John Keeley’s Keeley Funds annual shareholder letter for the year ended 2014.
Dear Fellow Shareholders,
An accommodative Ben Bernanke in his last year as Fed Chief and market acceptance of quantitative easing (i.e. tapering) drove the strong market performance in 2013. For 2014, this Fed focus continued to heavily influence the market action; however, tapering concerns were replaced with the possibility of earlier rate hikes. There were glimmers of hope that the market would return its focus to companies’ fundamentals with the strengthening US economy, but macroeconomic forces again took center stage. As Janet Yellen became Fed Chair, perception of a possible change in rate policy plus high valuations, especially in small caps, led to a weak January. Reassurances by Yellen that the Fed would adjust accordingly if the economy slowed led to solid performance in the first and second quarters of 2014. Even the political situation in Ukraine presented itself only as a temporary stumble, with the market marching onward as the US economic data continued to strengthen after the terrible winter weather.
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Eventually this growth began to spur speculation about the possibility of an interest rate hike in early 2015, the US dollar continued to strengthen, and the 10 year treasury yield jumped from a yearly low of 2.34 percent to 2.62 percent. Adding to these events were a slowing Europe with Mario Draghi talking of a quantitative easing program, and China struggling to maintain its minimum growth goal (latest report was 7.5% GDP growth). It appeared that the market was beginning to question the sustainability of US growth with slowing world economies, and whether US economic growth had reached escape velocity to withstand the effects a tightening in monetary policy.
How events in the stock markets affected John Keeley’s Keeley Funds?
How have all these events affected the Keeley Funds? As we entered into 2014, small caps were near all-time highs in terms of relative valuation. After two very strong performance years, many market strategists began directing investors to move from small cap to large cap stocks. It should be noted that certain factors that one would expect to advantage larger cap over smaller cap companies such as rising interest rates and a rebound in global markets has not occurred. Yet the Russell 1000 has outperformed the Russell 2000 by almost 1200 basis points through the end of September 2014. As such, it appears that the macro headwinds mentioned earlier may have had an impact in leading investors to less volatile companies, which tend to be larger in market capitalization.
The consideration of macro and geopolitical factors often create uncertainty, which occasionally results in heightened volatility. We have seen such an increase, as the VIX volatility index has spiked from its mid-teens average all year to over 30, further demonstrating the market’s dampening risk appetite. Despite our belief that the Funds’ holdings represent lower risk, since such holdings were purchased below our assessment of fair market value, others view companies undergoing restructuring-driven change as problematic due to heightened execution risk. Thus, in times of increased volatility, restructuring companies occasionally will face increased selling pressure, resulting in periods of underperformance.
John Keeley’s Keeley Funds finding investment opportunities through the theme of event-driven change
Nevertheless, the Funds maintain their philosophy of finding investment opportunities through the theme of event-driven change. Spin-offs, in particular, have been a very fruitful investing area, and studies have proven that they generally outperform the market over a 3-5 year period. For the Keeley Funds, spin-offs represent an ownership change due to restructuring efforts by the parent company. Moreover, a change in the shareholder constituent base often occurs post-transaction, as the spun-off company usually has different financial characteristics from its parent, thereby attracting different investors. The transaction creates opportunities to purchase the undervalued stock of these companies before their fair market value is recognized by Wall Street. However, in this more risk averse, volatile market environment, even the spin-off strategy has encountered pressure. More than half of the 24 spin-offs that began trading as separate companies since the end of January 2014 are down double digit percentages from their initial trading prices. The market unease seems to have steered investors away from these companies, as they fear the perceived extra risk of owning “new companies led by sometimes unproven management teams.” Although this may hurt performance in the short term, we believe that this type of neglect makes spin-offs and restructuring companies even more attractive at these lower prices, making them excellent investment opportunities over a longer time horizon.
John Keeley’s Keeley Funds: Spin-offs underperformed due to fundamental issues
Two recent spin-offs, Civeo (CVEO), which came out of Oil States International (OIS), and Rayonier Advanced Materials (RYAM), which was spun from Rayonier (RYN), have underperformed due to fundamental issues. Civeo management opted not to convert to a REIT structure and then guided down fourth quarter 2014 performance expectations due to a lessening of demand for Canadian energy support services. Rayonier Advanced Materials was impacted by more than expected competitive capacity taking away expected pricing benefits. Despite these examples of the risks we encounter, a number of the Funds’ more mature spin-off holdings have been top contributors for the twelve months ending September 30, 2014. Two spin-offs from Sara Lee have done exceptionally well as stand-alone businesses. Hanesbrands (HBI), up 72 percent, has been able to grow its business since the split by making accretive acquisitions of Maidenform and DBApparel (ironically also a former Sara Lee company). Hillshire Brands, up 47 percent following its separation from Sara Lee, was on its way to grow via an acquisition of Pinnacle Foods when the tables turned and it became the target of two larger food companies. Our work has shown that spin-offs generally outperform three to five years following separation from the parent company, as the growth plans set forth by the new management team take hold and/or the company becomes a cleaner, pure play in its space, which in turn makes it an attractive takeover candidate.
John Keeley’s Keeley Funds: Decline in oil prices
Despite our focus on restructuring, the Funds have been adversely impacted by the dramatic drop in oil prices, particularly in the third calendar quarter of 2014. Oil price action was initially driven by the strengthening US dollar and increasing supply from the US shale discoveries, but then much further due to OPEC discord. Interestingly, Saudi Arabia did not lead the other members of OPEC to cut production. This lack of Saudi action was surprising, as other OPEC members were not adhering to quotas and there was tremendous supply being added to the market via US shale.
Instead, the Saudis cut the price on supply contracts for Asian demand to maintain market share. As a result, the price of Brent crude dropped from a high of $115 to $85 per barrel.
Despite the short-term decline in the price of oil, we remain very optimistic about the Funds’ energy-themed investments, which we discussed in last year’s letter. Over the past year, we have seen further evidence that the US is moving towards energy independence and likely will become a net exporter of oil and gas in the future. US crude oil production reached 8.65 million b/d, up 1.17 million b/d from last year. This domestic production increase has lowered the US amount of imported light crude by more than 600,000 b/d to less than 200,000 b/d. Newer technologies in drilling such as stacked vertical plays, the use of sand as a proppant in fracking, and down spacing are increasing the success rates and lowering finding costs for North American producers. Smaller, more experienced drilling teams have been able to make accretive acreage acquisitions from larger players by quickly exploiting those lands using these new drilling techniques. The restructuring change we are witnessing is a market share shift within the industry – from external to internal supply and from larger companies to smaller ones.
We have always believed that if you lack sufficient energy and independent production, you probably do not have much of a sustainable economy. China understands this well and has been using its clout to secure supply. Also, it is very clear that Europe is mercilessly dependent for energy on a plethora of Russia pipelines. Europe wants energy independence, while the Russians would prefer to keep their energy-based cash flow annuity from Europe intact. We are not sure what the answer to this problem is, but we are quite certain that solving the issue is going to be quite a challenge.
John Keeley’s Keeley Funds: Investing in China
As we mentioned earlier, China seems to place a high value on energy, as they recently secured a multi-year agreement with Russia to supply energy via a pipeline or multiple pipelines. This is intriguing and may be an answer for why there has been so much geopolitical interest in Afghanistan. Given that Saudi Arabia is generally regarded as the global energy swing producer, the Russian deal may have brought some angst to Riyadh, and despite a modestly growing global economy, the Saudis have maintained production at a very high level reportedly to maintain their market share in Asia. Interestingly, the Saudis recently signed a low price contract with the US, similar to that executed with China, to further maintain market share. These actions have had the intended effect of sending crude prices lower and more importantly, sending a clear message of “who’s the boss” to the energy world. Most of OPEC (Iran in particular), Venezuela, and Russia need much higher prices to make their budgets (the Russians need $100+ oil). In addition, some US shale production may become economically challenged at $75 or less per barrel. Also during this period, the Fed announced it was ending QE, which seemed to have the effect of firming the US dollar. Since oil is priced in US dollars, this put additional downward pressure on crude prices. This is all without even mentioning that it has occurred in an election year that saw a change in the balance of power in Congress.
We think things have become complicated, but this has not changed our investment approach. We are still attempting to find companies that we believe are in the throes of change. The Funds, some more than others, are overweight energy versus the Russell indices, and a number of these investments represent companies that are restructuring via spin-offs, asset sales or acquisitions. Unfortunately, individual company fundamentals have not mattered much, as the entire energy sector has declined significantly in a very short period of time. Nevertheless, we have not altered our energy investments as we are not sure if these macro changes are temporary or permanent. By nature, we are investors, not traders, and we do not attempt to time the market (in particular the energy market). Frankly, our general belief is that only the consumer benefits from cheap energy and that virtually every energy producing and exporting country in the world would benefit from higher energy prices. It seems more likely that if global growth remains moderate or perhaps better than moderate, energy prices will ultimately rise.
In the current environment, we continue to see no shortage of activity from activist shareholders. Their relentless drive for shareholder value continues to drive restructuring driven change. The building of a new position in certain Funds in Alere (ALR), a medical device company, was spurred by an activist’s attempt to change the board of directors to refocus management on its core business versus its runaway acquisition path that we believe has led to an over-levered balance sheet. A new Chairman of the Board was elected, the CEO was changed and the company is now on a restructuring path to turn around its core diagnostics business and to divest non-core assets to pay down debt. The spin-off of Civeo was instigated by activist investor Jana Partners involvement in its parent, Oil States International. Even CDK Global (CDK), the IT systems company for automotive dealers, has attracted the attention of activist investor Sachem Head only one month since its spin-off from Automatic Data Processing (ADP). As a result, management teams and boards of directors are becoming much more proactive regarding shareholder value and capital management. We are seeing this occur in the record number of spin-offs announced so far this year, greater than 60 versus the 37 spin-offs in calendar year 2013. In addition, the percentage of S&P 500 companies currently buying back their own stock is approaching its historical high of close to 90 percent, and the dollar value of share repurchases for the first half of 2014 was nearly equal to their peak, set in the first half of 2007. We believe these events illustrate that companies can no longer sit idle on their cash, nor can they hide behind underutilized balance sheets.
As we look into 2015, we are quite excited about the number of restructuring-driven investment opportunities in the marketplace. We believe a continuation of the slow growth environment could further the impetus for change to create shareholder value as the activists will not rest. With valuations more reasonable and the US economy being the strongest engine in the world market at the moment, we believe interest will return to more domestically focused small-mid caps. Lastly, as the employment data points to more confidence in the strengthening economy and as we may see more business-friendly policies coming out of Washington, we believe that the mergers and acquisition cycle could pick up in earnest. We further believe that the Funds will be a major beneficiary of a reborn M&A cycle as the restructuring efforts transform these companies into cleaner, purer plays that are more easily integrated into larger companies.
Thank you for the trust you exhibit by allowing us the opportunity to act on these ideas and to manage your hard earned capital. We take this responsibility very seriously and appreciate your support.
Thank you for your continued commitment to the KEELEY Funds.
John L. Keeley, Jr.
President, CIO and Lead Portfolio Manager
Brian R. Keeley
Edwin C. Ciskowski
Kevin M. Chin
There are risks associated with investing in small-cap and mid-cap mutual funds, such as smaller product lines and market shares, including limited available information. The risks of investing in real estate investment trusts (“REITs”) are similar to those associated with investing in small-capitalization companies; they may have limited financial resources, may trade less frequently and in a limited volume, may be subject to more abrupt or erratic price movements than larger company securities, and may be subject to changes in interest rates. You should consider objectives, risks and charges and expenses of a Fund carefully before investing. Additional information regarding such risks, including information on fees, is located in the Funds’ prospectus. Please read the Funds’ prospectus carefully before investing. The opinions expressed in this letter are those of the portfolio management team and are current only through the end of the period of the report as stated on the cover. The portfolio management team’s views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.