To Our Shareholders,
For the quarter ended September 30, 2023, the Keeley Small-Mid Cap Value Fund's net asset value (“NAV”) per Class A share fell 3.5% compared with a 3.7% fall in the Russell 2500 Value Index. On a year-to-date basis, the Fund is up 4.3%, a bit better than the 2.0% gain in the benchmark.
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 is up 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 in ation. 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. We are excited about the activity level in spin-o s. rough the rst three quarters of the year, eight companies had spun from their parents. Four more made their independent debut at the beginning of October and another two are likely before the end of the month. ere could be six more between then and the end of the year. Activity, and therefore opportunity, on this front has certainly picked up.
Portfolio Results
The Fund slightly outperformed the Russell 2500 Value benchmark. For the fourth quarter in a row, the KeeleySmall-Mid Cap Value Fund outperformed its benchmark. It fell 3.5% in the quarter, about 20bps better than the Russell 2500 Value index.
Sector Allocation and Stock Selection each contributed a little to the outperformance. When we disaggregaterelative performance into Sector Allocation and Stock Selection, we see that Sector Allocation and Stock Selection each contributed positively to relative performance. When the aggregate performance di erence is not large, it can either arise from large impacts o setting each other or small impacts accumulating and netting. is quarter was the latter.
- Sector Allocation provided a slight bene t to relative performance. e largest sector impacts came from a slight overweight in the Energy sector, which was the best-performing of the eleven sectors. is was partly o set by a small overweight in the Health Care sector, which was the worst-performing sector.
- Stock Selection also contributed to the Fund's outperformance. No sectors really stood out, but the Fund benefitted from slightly better than benchmark performance in the Industrials and Consumer Discretionary sectors. It gave back some of this performance in the Real Estate and Materials Sectors.
The details for those who want to dig deeper.
Industrials – The Industrials sector performed slightly worse than the Russell 2500 Value index, but the Fund'sholdings performed a little better. e Fund did not have any standouts, but four of its holdings were up during the quarter on an absolute basis. On the other side of the coin, it had double-digit losses in Fortune Brands, Hillenbrand, and RXO. Consumer Discretionary – The Consumer Discretionary sector lagged the benchmark, but the Fund's holdings fellless than those in the index. Like the Industrials sector, the Fund did not have any standouts, but four of the ten holdings were up. Only two, Tri Pointe and Valvoline, produced double-digit losses. Real Estate – The Real Estate lagged as well, and the Fund's holdings performed even worse. OUTFRONTMedia and peer Lamar Advertising accounted for more than all of the negative variance. OUTFRONT was one of the Fund's biggest detractors and is discussed in the Let's Talk Stock section of this update. Materials – Given the volatility in the market during the quarter, it is a little surprising that Materials was one ofthe better performing sectors. It was still down a little, but not much. e Fund's holdings performed a little worse than the overall sector. Most of the underperformance can be attributed to the fall in the shares of Summit Materials, but Ardagh Metal Packaging was not far behind. Summit was one of the Fund's biggest detractors and is discussed later in this report. ese losses o set a strong performance from recent spin-o Knife River Holdings.During the quarter, we initiated four new positions and finished the sale of three holdings.
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.Black Knight Inc. (BKI, Financial) is the leading provider of software solutions for the servicing of residential mortgages. Thecompany agreed to be acquired by the Intercontinental Exchange (ICE, Financial) in May 2022, but antitrust concerns slowed the process. During the rst half of 2023, the company agreed to divest a couple of units that the regulators feared could reduce competition if owned by the same company. is paved the way for the third quarter close of the deal. e stock, which had traded at a wide discount to the deal price due to regulatory concerns, closed the discount and generated a good total return.
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 offshore oil production as beneficial to the company's production chemical business.
The three largest detractors in the quarter were 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.Summit Materials (SUM, Financial) (SUM - $31.14 – NYSE) is a leading construction materials company supplying aggregates,concrete, and asphalt. While the company reported another quarter of strong nancial performance, an acquisition announcement in September took the stock down. Summit announced the acquisition of Argos NA, the US cement division of Cementos Argos, which will create the fourth largest cement producer domestically. Summit will pay more than $3 billion comprised of cash and stock. e stock fell more than 7% on the day, re ecting the market's collective dissatisfaction with the deal. ere are a couple of reasons for this reaction: rst, the increased exposure to cement, which is less appealing than aggregates and increases the overall cyclicality of the business. Second, and perhaps more importantly, it entailed giving up a control premium without receiving a premium in return, as a signi cant number of shares were used to nance the deal, potentially creating an overhang on the stock. at being said, Summit remains attractive from a valuation perspective, especially when considering the substantial government infrastructure spending anticipated to start in 2024.
Verint Systems (VRNT, Financial) (VRNT - $22.99 — NASDAQ) develops and markets software used by its clients to drivecustomer service interactions over the phone and on-line. Shares fell during the quarter after the company's second scal quarter (July) earnings fell short of expectations and guidance and it reduced its forward earnings outlook. In the previous quarter, Verint had seen delays in decision-making at clients due to concerns about the macro environment. is worsened in the July quarter and management is not planning for an improvement in deal timing in the second half. Interestingly, the company did not change its full year outlook as it believes it can o set the shortfall in the year-to-date results and the slower contract signings with better margins and expense controls.
Conclusion
In conclusion, thank you for your investment in the KEELEY Small-Mid Cap Value Fund. We will continue to work hard to earn your confidence and trust.
This summary represents the views of the portfolio managers as of 9/30/2023. 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.
