To Our Shareholders,
For the quarter ended September 30, 2023, the Keeley Small Cap Dividend Value Fund's net asset value (“NAV”) per Class A share fell 3.0% compared with a 3.0% drop in the Russell 2000 Value Index. For the year-to-date, the Fund trails its benchmark by 2.3%, down 2.9% vs. a 0.5% decline for the Index.
Commentary
After a strong start to the year and a very good second quarter, stocks retreated somewhat in the third quarter. e third quarter ended with a typically weak September. In the stock market, September is the only month that broadly has a negative average monthly return. Since 1978, the average return for the S&P 500 in September is -0.52%. Over that time period, the market rose in only 51% of Septembers. In most other months, it is up more than 60%of the time.
While there have been some famously bad Octobers, on average the market rises. e fourth quarter has historically been the best quarter of the year for stocks with an average quarterly return of 5.4% and a 73% hit rate since 1978.
As we look over the next year, we see both positives and negatives. How they develop will likely determine the course of the market.
Reasons for optimism
Economic growth looks strong. Wecould point to a lot of indicators here, but the Atlanta Fed's GDPNow currently stands at 4.9%. Nearly 5% growth is a pickup from the rst half and the acceleration comes despite a tougher comparison. Estimates have stabilized. Earningsestimates for the S&P 500 began to fall when the Fed started to raise interest rates. From March 2022 to June 2023, the 2024 estimate fell about 11% and fell almost every month. Since then, it has risen slightly. Valuations do not look stretched. At the end of the quarter, the forward P/E on the S&P 500 was 17.9x. is isup from a year ago and above the long-term average but is not in the “danger zone” where forward returns have been negative. Midcaps and small caps look especially appealing as they both trade below their long-term averages. Seasonality is on our side. Since 1979, the average return in the fourth quarter of the year has been 5.4% for theS&P 500. It has appreciated in 73% of fourth quarters since then. In the quarters where the market was down in the third quarter, the S&P averaged a 6.7% gain and was up thirteen out of fteen times.Causes for concern
The recent surge in oil prices could reignite inflation. While food and energy are typically excluded from manycalculations of in ation, energy is an important input into many elements that are included in in ation. If in ation increases, rates will likely go higher, or stay higher longer than investors currently anticipate and will increase the odds of an economic downturn. The rise in longer-term interest rates could persist. Longer-term interest rates should re ect investorexpectations of what short-term rates should average over the longer time period. With the US government's accumulated de cit surpassing $33 trillion and the increase in rates over the last eighteen months, interest expense has become an important expenditure. Earnings estimates for 2024 might be optimistic. According to FactSet, current consensus estimates project12% earnings growth for the S&P 500 and 34% growth in pro ts for the Russell 2000 in 2024. Geopolitical events have cast a cloud on world peace. e war in Europe and the turmoil in Congress make thegeopolitical outlook a bit more unsettled than usual.Overall, we think the outlook appears fairly balanced. Our process is built on the pillars of quality, timeliness, and value. At this juncture, we lean more heavily on quality. Our bottom up process seeks companies that can sustain their dividends in a higher rate environment.
Portfolio Results
The Fund performed in line with the Russell 2000 Value Index.
e Keeley Small Cap Dividend Value Fund fell3.0% in the third quarter, the same as the 3.0% loss in the benchmark.Allocation and Dividends helped performance in the quarter. We disaggregate performance into three factors:Dividend vs. non-dividend, Sector Allocation, and Stock Selection. In the third quarter, dividends and allocation were slightly favorable, while stock selection was a push.
- We estimate dividend-payers within the Russell 2000 Value index outperformed the overall index by more than 200 basis points. It is sometimes di cult to disaggregate this factor from the other two, but we did not capture as much of this tailwind as we would have liked.
- Sector Allocation had a bigger impact on relative performance than it usually does. In fact, Sector Allocation had the biggest impact on relative performance this quarter. A small underweight in the weak-performing Technology sector helped a little, but the lion's share of the outperformance came from the Fund's underweight positioning in the Health Care sector. e Fund has consistently been underweight Health Care largely owing to the fact that about half of the index's Health Care weight is in biotechnology stocks and none of them pay dividends. Biotechnology performed poorly in the quarter.
- Stock Selection had little impact on overall relative performance and only a couple sectors stood out either positively or negatively. Stock Selection in Health Care was a signi cant positive, while it was a detractor in the Consumer Discretionary and Industrials sectors. It did not rise above noise in the other eight sectors.
The details for those who want to dig deeper.
Health Care – Health Care was the worst-performing of the eleven sectors in the third quarter. Most of thedecline was due to a steep drop in the shares of biotechnology companies. Because none of them pay dividends, the Fund does not own any. at helped this quarter. Aside from that, the Fund's holdings produced mixed results. All were down, but Chemed and Ensign were only down by low-single-digit percentages. On the other side of the ledger, Embecta and Premier produced 20%+ losses. Consumer Discretionary – Stocks in the Consumer Discretionary sector lagged the Russell 2000 Value index andthe Fund's holdings fell a little more. Most of the disappointment came from a sharp fall in the shares of Jack in the Box which is discussed in the Let's Talk Stocks section of this report. Marriott Vacations also fell in the quarter and detracted from performance. On the positive side, Kontoor Brands and Shoe Carnival rose in the quarter. Industrials – e Industrials sector fell a little more than the overall market and the Fund's holdings fell a littlemore than the benchmark. at said, there was a whole lot of action within the sector as it included one of the Fund's biggest contributors (Argan) and one of the biggest detractors (Spirit). Both are discussed later in this report.During the quarter, we bought one new stock and sold four stocks.
Let's Talk Stocks
The top three contributors in the quarter were:
TechnipFMC (FTI, Financial) (FTI - $20.34 – NYSE)
manufactures highly-engineered equipment and systems that are critical tothe production of oil & gas in both o shore and onshore projects. Not only was there a signi cant move up in commodity prices that saw domestic crude oil prices climb to the low-$90 per barrel level from the high-$60s, but Technip FMC also saw a record quarter of orders for subsea equipment in o shore projects. e outlook for the number of o shore projects that may go forward has improved, which gives management high con dence that the elevated order rate in this business is sustainable. Furthermore, the company instituted a framework to return 60% of its free cash ow to shareholders which included the initiation of a regular dividend and the doubling of its existing share repurchase authorization.Argan, Inc. (AGX, Financial) (AGX - $45.52 – NYSE) specializes in the construction of power generation assets including gas- redelectrical plants, solar projects, and grid-scale battery installations. Argan reported an excellent second scal quarter, e ectively leaving behind the previous quarter's setback. Argan demonstrated strong project execution with a notable increase in revenues, a signi cant improvement in gross margin, and the achievement of several new project milestones. e company also secured two large new projects including a noteworthy win in the renewables market. ese wins slightly increased Argan's backlog. Its cash-rich balance sheet not only provides stability to the business but is now generating more interest income which contributed to earnings growth. Finally, Argan continues to return capital to shareholders. It has retired approximately 16% of its outstanding shares since November 2021 and recently increased its quarterly dividend by 20%.
ChampionX Corporation (CHX, Financial) (CHX - $35.62 – NYSE) is a market leader in both chemicals used in the production ofoil & gas and lifting systems that bring commodities to the surface for gathering in production. Shares of ChampionX clearly bene tted from a favorable backdrop of rising oil prices globally in the wake of OPEC supply reductions. Moreover, management increased its pro t margin target because of improved pricing and cost reduction e orts. e company also remains on track to return at least 60% of its free cash ow to shareholders this year. We see a shift toward more o shore oil production as bene cial to the company's production chemical business
The three largest detractors in the quarter were:
OUTFRONT Media (OUT, Financial) (OUT - $10.10 — NYSE) is a Real Estate Investment Trust (REIT) that is one of theleading providers of advertising space on out-of-home structures in the form of billboards and transit displays. OUTFRONT reported a di cult quarter as its Transit business continues to be impacted by the slow return to the o ce, particularly in New York City. is not only led to disappointing in-quarter results but led the company to write down the value of the assets linked to the recent NYC Transit display upgrade. Management also highlighted that it anticipates the weakness in Transit to persist well into 2024. Not all of the news was bad as the core billboard business generated solid revenue growth and the per-board yield increased by 5% year-over-year. Despite the headwinds, we believe OUTFRONT is favorably positioned to bene t from the recovery in Transit once return-to-o ce trends normalize. Furthermore, it continues to have a large opportunity to convert static billboards to digital, a good source of revenue and earnings growth.
Spirit AeroSystems (SPR, Financial) (SPR - $16.14 – NYSE) manufactures fuselages and aftermarket parts to support commercialand defense aircraft production, primarily for Boeing. During the quarter, the company was forced to slow production on the 737 MAX due to an engineering aw in a key component made by one of its suppliers. Spirit alerted Boeing to this aw which triggered a Spirit-funded inspection program which will cause further delays in 737 MAX production. is will also hamper the company's ability to return to positive free cash ow. While the fragility of the commercial aerospace supply chain has been frustrating and compounded at times by Spirit directly, we believe demand for this aircraft by airlines remains strong globally. Eventually, production will return, and Spirit will bene t.
Jack in the Box Inc. (JACK, Financial) (JACK - $69.06 – NADSAQ) operates and franchises quick-service restaurant chains Jack inthe Box and Del Taco. During the third quarter, shares declined after the company did not increase its full-year revenue and earnings guidance despite reporting earnings that topped expectations. e stock also came under pressure from dynamics related to wages and franchises. e company has meaningful operations in California, where a recently amended law guarantees a $20 minimum wage at large, fast-food chains, thus increasing the company's labor costs. As for franchises, Jack in the Box's ongoing e ort to develop new restaurant locations with franchise partners now may be at risk due to the macroeconomic picture including higher interest rates. Despite these cross currents, Jack in the Box remains in a position to continue to grow same-store sales through menu innovations, digital growth, and operational excellence.
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.
This summary represents the views of the portfolio managers as of 9/30/23. 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.
