Commentary – 1st Quarter 2019


For the quarter ended March 31, 2019, the Small Cap Dividend Value Strategy rose 13.67% gross (13.41% net of fees) versus a 11.93% increase for the Russell 2000 Value Index.

Macroeconomic Review

The market, as measured by the S&P 500, got off to its best start in the last twenty years and posted its best overall quarter since Q3-2009. The quarter’s 13.6% gain nearly recouped the fourth quarter’s steep drop. The first quarter was the sixth time since 1970 that a quarter with a double-digit loss was followed by a quarter with a double-digit gain.1 In four of the five previous instances of this pattern, the subsequent quarter also saw a double-digit gain. While that is too small a sample size to factor it into one’s outlook, it is an interesting data point.

We think that the bounceback was mostly driven by an easing of the worries that led to the fourth quarter drop. As the fourth quarter progressed, investors became increasingly concerned about the potential that an overshoot on rate increases by the Fed, combined with the impact of trade sanctions would push the economy into recession. A slight thawing in the rhetoric around trade and clear signals from the Fed that it would at least put its rate tightening campaign on hold were enough to stop the decline and drive a sharp reversal.

And reversal is a pretty accurate description. In the fourth quarter, the market fell, small caps fell more than large caps (as measured by the Russell 2000 and Russell Top 200 indices), and growth fell more than value (as measured by the Russell indices). In the first quarter, the market rose, small caps led large caps, and value lagged growth. We also saw a sharp snapback in the price of oil; up 32% in Q1-2019 after falling 38% in Q4-2018. The two benchmark assets that sustained their fourth quarter trends were gold, which rose in both periods, and the yield on the ten-year Treasury, which fell in both periods. The sum of the last six months is that we have had a lot of movement in the markets, but we are pretty close to where we started.

The economic outlook, on the other hand, has probably deteriorated slightly. While the labor market in the US remains tight, growth expectations around the world are lower than they were six months ago. You see the signs in a variety of reports of both sentiment and activity. We believe that most of this slippage arises from the various trade actions coming out of Washington. When we talk to company management teams about any softness they are seeing, they cite higher materials costs as one source of pressure, but also the uncertainty created by the possibility of an expansion of the tariffs.

The good thing about this is that it appears that the US and China will come to a trade agreement that will remove this overhang. Last quarter, we suggested that a conclusion to these trade disputes (along with the ending of the government shutdown) might drive strong market performance. While we think a resolution of the trade disputes would be a positive, at this point the market has discounted much of that potential.

The strong move in the market, combined with a slight reduction in forward EPS estimates, has made the market somewhat more expensive. At year-end, the S&P 500 traded at 14.4x forward EPS compared with 16.5x at the end of the first quarter. This is a little above average, but not worrisome. Small caps, as measured by the S&P Small Cap index, traded at 14.1x then vs. 16.7x now. The Russell indices tell a similar story. In almost all cases, valuation has moved from below average to slightly above average. What has not changed is that small caps continue to look attractive relative to large caps and value looks compelling compared to growth.

Portfolio Results

We are pleased with the outperformance of the Keeley Small Cap Dividend Value Strategy in the first quarter. It was able to overcome two influences that have historically been headwinds for relative performance. First, in past periods when the market experienced strong gains, the Strategy had difficulty keeping up. In addition, non-dividend-payers outperformed dividend-paying stocks in the benchmark.

We think that a couple of factors allowed the Strategy to achieve its strong results. First, we believe that some of the strength was a catch-up from last quarter when the Strategy performed in line with the benchmark under conditions where it has historically outperformed. The bounce back in several of the Strategy’s bank and energy stocks were most noticeable. Second, the Strategy had very few problem stocks. Only seven of the seventy-two stocks the Strategy held in the quarter were down and none was down more than 9%. At the same time, the Strategy held ten stocks that provided total returns of 30% or more.

As readers of previous reports well know, we usually talk about performance in its constituent parts, sector allocation and stock selection. The Strategy usually sees a much greater impact from stock selection than sector allocation. This quarter followed that script with allocation not having much impact either way on a net basis and selection accounting for the Strategy’s outperformance.

Within Allocation, small underweights in the lagging consumer sectors helped relative performance, but were offset by a small underweight in the strong technology sector and the Strategy’s small cash holdings.

The positive Stock Selection effect was broad-based with the Strategy’s holdings outperforming those of the benchmark in seven sectors, lagging in one sector, and in line in three sectors. The strongest relative performance came in the Industrials, Consumer Discretionary, and Health Care sectors while Information Technology was the lone sector with significant underperformance.

In the Industrials sector, five of the ten stocks owned by the Strategy during the quarter were up more than 20%. The Strategy lagged a little in this sector in the fourth quarter, but solid earnings from companies like Covanta and Astec, fueled a rally this quarter.

Strength in the Consumer Discretionary sector was driven by strong performance from both Winnebago and Marriott Vacations Worldwide. Both stocks gained about 30% after weak Q4 stock price performance. Solid earnings results seemed to calm worried investors.

A more than 30% gain in nursing home operator Ensign Group drove outperformance in the Healthcare sector. It was also one of the Strategy’s better stocks in Q4 and we discuss its strength below.

The Technology sector was the only one which was a meaningful detractor to Strategy performance. It was also the strongest sector in the index with a 19.6% gain in the quarter. Small gains and small losses in Hackett Group, Dolby Labs, TiVo, and Perspecta created the shortfall relative to the benchmark.

During the quarter, the Strategy initiated two new positions (Perspecta Inc. and James River Group), eliminated two holdings (John B. Sanfilippo & Son and Hanmi Financial), and had two stocks converted into other companies (State Bank Financial acquired for stock by Cadence Bancorporation and Guaranty Bancorp acquired for stock by Independent Bank Group).

Leading Contributors

Nexstar Media Group (NXST) is one of the largest owners of television broadcasting stations. Shares performed well in the quarter after falling sharply at year-end. Nexstar has been reporting solid results over the last year as it took out cost from and integrated operations acquired from Media General. In addition, political advertising was very strong in the fourth quarter and helped to drive upside. It was also able to make significant progress toward completing the conditions necessary to close its acquisition of Tribune Media stations. The Tribune deal should be nicely accretive to earnings over time.

Ensign Group (ENSG) is a provider of healthcare services in the traditional skilled nursing, assisted & independent living, and home health and hospice markets. This stock has been a top contributor a few times over the past year as Ensign recovered from a bad acquisition that depressed results for much of 2017. Since then, it has returned to its strategy of providing superior level of service within its facilities while acquiring and fixing struggling skilled nursing operations.  The latter has provided a nice avenue of growth as these properties stabilize and has helped the company beat consensus estimates over the last few quarters. The near-term outlook remains solid for the company. /p>

OUTFRONT Media (OUT) is a Real Estate Investment Trust (REIT) that is one of the leading providers of advertising space on out-of-home structures in the form of billboards and transit displays.  The company produced a very good quarter posting double-digit revenue growth on strength in both national and local advertising.  The company started to receive benefits from recent transit wins (San Francisco BART and Boston MTA) while continuing to refresh advertising on New York City’s transit system.  This effort will start to generate benefits in 2020 and beyond.    Near-term outlook is very favorable as management noted that the positive advertising trends have carried over into the start of the year.

Leading Detractors

Columbia Banking System (COLB) is a community bank headquartered in Tacoma, Washington and serving the larger Pacific Northwest region. Its shares retreated a little in the first quarter after it reported slightly disappointing earnings. While most drivers of earnings were good, expenses were higher than expected. Furthermore, management indicated that trend may continue as the company will be investing to retool its online presence and expand its digital offerings. This led to downward revisions in earnings estimates on a stock that already enjoyed a premium valuation.

Matthews International (MATW) is a leading provider of advertising collateral, funeral products, and industrial printing solutions.  The stock fell last quarter after the company reported quarterly results that failed to match expectations. Results were particularly weak in its Brand Solutions unit, due to a delay in the timing of certain client projects, along with the announcement of the loss of some photo studio business from one customer.  Management reaffirmed its full-year guidance for 2019, largely because that photo studio business loss had been contemplated in guidance. However, the news surprised investors, who had not realized that earnings guidance had taken into account that loss.  Matthews’ other two business segments, Memorialization and Industrial, both performed well.  Shares remain inexpensive, particularly given the earnings growth that analysts forecast for 2019 and 2020.

Virtu Financial (VIRT) is one of the largest independent market-makers in stocks, bonds, and commodities. In characterizing this as a detractor, we are stretching a little here because the position only cost the Strategy one basis point despite the fact that VIRT fell about 6% in the quarter. The stock retreated on slowing market volumes and falling falling market volatility, but some well-timed trims of the position reduced the impact.


As we look ahead, we believe the economy will continue to muddle along. The resolution of trade disputes should resolve some uncertainty, but unemployment is very low and the stimulative impact of the 2017 tax cuts should begin to fade. In addition, a stronger dollar and higher energy prices are slight headwinds as well.

It seems to us that a slow, steady-growth environment, combined with stable low interest rates, and above average valuations suggests only modest market returns. We also believe we are entering a great period for dividend-paying stocks and a good environment for differentiated returns from stock selection. Value should begin to outperform growth.

In conclusion, thank you for your investment in the Small Cap Dividend Value Strategy. We will continue to work hard to justify your confidence and trust.