John Keeley’s Keeley Funds Annual Letter to Shareholders 2013

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Dear Fellow Shareholder,

Despite economic and political turmoil, equity markets performed well across the board in September of 2013 and over the trailing twelve months. The September gains reversed losses in August and also resulted in positive overall quarterly performance with a number of major indexes moving further into record territory. After disturbing the markets in May and June with comments that they may taper Quantitative Easing (QE), the Fed surprised investors with an announcement that it would not reduce its asset purchases in the near-term. The announcement removed fears that a continued rise in interest rates may stall the economic recovery, as seen by the market’s negative reaction to the sharp rise in the 10-year Treasury rate in August of 2013. Investors were also comforted by improving fundamentals both domestically and abroad. The Eurozone may finally be emerging from its prolonged recession and a number of economic reports in the U.S. continue to show progress. Specifically, initial unemployment claims dropped to a multiyear low early in September and the housing market continued to improve, as evidenced by prices rising 12.4 percent year-over year, which along with the stock market’s strength, has created a positive wealth effect for consumers. In response to this general economic improvement, consumer confidence increased at the end of September, and the index of leading economic indicators ticked up as well, suggesting that, absent the effects of politics, the recovery in the real economy was continuing. Our portfolios that focus on corporate restructuring (Keeley Small Cap Value, Keeley Small-Mid Cap Value, Keeley Mid Cap Value, Keeley All Cap Value, and Keeley Alternative Value) have all experienced a productive investment cycle with respect to their opportunity sets, and many of our holdings have posted impressive results in recent quarters. Although we acknowledge an improving economy has boosted the outlook for our more cyclical holdings, our research has guided us toward many areas that seemed undervalued with low expectations. At the core, we are a bottom- up research driven investment firm that generates ideas through our investment philosophy involving corporate restructuring (corporate spin-offs, companies emerging from bankruptcy, event-driven/special situations, savings & loan and insurance conversions). Corporate restructuring is designed to provide superior growth in a slow growth economy. It is often the case that when conducting our bottom-up security analysis on company-specific restructuring ideas, we are led to identify industry specific themes. For example, for much of 2012 and early in 2013, the Funds benefited from exposure to the recovery in housing. However, it was our focus on corporate spin-offs that led us to the housing recovery theme. We invested in Walter Investment Management Corp. (WAC), a mortgage servicer that was formed when it was spun out from Walter Energy and merged with GreenTree; Lender Processing Services (LPS), a mortgage and consumer loan processor that was spun out from Fidelity National Information Services and subsequently acquired by Fidelity National Financial; PHH Corp. (PHH), a mortgage and fleet management services company that was previously spun out of Cendant Corp.; Fortune Brands Home and Security (FBHS), a manufacturer of home and security products that was split off from Beam Inc.; and CoreLogic Inc. (CLGX), a provider of property, financial and consumer information services, which was spun off from First American.

We believe that a significant reason these companies were spun-off was to unlock the inherent value that was buried underneath poor investment sentiment and extreme uncertainty with respect to housing. The degree of undervaluation and negativity prompted us to take a closer look at the industry as a whole and ascertain exactly what was occurring. Was there something more going on here? Were there any catalysts to spark a recovery, and if so, who would benefit? We may have been drawn to housing through our focus on spin-offs, but recognizing the turnaround/industry restructuring that was taking place led us to invest directly in homebuilders such as Toll Brothers (TOL) and Pulte Group (PHM), which provided the greatest contribution to the Funds’ performance.

Despite our optimism for many of these stocks, the recent move in interest rates did cause us to exit or trim some of our holdings in this area. We experienced strong returns and felt that we should realize some profit and move those dollars to areas we believe have greater upside from current levels. We continue to hold many of the indirect housing plays mentioned above, and we still believe that they possess excellent long-term potential. The investment in housing-related stocks not only sheds some light on positions that have positively impacted our shareholders over the past year, but also demonstrates aspects of our investment process and how we believe it may provide superior investment returns.

Another area that is intriguing to us is the North American energy sector which looks to have a number of interesting catalysts currently. While the energy sector is at present only a modest overweight in the portfolios, we have been encouraged by several trends taking place for a number of years. These positive developments are also having an impact that goes far beyond the energy sector itself. Many believe that the U.S. will become energy independent and possibly a net exporter of natural gas and oil (currently restricted by law) in the next decade. This opinion is based primarily on the development of new drilling techniques (i.e. horizontal drilling, and high pressure fracking) that have enabled companies to access oil and natural gas reserves in shale formations that were previously not economically viable. The ability to tap into this acreage is a game-changer in our view and is already having a tremendous impact on the economy. Employment rates in these mostly rural areas surrounding the shale basins are very high and companies thus find hiring extremely competitive. Strong labor markets tend to create strong local economies. Oil States International (OIS) has been able to capitalize on this trend by providing housing and other services to oil service workers that are in demand in the area. CST Brands (CST) operates gas stations in Texas, but it is increasingly looking to broaden its product offering beyond fuel. Rail companies like Union Pacific (UNP), Canadian Pacific (CP), Kansas City Southern (KSU) and Genesee and Wyoming (GWR) have also benefited substantially. Given that shale areas are rural and often lacking infrastructure, substantial investment must be made to support drilling and production activities. Without pipelines in place, railroads have been the primary takeaway mechanism for moving production to the various clusters of refining capacity around the United States. In order to serve this demand, massive investment in railcars has been needed. Trinity Rail (TRN), Greenbrier (GBX), and Wabtec (WAB) all benefit from increased production of specialized sand, pipe and oil rail cars. On the production side, Bonanza Creek (BCEI), Gulfport Energy (GPOR), and Goodrich Petroleum (GDP) have all grown production significantly in their operating basins. While the initial move has rewarded them for proving out that their acreage contains significant hydrocarbons, the next step is optimizing production. In this stage, they are increasing/decreasing the number of frac stages, experimenting with longer lateral well lengths, and altering the amount and type of proppant they use (mostly sand to keep an induced fracture open). These actions have lowered their drilling costs and increased the total estimated reserves of their land holdings. Better cash flows and relatively stable commodity prices have thus led to higher sales on comparable properties. These factors have been very good drivers for their stock prices over the past years, and we believe costs will continue to decline. Looking farther out, Chicago Bridge (CBI) continues to see very good activity in helping the energy sector build out terminals to export product. They are a leader in building liquified natural gas terminals and will play a large role in helping get North American gas to a hungry world market. Although our current weight in energy is modest relative to our respective indexes in each portfolio, we believe this is an exciting time to be involved in the sector. We want to make sure our shareholders have exposure to some of the companies that can benefit most from this transformational shift, and our holdings in this sector have made a strong contribution to our results in 2013.

Overall, we have been pleased with our results over the past year, and we continue to have a favorable view on the equity markets despite rising valuations. We expect that the U.S. economy will continue to grow, albeit at a modest pace. We are thus looking for companies that we believe can thrive in a slower-growth environment. It has now been five-years since the fall of Lehman Brothers, and although uncertainties remain and more needs to be done, the U.S. economy has come a long way and has made a great deal of progress in a number of areas. Our discussion on energy in this letter is just one example of a generational shift that could have a massive impact on our economy. With all of that said, it is a rare situation for equities to have risen so sharply yet with so little enthusiasm. A number of media outlets have opined about this market being hated and we completely agree. We have stated many times that the equity market continues to climb the wall of worry. Until investors participate more broadly and become more confident, we believe this cloud of negative sentiment can act as a tailwind for future equity gains. On a fundamental level, we recognize that valuations are higher and the upside in certain companies is limited. We have taken advantage of this fact and trimmed or sold many of our successful holdings. However, we are also finding plenty of opportunities in new spin-offs and some of the thematic, event driven ideas we mentioned earlier in the letter. We become most worried when others are confident, and we are simply not seeing that excess in today’s investment landscape. Due to the sharp downturn in 2008 and 2009, equity gains have been very modest over the past ten years. This is despite impressive gains in productivity due to massive technological advances within this time frame. The companies in which the Funds have invested have become more efficient and continue to translate gains in productivity to the bottom line. Additionally, our focus is on companies undergoing restructuring. Although the downturn was painful to many, it forced a tremendous amount of change. Management teams have gone to extraordinary measures to increase productivity and efficiency – not to mention taking advantage of an incredibly attractive credit environment. Access to cheap money has allowed companies to restructure swiftly and effectively, which has allowed many leaders to strategically move their companies forward in a rapidly changing economic environment. Yes, we are mindful of the uncertainty that exists in the global economy. We understand that the market has performed well and future investment ideas will become more challenging to find. But it is hard to ignore some of the positive developments that are occurring in our economy, and we believe that much of this has been viewed with skepticism by the investment community. Our enthusiasm is predicated on the fact that many of our current holdings are executing well, and we believe that their long-term outlooks are positive. We also see many encouraging themes at play that should warrant more investment opportunities in the future. That motivates us to work harder to uncover that next new idea that can drive returns and reward our shareholders. 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 that responsibility very seriously and appreciate your support. Thank you for your continued commitment to the KEELEY Funds.


John L. Keeley, Jr.

President and CIO

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 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 Mr. Keeley and are current only through the end of the period of the report as stated on the cover. Mr. Keeley’s views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.

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