the fall in longer-term interest rates. The relative ranking of other sectors was fairly size/style specific. For example, the Magnificent Seven (Alphabet, Amazon, Apple, Microsoft, Meta, Nvidia, and Tesla) drove the technology sector to lead large cap performance, but Technology lagged in the Russell 2000 Value index.
We were particularly encouraged by the outperformance of small and mid-caps. As small- and midcapspecialists, we were heartened to see that small cap stocks outperformed large and mid-caps in the core and value styles and mid-caps outperformed large caps in core, value. and growth. The single best performing size/style in the quarter was the Russell 2000 Value which rose 15.3%. This was a substantial change from the first three quarters of the year when that index was down 0.5% compared with the 13% gain in the S&P 500.
Mid-caps remain attractive even after a quarter of outperformance. We were optimistic that a turn in relativeperformance was coming, and this may be the start of it. Even with the outperformance this quarter, mid-caps remain near record low valuations relative to large caps. At year-end, the forward P/E of the Russell MidCap index stood at 17.1x. This is 84% of the P/E of the Russell Top 200 index. The average since 1999 has been 103% and the relative multiple has been at this wide a discount only about 5% of the time. Value also looks inexpensive relative to growth with the Russell MidCap Value index trading at 15.0x, 57% of the P/E of the Russell MidCap Growth index vs. a more typical 69%.
A levelling-off or a decline in rates should be good for dividend payers. The strong fourth quarter relativeperformance of the Real Estate and Financial sectors may presage further outperformance for these sectors if the Fed is done raising rates and begins to pull back on some of the tightening of monetary conditions. Utilities might also participate as they have historically done. ese sectors all have high propensities to pay dividends and are much larger weights in the value benchmarks.
As we look ahead, we are encouraged by the opportunities in our sector of the stock market. While large cap stocks trade at valuations well in excess of past averages, small and midcap stocks are much closer to average and are at historically wide discounts to the overall market. As always, we remain focused on nding stocks of companies with better than average businesses, where the future looks better than the recent past, and which trade at discounts to our assessment of intrinsic value.
Portfolio Results
Stock Selection drove the modest outperformance in the quarter. When we evaluate performance, we look atthree factors: Dividend vs. non-dividend, Sector Allocation, and Stock Selection. In the fourth quarter, the Fund's focus on dividend-payers detracted from performance and Sector Allocation was a slight negative, but Stock Selection was good enough to drive outperformance.
- We estimate dividend-payers within the Russell Midcap Value index lagged the overall index by 150-200bps, although this factor was woven into the other two factors.
- Sector Allocation (do the sectors the Fund is overweight/underweight outperform/underperform?) was a small detractor from relative performance. Slight underweights in the strong performing Financials and Real Estate sectors offset a positive contribution from a slight overweight in Consumer Discretionary.
- Stock Selection (do the stocks held by the Fund outperform the sectors in which they reside?) contributed positively to relative performance. The Fund's holdings in Financials, Consumer Discretionary, and Health Care outperformed those sectors, while the Fund lagged in the Energy sector.
The details for those who want to dig deeper.
- Financials – Financials are the second largest sector, and they outperformed the overall index. TheFund's tilt towards Bank stocks (as opposed to insurance or asset management) paid off this quarter as each of the Fund's seven bank stocks appreciated more than 25% in the quarter.
- Consumer Discretionary – Consumer Discretionary is a mid-sized sector within the Russell MidcapValue index and performed better than the overall market in the quarter. The Fund's holdings exceeded the sector. Gains were broad-based with seven out of eleven positions outperforming and only two declining. PVH (the Fund's biggest contributor) and Victoria's Secret led the Fund's holdings with gains of nearly 60%. e sector also included Hasbro, the Fund's largest detractor. Both it and PVH are discussed further in the “Let's Talk Stocks” section of this report.
- Health Care – Health Care is another mid-sized sector, but it was the third worst performing of theeleven sectors ahead of only the Energy and Consumer Staples sectors. While the Fund had both winners and losers, strong gains by Agilent, Universal Health Services, and Ensign led to outperformance in the sector.
- Energy – Energy was the worst performing of the eleven sectors, driven largely by slumping commodity e Fund's holdings performed worse than the sector overall with only one of its holdings managing to end up in the black. The other four declined with the worst performance coming from ChampionX, which ended the quarter as one of the Fund's largest detractors and is discussed later in this update.
During the quarter, the Fund bought one new position, received another new position as a spinoff, and completed the sale of one holding.
Let's Talk Stocks
The top three contributors in the quarter were:
PVH Corp. (PVH, Financial) (PVH - $122.12 – NYSE) is an apparel firm that owns two iconic brands, Tommy Hilfiger and CalvinKlein. PVH has been in the middle of CEO Stefan Larsson's “PVH+” turnaround program, which targets a 15% operating margin by 2025. The multi-year turnaround largely has been going smoothly, with PVH continuing to move toward its goal of a 25% reduction in inventory by the end of 2024. In addition, in November, PVH reported favorable early results for the holiday season, with November trends including Black Friday exceeding management's plan in both North America and Europe. PVH also made headway with its operating margin due to improvements in the profitability of its North America business.
NRG Energy (NRG, Financial) (NRG - $51.70 - 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. Two positive developments in the quarter drove strong stock price appreciation in the quarter. First, the company surpassed earnings expectations in the quarter, with EBITDA more than doubling due to robust operational performance and sustained, solid contributions from recently-acquired Vivint. This marks the second consecutive quarter of enhanced performance from Vivint, alleviating investor concerns that persisted since the acquisition closed in early March. In response to this strong performance, management raised its full-year guidance. Second, towards the end of November, the company announced a cooperation agreement with activist investor Elliott Investment Management, leading to a change in CEO, a Board of Directors refresh, and a comprehensive review of the overall cost structure. Lastly, NRG anticipates completing the remaining $950 million of share repurchases once the sale of its 44% interest in South Texas Project Generating Station (STP) to Constellation Energy Corporation (CEG - $xx - NASDAQ) for $1.75 billion closes.
Gen Digital (GEN, Financial) (GEN - $22.82 –NASDAQ), formerly Norton Lifelock, is the leading provider of online securitysoftware (anti-virus, VPN, etc.) for personal use. While operating results have generally been in line with expectations, the bottom line has been pressured by the impact of rising interest rates on the debt Gen took on to acquire Avast in 2022. In addition, subscriber counts stagnated after the close of the acquisition. In the September quarter, however, Gen reported much better subscriber trends and the fall in rates should eventually reverse the slumping forward EPS estimates. The stock responded well to the improvements but remains cheap at only ten times fiscal 2025 (March) EPS.
The three largest detractors in the quarter were:
Hasbro, Inc. (HAS, Financial) (HAS - $51.06— NASDAQ) is a leading international toy and entertainment company that has iconic brands such as Nerf, Play-Doh, and Monopoly along with a portfolio of licensed brands. The company reported a difficult quarter due to top line weakness that drove an EPS shortfall relative to consensus estimates. Revenues declined 10%, primarily attributed to weakness in the Consumer Products (toys) segment and challenges from the recent Hollywood writers' strike, which impacted the Entertainment segment. This downturn overshadowed robust growth in The Wizards of the Coast and Digital Gaming segment. Looking ahead, management anticipates further revenue challenges in the fourth quarter due to a softer outlook for spending on toys. Although the company aims to o set some of these headwinds through cost reductions, the impact of these efforts is not expected to materialize until 2024.
ChampionX Corporation (CHX, Financial) (CHX - $29.21 – NASDAQ) is a market leader in both chemicals used in theproduction of oil & gas and lifting systems that bring commodities to the surface for gathering in production. The company's third quarter results fell below expectations due to slower well completion activity that occurred in September and carried on into October. This caused the company to lower its outlook. Despite a decline in commodity prices, management sees growth in its chemical business in 2024 due to an increase in offshore well completions which use more chemicals than onshore wells. Onshore customers are also increasing the intensity of chemicals per well which points to improved growth.
Franco-Nevada Corporation (FNV, Financial) (FNV - $110.81 — NYSE) is a leading gold-focused royalty company. It provides financing to mine developers in return for an ongoing percentage of the production of the mine. Despite gold reaching new highs during the quarter, the company's stock faced challenges. One of its largest operators, First Quantum, became entangled in a dispute with the Panamanian Government over the operation and mining concession of the Cobre Panama copper mine, Franco-Nevada's single largest royalty stream. The unexpected nature of this issue surprised many, as it was initially believed to have been resolved in October. However, it escalated to the Panamanian Supreme Court, which ruled against First Quantum. We anticipate a resolution in 2024, and shares of Franco-Nevada are likely to remain rangebound until that happens. Nevertheless, the company has more than $1 billion in cash and no debt, and the stock is down more than the impact from Cobre Panama should justify.
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.
