To Our Shareholders,
For the quarter ended December 31, 2022, the Keeley Mid Cap Dividend Value Fund’s net asset value (“NAV”) per Class A share rose 12.8% compared to the 10.5% increase in the Russell Mid Cap Value Index. e Fund outperformed its benchmark in all four quarters in 2022 and ended up outperforming its benchmark by 6.5 percentage points. For the full calendar year, the Fund declined 5.5% versus a decline of 12.0% for the benchmark.
Commentary
Even with a strong fourth quarter rebound most investors are glad that 2022 is over. The S&P 500 was down 18% and the Russell 2000 fell a little more than 20%. International stocks did a little better as the EAFE declined only 16% in dollar terms. Unlike previous downturns over the last couple decades, bonds did not provide a safe haven as the Bloomberg Aggregate declined 13%. Commodities fared a little better as energy-related commodities were all up, metals were mixed, and agricultural commodities were mostly higher.
Starting in March, the U.S. Federal Reserve raised the federal funds rate at seven consecutive meetings with a total increase of 4.25%. e stock market fell as interest rates are a key variable in valuing assets and higher rates mean lower values. e multiple on the S&P 500 fell 4.8 points from 21.5x at the beginning of the year to 16.7x at the end. In smaller stocks, the Russell 2000 saw its P/E contract from 23.5 to 19.1. e Russell 2000 Growth index declined 26.4% in 2022 compared with the 14.5% fall in the Russell 2000 Value.
The 400 basis points of increases and nine months of time elapsed since the beginning of the rate raising cycle seem to be starting to impact the inflation numbers. While it is hard to make much of a month or two of data, the year/year rate of core inflation slowed from 6.6% in September to 6.3% in October, and 6.0% in November. The December reading is expected to fall further to 5.7%. These numbers remain well above the Fed’s 2% target rate, but the trend looks favorable.
Global central banks have embarked on a concerted e ort to combat in ation through restrictive monetary policies. As a result, the global stock of negative yielding bonds has dwindled to zero after last month’s policy shift by the Bank of Japan. e market value of debt trading at yields below zero approached $18 trillion in late 2020 as central banks slashed rates and launched huge bond buying through massive “quantitative easing” programs in the wake of the COVID-19 pandemic. is past year marked an end to the era of easy money. e shift to monetary tightening remains a major headwind for equity markets in 2023. A rapidly slowing economy and declining in ation could force the Fed to pivot toward monetary easing sooner than expected, a potential catalyst for a rebound in global markets.
Meanwhile, the economy and markets seem well positioned to absorb a slowdown. Stimulus money granted during the pandemic bolstered the balance sheets of individuals and businesses. While much of this has burned o or been absorbed by in ation, people and the companies they work for appear to be in a healthier position. Second, many of the excesses (negative interest rates, SPACs, pro tless innovation) created in the bull market leading up to last year’s downturn appear to have at least partly unwound already. Finally, valuations appear more reasonable. While large cap stocks trade above their long-term averages, small- and mid-cap stocks trade well below the averages since 1999.
Several factors make us optimistic that the Mid Cap Dividend Value Fund can continue to deliver good relative performance in the periods ahead.
- Midcap Value looks attractive. After several years of underperforming their larger peers, the relative valuation for mid-caps is attractive. e Russell Midcap index trades at 89% of the P/E of the Russell Top 200 index compared to an average of 104% since 1999, a 1.3 standard deviation discount. In addition, the Russell Midcap Value looks attractive relative to its growth counterpart at a 64% relative valuation compared to 70% historically.
- Dividend payers seem to be coming back into favor. After lagging non-dividend payers badly from 2019 through the middle of 2021, dividend payers have been outperforming.
- Finally, the characteristics of the Fund are attractive. With a weighted average Price/2023 Earnings (P/FFO for REITs) of only 10.6x, the Fund appears materially cheaper than the 13.4x for its benchmark, the Russell Midcap Value index. Furthermore, ROA, ROE, and expected growth rate are better for the Fund than the index. Finally, At the same time, 72% of the holdings in the Fund raised their dividend over the last year and 78% have a payout ratio below 50%.
Portfolio Results
All three pillars of performance contributed. When we disaggregate performance, we look at three factors: Dividend vs. non-dividend, Sector Allocation, and Stock Selection. In the fourth quarter, all three factors contributed to the Fund’s outperformance.
- We estimate dividend-payers within the Russell Midcap Value index outperformed the overall index by about 100 basis points, although this factor is interwoven into the other two factors.
- Sector Allocation (do the sectors where the Fund is overweight/underweight outperform/underperform?) added a little to relative performance. A small overweight in Energy and small underweights in Information Technology and Real Estate accounted for most of the benefit.
- Stock Selection (do the stocks held by the Fund outperform the sectors in which they reside?) accounted for the vast majority of the Fund’s relative outperformance. Selection added value in six sectors, detracted in two and was a push in the remaining three. e largest outperformance came in Consumer Discretionary, Real Estate, Industrials, and Health Care. Financials lagged.
The details for those who want to dig deeper.
- Consumer Discretionary – The sector performed better than the Russell Midcap Value index and the Fund’s holdings performed even better. Only one of the Fund’s ten holdings declined: Hasbro, discussed later in this report. Among the rest, we saw strong performance in retail-oriented holdings such as PVH, Bath & Body Works, and Victoria’s Secret which all appreciated more than 25%. We even got a nice bounce from homebuilder KB Homes.
- Real Estate – The Real Estate sector was the second worst performing sector in the benchmark during the fourth quarter, but the Fund’s holdings nearly kept pace with the Russell Midcap Value index. Six of the Fund’s eight holdings outperformed the sector and only Hudson Paci c was down on an absolute basis. On the positive side, retail REIT Brixmor and industrial REIT STAG led the gains.
- Industrials – Industrials lagged only Energy among the best-performing sectors in the index and the Fund’s holdings outpaced the sector. Outperformance was broad-based as eleven of the Fund’s twelve holdings appreciated and eight of the twelve outperformed the sector.
- Health Care – Without the drag from a large number of money-losing, development-stage biotechnology stocks, the Health Care sector in the Russell Midcap Value index outperformed the overall benchmark. e Fund’s holdings did even better with broad-based gains. Interestingly, two of the Fund’s eight holdings declined, but the remaining six appreciated more than 20%. e sector included one of the Fund’s biggest contributors (Universal Health Services) which is discussed later in the “Let’s Talk Stocks” section of this report.
- Financials – The Financials sector performed slightly worse than the overall index and the Fund’s holdings performed worse than that. Within Financials, the Fund has historically overweighted banks and that positioning hurt performance this quarter. While the Fund’s holdings in the Bank subsectors outperformed that subsector in the index, Banks were the worst performing subsector in Financials. Insurance and Capital Markets would have been a better place to be.
During the quarter, the Fund added four new positions and sold three holdings.
Let’s Talk Stocks
The top three contributors in the quarter were:
Olin Corporation (OLN, Financial) (OLN - $52.94 – NYSE) produces commodity chemicals, notably chlorine, caustic soda andepoxy resins. Olin also manufactures small caliber ammunition under the Winchester brand. Amidst concerns over what the company could earn in a recessionary environment, management reiterated an EBITDA range of $1.5-$2 billion level if all of its businesses were operating at recessionary levels or at 50% of capacity. In this scenario, the company believes it could still generate $1.1 million in free cash ow and continue to use its $2 billion share repurchase authorization. As of the end of the third quarter Olin had repurchased 14% of its outstanding shares this year. ese indications were better than the company has performed in past down cycles and better than most investors expected.
Universal Health Services (UHS, Financial) (UHS - $140.89 – NYSE) is one of the nation's largest hospital companies. It owns andoperates acute care and behavioral health hospitals and ambulatory centers in the U.S. and in Puerto Rico. Along with other publicly traded hospital rms, UHS rallied nicely in the fourth quarter after the tone on the labor outlook from public acute care companies improved. Hospital companies believe they have seen the high-water mark for wage increases, with clear evidence of lower usage of high-cost contract labor. In addition, during the fourth quarter, UHS reassured investors that reimbursement rates in its behavioral health segment will remain strong in 2023.
ChampionX Corporation (CHX, Financial) (CHX - $28.99 - NASDAQ) is a provider of consumable products (chemicals and drillbits) and arti cial lifting solutions used in the production of oil and natural gas. After reporting strong third quarter results, management raised its EBITDA margin target to 18% for the fourth quarter and 20% in the intermediate term versus its current 16%. e company also tripled its share repurchase authorization to $750 million of which $670 million remained at the end of the third quarter.
The three largest detractors in the quarter were:
NRG Energy (NRG, Financial) (NRG - $31.82 - NYSE) is one of the largest competitive energy retailers in the U.S. serving over vemillion customers supported by 18 gigawatts of conventional generation. In early December, shares of NRG fell 15% when the company announced the acquisition of Vivint Smart Home (VVNT-NYSE) for $12 per share. Investors did not see the bene ts of this deal as the lack of clearly de ned growth objectives and the incremental debt associated with the acquisition could negatively impact the attractive capital return policy of the company. While investors generally like Vivint’s recurring revenue subscription model, they are not yet sold on the cross-selling opportunities into NRG’s legacy utility customer base. Furthermore, investors remain skeptical of the competitive nature of the home security market. Finally, this transaction further complicates an already complicated story as the company diversi es away from its IPP (Independent Power Producer) roots.
Popular Inc. (BPOP, Financial) (BPOP - $66.32 – NASDAQ) is a bank holding company comprised of the largest bank on the islandof Puerto Rico and some US operations. Its shares fell after the company reported slightly disappointing third quarter earnings and outlined a few headwinds that will impact 2023 results. While rising rates help its interest income, deposit costs are starting to pinch earnings. Furthermore, lower noninterest revenue and rising employment costs will also pressure pro tability.
Hasbro, Inc. (HAS, Financial) (HAS - $61.01 — NASDAQ) is a leading international toy and entertainment company that hasiconic brands such as Nerf, Play-Doh, and Monopoly along with a portfolio of licensed brands. e company reported a di cult quarter with gross margin pressure driving EPS below expectations. Revenues declined 15% as Hasbro was up against a di cult prior year comparison along with negative impacts from FX headwinds and increased promotional activity. On its quarterly earnings call, management noted that its consumers started to become more price sensitive. ese headwinds, coupled with a potentially challenging macro backdrop, impacted the all-important holiday shopping season and pressured the stock price.
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 12/31/2022. 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.
