KEELEY All Cap Value Fund 4th Quarter Commentary
- By Holly LaFon
The market entered the final quarter of a bullish 2016 with some trepidation. Stock market implications surrounding the U.S. presidential election and the Federal Reserve's (Fed) interest rate hike raised investor caution. But the uncertainty was quickly dismissed and a risk-on rally ensued post the Trump victory. U.S. equity markets finished the year strong, with the S&P 500 Index gaining 12.0% for the year and 3.8% for the quarter. Small cap stocks were especially strong, and value outperformed growth across all market caps. Among U.S. equities, small cap value stocks led the way as the Russell 2000 Value Index gained 31.7% for the year, rising 14.1% in the fourth quarter. Midcap value stocks also finished the year in bullish fashion with the Russell Mid Cap Value Index closing the year up 20% and the quarter up 5.5%, while large caps, represented by the Russell 1000 Value Index, gained 17.3% for the year and was up 6.7% in the fourth quarter.
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Energy and Financials were particularly strong in the fourth quarter. The Energy sector continued to rebound from last year's plummeting oil prices as crude gained 11.4% in the fourth quarter (up 45% for the year) following OPEC's decision to cut production. The Fed's interest rate hike had a positive effect on Financials this quarter, though rising interest rates may pose challenges for high dividend yielding stocks in Telecom, Utilities, and Consumer Staples sectors. Given the uncertainty surrounding the Affordable Care Act (Obamacare) and potential reforms by the new administration, Health Care stocks struggled in the fourth quarter. In our view, the U.S. economy looks relatively healthy - GDP gained 3.5 percent in the third quarter (its best quarterly change in two years), and the unemployment rate closed 2016 at 4.7%. We are also encouraged by generally positive earnings growth and believe that companies should see positive growth and revenues in 2017.
For the fourth quarter of 2016, the Keeley All Cap Value Fund underperformed the Russell 3000 Value Index, gaining 5.83% versus 7.24%. Overall, the Fund experienced positive stock selection, whereas sector allocation weights hindered performance. The Fund benefited from an overweight and positive stock selection in Utilities and although the underweight in Financials hurt performance, strong stock selection in the sector made it a positive contributor this quarter. Additionally, a slight overweight and strong stock selection in Technology drove positive results, as did an underweight in the underperforming Consumer Staples sector. The Fund was also helped by its overweight and stock selection in Industrials, as well as avoiding Telecom.
Stock selection in the Materials sector made it the leading detractor from a sector perspective, despite the fact that the slight overweight generated positive results. In addition, the impact of rising interest rates had negative effects both in terms of the Fund's overweight as well as stock selection in the Real Estate sector. The Fund also struggled in the lagging Consumer Discretionary and Health Care sectors, where moderate overweights and poor stock selection hurt performance. Stock selection in Energy also detracted from relative performance.
Given the strength in Financials this quarter, the Fund's top contributors were intrinsically linked to this sector: Voya Financial (VOYA), Hanmi Financial Corporation (HAFC) and Air Lease Corporation (AL). All three companies would be beneficiaries of higher interest rates, a lower corporate tax rate, and less regulation.
Hanmi (HAFC)will also benefit from continued cost cutting and operational improvements at its core banking business. For Voya, the perceptive risk of their closed block variable annuity book, which management claims is fully hedged, would decline as rates rise. Though categorized as an industrial stock, we believe the market has begun to view Air Lease Corporation as a financial given its business in the purchase and leasing of commercial jet aircraft to airlines and is a beneficiary of higher interest rates.
Tribune Media Co. (TRCO) was the Fund's leading detractor this quarter. Despite the company's review and sale of non-core assets (i.e., real estate, Gracenote database, internet property CareerBuilder) to unlock value and return capital to shareholders, weak political advertising spending during this Presidential election year put pressure on the entire broadcasting group.
Given the volatile Health Care sector this quarter, the Fund's position in Shire (SHPG) was also a leading detractor. Headline risk regarding potential pharmaceutical price controls has impacted the stock. With continued synergies from its acquisition of Baxalta and trading at 11x earnings, we feel the stock remains quite attractive.
Another leading detractor was Kennedy-Wilson Holdings (KW). Despite beating expectations for its third quarter report, was similarly impacted by macro concerns regarding the effects of higher interest rates on its real estate operations.
Over the course of 2016, we noticed a lot of mean reversion tendencies within the Fund. Sectors or stocks that had a rough month or quarter rebounded the following quarter, or vice versa. Similar behavior occurred between growth and value stocks as well as large caps versus small caps. We believe this type of activity is likely to persist in 2017, especially as markets grapple with the uncertainty of a Trump administration. Rising interest rates should benefit Financials, yet Health Care will likely be volatile given the uncertainty surrounding Obamacare. Looking forward, we are excited about the prospects for more corporate changes among U.S. value stocks.
Though we are disappointed by the Fund's relative underperformance this quarter, we are encouraged by the amount of performance dispersion that took shape. Within the Russell 3000 Value Index, the worst-performing sector was Health Care, declining nearly 5%, while the top performing sector was Financials, up over 22%. We believe this dispersion is highly advantageous for active stock pickers, particularly when it comes to the inefficiencies in the small and mid cap value segments. In addition, when markets shun or avoid particular stocks due to the lack of readily available information, we believe in our investment process to identify those names that are undergoing some form of transformation. These transformations include ownership changes (spin-offs, divestitures, de-mutualizations), operating changes (new management, cost cutting, M&A) and capital restructurings (emergence from bankruptcy, refinancing, capital reallocation). We also look forward to taking advantage of shifts in the marketplace, including regulatory changes and industry consolidation.
As always, thank you for your support of the KEELEY All Cap Value Fund.
This article first appeared on GuruFocus.
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