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.
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