To Our Shareholders,
For the quarter ended March 31, 2024, the Keeley Small Cap Dividend Value Fund's net asset value (“NAV”) per Class A share gained 4.9% compared with rise of 2.9% for the Russell 2000 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 performed very well in the first quarter. The Keeley Small Cap Dividend Value Fund rose 4.9% in thefirst quarter compared with the 2.9% gain in the Russell 2000 Value index. It was an interesting quarter in that the Fund produced most of its outperformance in March, which was the strongest month of the quarter for the market and a month in which small caps and value stocks performed best.
All the Fund's outperformance came from Stock Selection. Readers of these letters know that we disaggregateperformance into three factors: Dividend vs. non-dividend, Sector Allocation, and Stock Selection. In the first quarter, our focus on dividend payers was a headwind, Sector Allocation was neutral, and Stock Selection drove outperformance.
- We estimate dividend-payers within the Russell 2000 Value index lagged the overall index by about one hundred basis points. We are encouraged that we were able to overcome this slight headwind.
- Sector Allocation (do the sectors the Fund is overweight/underweight outperform/underperform?) had minimal impact on relative performance in the quarter. The Fund is relatively neutral to the benchmark from a sector standpoint with the largest overweight less than three percentage points in the Consumer Staples sector. The largest underweight is similarly sized in the Consumer Discretionary sector.
- Consumer Staples – The Consumer Staples sector was one of five that declined in the quarter. The Fund's positions, however, produced strong gains. In fact, this sector was the strongest of the eleven in the Fund. It is small, with only three stocks, but they all gained more than 10%. They were led by the shares of recent spin-off WK Kellogg. It was one of the Fund's biggest contributors and we talk more about it in the “Let's Talk Stocks” section of this letter.
- Health Care – The Health Care sector is a mid-sized sector within the Russell 2000 Value index andperformed better than the overall index in the first quarter. The Fund's holdings lagged the sector partly because of what we did not own and partly because of what we did own. We did not own Biotechnology, which performed very well. None of those companies pay dividends. The other part of the shortfall was weakness in the shares of Embecta. It was one of the Fund's biggest detractors and will be discussed later.
- Consumer Discretionary – This is another mid-sized sector that outperformed the overall index in theFund's holdings did not keep pace. Mid-teens declines in the shares of Standard Motor Products and Jack in the Box accounted for most of the underperformance. Standard Motor Parts reported weak fourth quarter results in part due to order timing. Jack in the Box's results were mostly okay, but same-store sales were a little weaker than expected.
During the quarter, we initiated positions in three new stocks and completed the sale of two holdings.
Let's Talk Stocks
The top three contributors in the quarter were:
Primoris Services (PRIM, Financial) (PRIM - $42.57 – NYSE), which is a diversified engineering and construction companyspecializing in pipelines, utility-scale transmission and distribution systems, telecom, and heavy civil projects, delivered solid financial results in the first quarter of 2024. The company reported a 14% increase in revenues, driven by continued strong revenue growth in its Energy segment which is primarily fueled by renewables. The company expects 2024 to be another strong year of growth as backlog increased 20% to a record for the third consecutive year. Renewables have been an important part of this growth and backlog is up 85%. Primoris is well-positioned to achieve its objectives and capitalize on the strong secular growth trends in renewables, particularly utility-scale solar.
WK Kellogg (KLG, Financial) (KLG - $18.80 – NYSE) is the second-largest ready-to-eat cereal business in North America. The firmspun off last year from Kellogg Company, which then changed its name to Kellanova and is largely a snack business. W.K. Kellogg owns iconic cereal brands such as Frosted Flakes, Froot Loops, Special K, Raisin Bran and Rice Krispies, and the firm has an opportunity over the next several years to meaningfully boost margins as it improves its operations. In the first quarter, W.K. Kellogg shares rallied nicely after the company reported solid earnings, with results broadly ahead of expectations. The company also reported its highest gross margin in the last twelve quarters as it benefited from improved supply chain execution, pricing and product mix, and greater productivity.
TechnipFMC plc (FTI, Financial) (FTI - $25.11 – NYSE) TechnipFMC is a provider of equipment used in both offshore andonshore oil & gas development. With the fourth quarter results, the company increased its expectations for offshore equipment orders in its Subsea segment based on engineering inquiries the company is already working on. A new technology for separating CO2 from hydrocarbons is a major factor in this increased outlook. Management also increased its margin expectations for its Subsea segment to a level that was higher than prior investor expectations and higher than where it finished 2023.
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 (CRE) loan portfolio. This has been a hot button issue for investors since New York Community Bank (NYCB) announced measures to increase its loan loss reserves because of troubles in its CRE book. 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 di erent than in New York City.
Pacific Premier Bancorp (PPBI, Financial) (PPBI - $24.00 – NASDAQ), headquartered in Irvine, CA, provides banking services tocommercial customers on the West Coast. Like Columbia, it has a relatively large commercial real estate loan book and its stock suffered from the concerns created by NYCB. The strength in bank stocks in the fourth quarter also probably contributed to the first quarter's weakness as shares gave back some gains. With ample capital, slow loan growth over the last few years, a relatively high loan loss reserve, and a good record of managing credit, we think Pacific Premier is well positioned.
Embecta Corporation (EMBC, Financial) (EMBC - $13.27 — NASDAQ) is a diabetes equipment business that spun off from BectonDickinson in early 2022 that manufactures needles for insulin injections. The company also has been developing an insulin patch pump that is being reviewed by the FDA. Embecta shares were weak in the first quarter after the firm topped expectations in its fiscal first-quarter earnings release but raised full-year earnings guidance by less than the amount of the first quarter outperformance. In addition, the continued growth in the number of prescriptions issued for weight-loss drugs like Ozempic and Wegovy constrained investor sentiment toward companies like Embecta that are tied to growth in the number of patients with diabetes. Finally, some investors have expressed concerns about Embecta's decision to pursue growth in the form of a patch pump and the capital that the firm would need to devote to commercialize such a product.
Conclusion
In conclusion, thank you for investing along with us in the KEELEY Small 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.
