John Keeley’s semi-annual letter to Keeley Funds shareholders for the period ended March 31, 2015.
Dear Fellow Shareholders,
The environment for the first half of the Funds’ fiscal year was eerily similar to last year, with the performance of the past two quarters being driven by different forces. The fourth quarter of 2014 started with a continuation of the concerns that pulled the market down in September – a weakening Europe, declining economic growth out of China, the threat of an Ebola virus outbreak that would further hinder any growth worldwide, and uncertainty about the timing of the first Federal Reserve (Fed) rate hike. However, all was forgiven by the end of October, as the world received its Z-pack. Draghi initiated Quantitative Easing (QE), the Chinese government began to ease, and the Fed clarified their statement on possible rate hikes, pushing the timing on such action out to mid-2015. The 10-Year Treasury yield dropped from 2.50% on September 30, 2014 to 2.19% by the end of the year, and the macro-driven, risk-on trade was back, as evidenced by the outperformance of small cap stocks in the fourth quarter of 2014. Further, the U.S. dollar strengthened as the U.S. was the best house on a bad block offering some of the highest yields. Investors seemed to prefer more domestically exposed companies (primarily small caps) in order to limit their currency risk. The only sector to dramatically underperform in the quarter was Energy, which was driven by the Thanksgiving Day Saudi decision not to cut back on its oil production. This ultimately sent oil prices down sharply.
The first quarter of 2015 also started out with caution given the performance in the prior quarter, as well as concerns about upcoming earnings reports. Fortunately, the Ebola scare passed without much incident, though other headwinds, such as a series of bad snow storms and the West Coast port strike assisted the “lower for longer” rate mentality. The market volatility swings present in the fourth quarter and through January eventually subsided, and, with the added benefit of lower energy costs, the market became more rational, focusing on core fundamentals. Earnings estimates were lowered leading to a 1Q 2015 earnings season that went reasonably well. We believe that this provided active managers a better opportunity to outperform.
John Keeley: Keeley Small Cap Value Fund’s Performance
Our products had a difficult time versus their benchmarks in 4Q 2014 given the macro driven market and the rush back into yield stocks (REITs and Utilities). In the first quarter of 2015, our products performed better, although the Keeley Small Cap Value Fund had to compete against the tougher Russell 2000 Index, with its larger weights in the more growth-oriented Healthcare and Technology sectors, which were the two best performing sectors in the index. A mergers and acquisitions boom in the biotech/pharma space is occurring, as the larger pharmaceutical companies need to rebuild their patent-expired portfolios and the smaller biotech’s need to build scale in order to survive.
Throughout these macro mood swings of the market, we have remained focused on our investment approach, focusing on companies that are restructuring to create more shareholder value. As such, one of our successful investment themes has been investing in restaurant companies restructuring their operations by moving to a more asset-light franchise model. The stocks of these companies also benefitted from the view that the savings from paying lower gas prices at the pump would translate into more people eating out. Examples include Denny’s, Popeye’s Louisiana Kitchen, Jack in the Box and BJ’s Restaurants. These stocks were up between 40% and 62% during the last six months, and they meaningfully contributed to the outperformance of the Consumer Discretionary sector, the Funds’ best performing group. Denny’s was an over-levered restaurant chain that moved from 60% to 90% franchise owned restaurants to reduce debt under the leadership of a new CEO. Popeye’s and BJ’s are capital reallocation stories with under-levered balance sheets that can be used to return capital back to shareholders or be reinvested to accelerate growth. Jack in the Box is a turnaround story where management had to refocus the Qdoba Mexican food chain to improve franchise growth opportunities. This may eventually lead to a value enhancing split/spin of Qdoba from the core Jack in the Box chain.
John Keeley: Keeley Fund’s Investment themes
A new investment theme where we have recently been active relates to the broadcast media space. The old media model of owning as much as possible (print, radio and TV) within a given market has fundamentally changed. The industry is now unwinding this conglomerate mentality and restructuring to separate its low to no growth print media assets from its faster growing broadcast media assets. The industry was in a consolidation phase prior to the recession, which resulted in overlevered balance sheets and declining print businesses. We first got involved in this area with an investment in Tribune, which had recently emerged from bankruptcy with a cleaner balance sheet and plans to spin off its newspaper businesses. In addition, the company still has the opportunity to renegotiate for higher retransmission fees, and new CEO, Peter Ligouri, is developing the company’s WGN network with its own content similar to the success he had in building the FX Network for 21st Century Fox. Another example is E.W. Scripps, which announced that it was merging with Journal Register and would simultaneously split into two new companies – a new Scripps with the combined TV broadcast assets of the two predecessor companies and a new Journal Media Group with the combined newspaper assets of the two predecessor companies. We held on to the new Scripps, which is also benefitting from retransmission fee negotiations. Our newest media investment is Media General. The company doubled in size when it purchased Young Broadcasting out of bankruptcy, and then doubled again through its recent purchase of LIN Media. The company now has much larger scale, which it should be able to use as leverage in retransmission fee negotiations. We also believe there will be additional benefits from merger synergies and the upcoming Presidential election, as it has good exposure to TV stations in the swing states. Another positive for the Broadcast group is its potential to unlock value from broadcast spectrum assets as the Federal government looks to facilitate a transfer of spectrum rights from broadcasters to wireless communications companies. The last spectrum auction, which concluded in January 2015, raised $45 billion, and the frequencies sold in that auction were, in our opinion, much less desirable, both economically and operationally, than the broadcast spectrum.
John Keeley on the current economic climate
The current economic climate has become a little cloudy – China appears to be slowing, and although Europe is showing a few signs of green shoots, the U.S. is now posting some weaker economic data. GDP growth in 1Q 2015 will be negative given the weather and West Coast port issues, but questions are now developing around lower 2Q 2015 GDP growth. Although the employment picture may have brightened, consumers do not seem to be spending their savings from lower energy prices. In addition, the latest productivity measures are showing that companies may have extracted as much as they can from labor efficiencies. As we have stated in