To Our Shareholders,
For the quarter ended March 31, 2023, the Keeley Small-Mid Cap Value Fund’s net asset value (“NAV”) per Class A share rose 3.0% compared with an 1.4% increase in the Russell 2500 Value Index.
Commentary
The first quarter of 2023 ended amidst stock market turbulence over fears that the collapse of a few regional banks would trigger a contagion of systemic deposit out ows. e rapid collapse into Federal Deposit Insurance Corp. FDIC, receivership of SVB Financial Group and Signature Bank, along with the virtual wipe out of First Republic Bank equity holders, has raised concerns over the stability and durability of US community banks as rising interest rates force markdowns of bank bond portfolio holdings.
SVB Financial (Silicon Valley Bank) and Signature Bank were the 16th and 29th largest banks in the US. ey represent the second and third largest bank failures in US history. Each bank had some unusual circumstances, but the fundamental driver of their closure was the loss of con dence by depositors which led to a run on the bank. e FDIC stepped in to guarantee all deposits in these cases and the Fed launched new programs to ensure that banks can access the liquidity they need to accommodate deposit out ows. While bank stocks are o sharply, it appears that conditions are stabilizing.
Rapid deposit out ows into higher yielding securities should ultimately crimp loan growth as smaller banks move toward enhancing liquidity. Profitability will be pressured given the likelihood that higher deposit insurance and compliance costs will force banks to hold more liquidity on their balance sheets. Fueling outflows are worries over uninsured deposits above the $250,000 threshold. To shore up confidence in the regional bank financial system, the Fed introduced a new backstop for lenders in need of liquidity. The Fed stood ready to make loans against the par or face value of underwater bonds on bank balance sheets. With some long term bonds, these loans could be as much as 50 percent above market value. U.S. o cials are also studying ways to temporarily expand FDIC coverage to all deposits. Treasury Secretary Yellen told lawmakers in March that regulators would take further steps to protect the banking system. Moreover, the Fed is contemplating tighter capital and liquidity requirements for smaller banks along with more rigorous stress tests.
First quarter market performance was surprisingly good. Despite all the negative headlines, the marketsperformed well in the rst quarter. Stocks, as measured by the S&P 500 were up 7.5%. Large-cap stocks outperformed small-cap stocks and growth stocks beat value stocks. International stocks did nearly as well with the MSCI EAFE up 6.7%. Bonds rebounded a little with the Bloomberg US Aggregate up 2.5%. Commodities were mixed with energy and agricultural commodities mostly falling and metals mixed, but gold gaining 8.8%. Bitcoin was up an astonishing 73%.
And was the opposite of 2022 on several fronts. Big Tech was back and was led by the usual suspects as Nvidia,Meta, and Tesla each rose more than 65%, Microsoft, Apple, and Amazon each gained more than 20%, and Alphabet was the laggard with a 17% gain. Indeed, only one of the thirty stocks in the Technology sector in the Russell Top 200 index was down in the quarter: IBM. Energy stocks, last year’s winners, were down as well. Among smaller stocks, the fall in bank stocks impacted returns. Only ve of the 198 bank stocks in the Russell 2000 were up in the quarter. Looking more broadly we see that the stocks that performed poorly last year performed best in the rst quarter.
We still see value in smaller companies. While the economy continues to advance, growth expectations declinedin the rst quarter as more than 400 basis points of rate increases began to impact activity. is, along with the recent turmoil in the banking sector is driving reductions in earnings estimates. With stock prices up and earnings expectations down, the valuation of the market increased. e P/E multiple on the S&P 500 now stands at 18.2x the next twelve months’ earnings, above the long-term average of 16.3x. Value can still be found in small- and mid-cap stocks which trade in line with or slightly below their long-term averages.
The Fund is well positioned. We are excited about many of the opportunities within the Fund and the pipeline ofpotential restructuring investments we see. e last two years a orded more spin-o opportunities than the prior couple of years. While many were too large to be considered for the Fund, we were able to participate in many. ese tend to play out over time, and we believe this has helped the Fund recently and we think it will continue. In addition, while we do not really like the idea of a slowing economy, it may lead companies to look more deeply at the composition of their business and take actions which create investable opportunities. Furthermore, companies undergoing the kinds of change we look for may be better positioned to grow earnings independent of the economic trends. Between what the Fund owns, what we see coming, and the possibilities created by a more challenging macro environment, we believe we will have ample opportunities to keep the portfolio fresh.
Portfolio Results
The Fund started the year well with solid absolute and good relative performance. e Keeley Small-Mid CapValue Fund gained 3.0% in the rst quarter and outperformed the Russell 2500 Value index by 1.6 percentage points.
Almost all the relative outperformance came from Stock Selection. We disaggregate relative performance intotwo factors: Sector Allocation and Stock Selection. In the rst quarter, Sector Allocation had minimal impact overall and Stock Selection drove the Fund’s outperformance.
- Sector Allocation (do the sectors the Fund is overweight/underweight outperform/underperform?) provided little net impact to relative performance. e Fund saw a slight bene t from an underweight position in Financials, but this was offset by a small overweight in Energy and a small underweight in Information Technology.
- Stock Selection (do the stocks held by the Fund outperform the sectors in which they reside?) drove the Fund’s relative outperformance. Selection added value in eight sectors, detracted in two and was a push in one. e largest outperformance came in the Energy, Industrials, and Consumer Discretionary, while the only signi cant detractor was Materials.
The details for those who want to dig deeper.
- Energy – e sector was the second worst performing among the eleven sectors in the benchmark, butthe Fund’s holdings were up compared to a decline in the sector overall. With only ve Energy stocks in the Fund, moves in a few have a signi cant impact. is quarter, strong gains at International Seaways and TechnipFMC o set weakness at Chesapeake Energy. International Seaways rose on prospects for stronger shipping volumes as Europe looks to replace Russian oil while TechnipFMC continues to see strong orders for o shore production equipment. Chesapeake fell on weaker natural gas prices and is discussed later in this report.
- Industrials – The Industrials sector was the third best performing sector in the Russell 2500 Value indexand the Fund’s holdings performed even better. Gains were led by ESAB Corporation which was one of the Fund’s biggest contributors in the quarter and is discussed in the “Let’s Talk Stocks” section of this update. It was not alone in producing strong returns and three other stocks appreciated more than 10%. Furthermore, only one of the Fund’s fourteen holdings declined in the quarter.
- Consumer Discretionary – is sector generated the second-best returns among the eleven sectors thisquarter and the Fund’s positions appreciated even more. Five of the eight stocks held by the Fund produced double-digit gains during the quarter. ey were led by homebuilder Tri Pointe Homes, which is discussed in the next section of this report. e other three holdings declined with the biggest loser in the sector being Bath & Body Works.
- Materials – e Materials sector performed well during the rst quarter, but the Fund’s holdings did not.Most of the shortfall in relative performance in the sector was due to a decline in the shares of Ardagh Metal Packaging, but the lack of holdings in mining was a missed opportunity as well.
During the quarter, we added one new position, retained a stock swapped in a merger, sold two holdings, and had two stocks merged away.
Let’s Talk Stocks
The top three contributors in the quarter were:
Tri Pointe Homes (TPH, Financial) (TPH - $25.32 – NYSE), one of the nation's top homebuilders, saw its share price move higheron improving sentiment toward homebuilders and the announcement of strong quarterly earnings. Moderating mortgage rates and strong employment numbers gave investors more optimism about conditions for selling homes and that backdrop allowed Tri Pointe to generate record revenues and EPS. ose results exceeded consensus expectations with much of the upside coming from better margins due to lower raw materials costs and improved build times. During its earnings call, management expressed cautious optimism for the upcoming spring selling season.
ESAB Corporation (ESAB, Financial) (ESAB - $59.07 - NYSE) is a leading manufacturer of welding equipment for a variety of industrial applications and was spun o from Colfax Corporation in April 2022. e company not only reported strong quarterly results which handily beat expectations but also announced it will be adopting the 80/20 operating philosophy to streamline its product portfolio. It will focus on its top 20% of products in its portfolio and rationalize the rest. is philosophy has been deployed in several leading industrial companies to great success.
Vontier Corporation (VNT, Financial) (VNT - $27.34 – NYSE) is a provider of critical components and repair services focused onmobility technology, speci cally fueling stations and convenience stores. Vontier not only delivered quarterly results above investor expectations but also highlighted share repurchases as a priority for free cash ow this year as opposed to acquisitions. e company also expects to be a bene ciary of the build-out of charging infrastructure for electric vehicles through its portfolio of back-end software solutions for its fuel station customers.
The three largest detractors in the quarter were were community banks.
PacWest Bancorp (PACW, Financial) (PACW - $9.73 — NASDAQ), Columbia Banking System (COLB, Financial) (COLB - $21.42 — NASDAQ), and Synovus Financial (SNV, Financial) (SNV - $30.83- NYSE) led the list of detractors, but six of the bottom ten were communitybanks. e sharp drop in bank shares came after the surprising failures of SVB Financial (Silicon Valley Bank) and Signature Bank in mid-March. Shares fell on concerns that the deposit runs experienced by SVB and Signature would spread more broadly. While banks are struggling, and will continue to struggle, with rising deposit costs, only PacWest is in the venture deposits or venture lending businesses that led to the run at SVB, and none is active in the crypto markets that were a source of volatility for Signature. We had been building a position in PacWest last year and earlier in the quarter as we believed new CEO Paul Taylor had outlined a plan to improve pro tability and reduce risk at the company. Having invested in two banks that he previously had turned around and then sold, we looked forward to a hat-trick. e turmoil in the banking market and the steep drop in the shares of PACW give the company less exibility in executing this plan. Other bank holdings do not have these speci c issues and are generally better funded than the average bank. Columbia, in particular, has an outstanding deposit base and its recent merger with Umpqua could lead to better cost savings than previously outlined. Our biggest concern arising from these recent events is that it leads banks to rein in lending which could have broader negative economic impacts.
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 3/31/2023. 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.
