John Keeley Jr.: Seasoned Value Seeker

WHAT MAKES US DIFFERENT IS WHERE WE LOOK."That's the way John Keeley Jr. explains his firm's distinctive approach to stock-picking, and its excellent returns.

The 15-year-old Keeley Small Cap Value Fund (KSCVX) searches for little-known companies going through restructurings or spinoffs, trading at significant discounts and not included in popular indexes.

Such stocks, many of them operating in unusual circumstances, are likely to be under-followed by Wall Street. And spinoffs in particular frequently end up getting acquired.

One recent example: Keeley Small Cap Value's largest holding, metallurgical coal maker Alpha Natural Resources (ANR), spun out of Pittston Coal in 2002, is being taken over for $10 billion by Cleveland-Cliffs (CLF). The shares are up 206% this year.

KEELEY'S METHODS CLEARLY have merit. Small Cap Value returned 4.95% for the 12 months ending Aug. 6, beating the Standard & Poor's 500 by 15.26 percentage points. Over three years, the fund has averaged 11.82% a year, trampling the benchmark by 8.15 percentage points. Its five-year numbers are even better: The fund has typically posted a 19.99% annual gain, 12.08 percentage points ahead of the S&P 500. The Small Cap Value Fund beat 98% of its peers in the one-year and three-year periods ending Aug. 6, and 99% of them over the five-year period.

"With more than $7 billion under management, it is not a one-man band anymore," says Keeley, 68, who got his B.A. at Notre Dame and his M.B.A. at the University of Chicago. He created Keeley Asset Management in 1982 with the aim of managing money for high-net-worth individuals and institutions. As recently as 2000, it had just $340 million. Today, it handles $11 billion.

Keeley's sons, Mark, 45, and John, 47, went to work for him in 2002, and Kevin, 41, came on board in 2005; they've since been joined by several senior managers and analysts. Dick Kindig, 72, an energy researcher, came out of retirement three years ago ("I was getting under my wife's feet") and reports to research head Robert Becker, 66. Mark Zahorik, 46, covers financials and David Woodyatt, 65, focuses on health care. Brian Leonard, 29, tracks utilities, while John Keeley Jr.'s nephew Brian, 38, works on transportation and industrial stocks, which are now among the fund's chief holdings.

Small Cap Value, which carries a stiff 4.5% front-end load and an expense ratio of 1.33%, holds a total of about 180 stocks. It is low on technology, media and telecom offerings, and stays away from big, concentrated bets. Since it doesn't automatically boot out any stock based on a market-capitalization threshold, the average market valuation has grown to $2.5 billion, which is on the high end for the small-cap blend category. Turnover is a modest 18%, since the fund keeps most stocks four to five years.

RIGHT NOW, THE AILING U.S. economy may provide some interesting bankruptcy plays, according to Keeley's analysts and portfolio managers.

"Bankruptcies are great, because a company has to tell the judge what it is going to do over the next five years -- and it is impossible to get that information any other way," says researcher Becker. Financials hold the most promise, but right now too many have such opaque balance sheets that they don't make Keeley's cut.

"We are not looking to go into controversial situations," Keeley says. "In the example of bankruptcy, we wait until it is all adjudicated, so that we can see what we actually get."

The goal is to cut as much risk as possible by keeping a sharp eye on metrics, such as return on equity and sales per share. The firm doesn't keep hard and fast benchmarks for these figures because they can be so variable in the midst of a spinoff or restructuring. However, academic studies support the idea that spinoffs tend to outperform, and once the entities are off on their own, they're more transparent to outside analysts and portfolio managers.

One area of recent interest to Keeley and his team is savings-and-loan and insurance conversions, since they allow the Small Cap Value Fund to buy a new stock without an underwriter. They bought Home Federal Bancorp (HOME), a Nampa, Idaho-based former mutual savings-and-loan that just completed a conversion in December 2007 at $10.

"The proceeds of the conversion give Home an equity-to-assets ratio over 27%, among the highest in the country," according to Zahorik, who doesn't rule out that the company will be acquired at two times book value, or 23.50 per share, after three years. It recently was at 10.80.

"While many community banks and thrifts are thinly capitalized, Home is heavily overcapitalized, yet still trades at just 87% of tangible book," Zahorik says. "In late December, Home will be permitted to deploy capital in the form of stock buybacks. Given the high level of excess capital, these buybacks could be substantial." Earnings estimates are 24 cents a share for this fiscal year, and 26 cents a share in 2009.

IN APRIL, KEELEY PICKED up Batesville, Ind.-based Hill-Rom Holdings (HRC), formerly Hillenbrand Industries, in the mid-20s following a spinoff and renaming. Hill-Rom manufactures and provides technologies and related services for the health-care industry, including patient-support systems like multipurpose beds that can also be used as chairs and as transportation. Earnings estimates are $1.25 a share for this fiscal year and $1.47 for the next.