To Our Shareholders,
For the quarter ended June 30, 2014, the net asset value (“NAV”) per Class AAA Share of The Gabelli Equity Income Fund increased 4.6% compared with an increase of 5.2% for the Standard & Poor’s (“S&P”) 500 Index. See page 2 for additional performance information.
The Quarter in Review
The second quarter of 2014 saw stocks rise once again, adding to the modest gains of the first quarter. The bull market we have been experiencing since March of 2009 has now been going on for sixty-three months, and the S&P 500 has almost tripled in that time. Some might say that those impressive gains are a sign that the market has gone up too far, too fast. However, we think it is more indicative of just how oversold the stock market was during the depths of the great recession. Our economy has been dealing with many problems, not the least of which is polarization in Washington. Although we still have political bickering in the capital, the budget deficit is finally starting to come down, and we no longer need to worry about issues such as a government shutdown. We are hopeful, although not convinced, that the Federal government will do a better job of promoting economic growth in our economy.
The housing market, which collapsed a few years ago during the great recession, has been making a steady comeback. We are starting to see home prices rise across the country and more homes are being built. The construction industry is a major employer, and as the U.S. continues to build more homes in the next few years, as we believe it will, unemployment levels will continue to decrease. We still are not building enough new homes to meet the demands of population growth and new household formation, and we feel the housing recovery will continue for many years to come.
Another bright spot for the economy continues to be the energy sector. In fact, we believe that “fracking” is truly a game changer, and that the U.S. is well on its way to becoming energy independent in the next few years. We already have very low natural gas prices here in North America as a result of fracking, and our energy prices should stay low versus the rest of the world for the foreseeable future. This competitive advantage in energy is a major plus for our manufacturing sector as well, especially for heavy users of energy such as the chemical industry. We are in the camp that believes the U.S. is now in the midst of a manufacturing renaissance - good news for our overall economy.
Along with the improving economy comes less need for monetary easing by the Federal Reserve. The markets, both equity and fixed income, have benefited from QE3, but we are finally nearing the end of QE3 and we expect the program to conclude before the end of the year. Sometime in the first half of 2015, we expect the Fed will start to move short term interest rates up, in a slow, measured manner.
Despite the very impressive performance of the stock market over the past few years, the retail investor has not been adding any meaningful new assets to the stock market. Only in the past year or so have retail flows in domestic stock mutual funds started to turn positive after many years of outflows. For the first six months of this year, domestic equity mutual fund sales have totaled a mere +$2.6 billion. By comparison, international equity flows have been +$55 billion, and fixed income funds flows have been +$49 billion. Although the retail investor may still be somewhat shell-shocked from the financial crisis of a few years ago, corporate America has been a very aggressive buyer of stock over the past few years through buyback programs.
Dividends are an important element in the historical returns of stocks. They provide current income and a growing income stream over time. In the second quarter of 2014, U.S. companies increased their actual cash payments by $12.6 billion, according to Standard & Poor’s, and the number of companies that increased their dividends was the largest since 1979. There is plenty of room to grow dividends in the future as well. Standard & Poor’s also states that the current dividend payout ratio is about 35%, well below the eighty year median of about 50%. Over the last fifty years, dividend growth has averaged 6%, almost double the rate of inflation.
Corporate America continues to return capital back to shareholders in the form of dividends. Not only are more dividends being paid, but the number of companies paying a dividend continues to increase. At the end of the second quarter, 422 of the companies in the S&P 500 paid a dividend, a level not seen since 1999. All thirty members of the Dow Jones Industrial Average pay a dividend. We believe that, over the next few years, dividends will continue to grow at well above the inflation rate, as has been the case historically.
During the second quarter, the S&P 500 was up about 5% on a total return basis, with all ten sectors of the index up. The three best performing sectors were energy, utilities, and technology, each up more than the S&P 500 itself. It is interesting to note that each of these three sectors underperformed the S&P 500 in 2013. The two worst performing sectors in the second quarter of 2014 were financials and discretionary and, again, it is interesting to note that both of these two sectors outperformed the S&P 500 in 2013.
Among the best performing stocks in the portfolio during the second quarter was Hillshire Brands (HSH) (0.6% of net assets as of June 30, 2014), the maker of Jimmy Dean sausage and other products, which is in the process of being taken over by Tyson Foods (TSN) (less than 0.1%). Another one of our holdings, Covidien plc (COV) (0.9%), also did very well in the quarter, as it too is being taken over by a suitor. Other top performers include energy related companies such as Halliburton (HAL) (0.8%), ConocoPhillips (COP) (0.5%), and Weatherford (WFT) (1.2%).
A few of the worst performing stocks during the quarter included JPMorgan (JPM) (0.5%), which announced that its trading business would be soft during the quarter. Another underperformer was Pfizer (PFE) (1.3%), which was trying to merge with another pharmaceutical company, AstraZeneca, but dropped the effort after AstraZeneca’s board rejected Pfizer’s offer.
Let’s Talk Stocks
The following are stock specifics on selected holdings of the Fund. Favorable earnings prospects do not necessarily translate into higher stock prices, but they do express a positive trend that we believe will develop over time. Individual securities mentioned are not necessarily representative of the entire portfolio. For the following holdings, the percentage of net assets and their share prices are presented as of June 30, 2014.
The Bank of New York Mellon Corp. (BK) (1.3% of net assets as of June 30, 2014) (BK - $37.48 - NYSE) is a global leader in providing financial services to institutions and individuals. The company operates in over one hundred markets worldwide and strives to be the global provider of choice for investment management and investment services. As of December 31, 2013, the firm had $27.6 trillion in assets under custody and $1.6 trillion in assets under management. Going forward, we expect BNY Mellon to benefit from rising global incomes and the cross border movement of financial transactions.
Genuine Parts Co. (GPC) (1.5%) (GPC - $87.80 - NYSE) is an Atlanta based distributor of automotive and industrial replacement parts, office products, and electrical and electronic components. We expect GPC’s well known NAPA Auto Parts group to benefit as an aged vehicle population, which includes the highest percentage of off warranty vehicles in history, helps drive sales of automotive aftermarket products over the next several years. Additionally, economic indicators remain supportive of the company’s industrial and electrical parts distribution businesses amid steady economic expansion. Finally, GPC’s management has shown consistent dedication to shareholder value via share repurchases and dividend increases.
Legg Mason Inc. (LM) (0.8%) (LM - $51.31 - NYSE) is a consortium of investment managers, known as affiliates, that operate under separate brand names, including Royce & Associates in small cap, Western Asset Management in fixed income, Legg Mason Capital in value equities, and Batterymarch Financial in quantitative strategies. As of May 2014, the firm had approximately $685 billion in assets under management. The company has been turning around investment performance while improving operating fundamentals. Using free cash flow, the company continues to retire shares under its $1 billion+ authorization.
Mondelez International Inc. (MDLZ) (1.3%) (MDLZ - $37.61 - NASDAQ), headquartered in Deerfield, Illinois, is the new name of Kraft Foods Inc. following the tax-free spinoff to shareholders of the North American grocery company, Kraft Foods Group Inc. (KRFT). On October 1, 2012, shareholders received one share of Mondelēz and one- third share of Kraft Foods Group for every share of Kraft Foods Inc. owned. Post spinoff, approximately 75% of Mondelēz’s revenue is generated from the snacking business, which includes leading brands such as Oreo, LU and Ritz biscuits, Trident gum, and Cadbury and Milka chocolates, while the remaining 25% consists of the international packaged food business, primarily coffee and powdered beverages. In May 2014, Mondelēz announced that it is combining its coffee business with D.E Master Blenders 1753 to form a new coffee company, Jacobs Douwe Egberts, in return for $5 billion of net proceeds and a 49% stake. This narrows the company’s product focus, as only 15% of revenue will be outside snacks, primarily Tang beverages and other products such as Philadelphia cream cheese, which management may look to divest in the future as it executes on its plan to accelerate growth in the faster growing snack business, building upon its international scale and improving margins.
National Fuel Gas Co. (NFG) (0.8%) (NFG - $78.30 - NYSE) is a diversified natural gas company. NFG owns a regulated gas utility serving the region around Buffalo, New York, gas pipelines that move gas between the Midwest and Canada and from the Marcellus to the Northeast, and an oil and gas exploration and production business. NFG’s regulated utility and pipeline businesses, as well as its California oil production business, provide stable earnings and cash flows to support the dividend, while the natural gas production business offers significant upside potential. NFG’s ownership of 800,000 acres in the Marcellus shale, including 745,000 acres in the shale fairway of Pennsylvania, holds enormous natural gas reserve potential, and we believe the position could be worth $3.4 billion based on recent comparable transactions. We continue to expect above- average long term earnings and cash flow growth from rapidly growing gas production and expansion of the strategically located pipeline network. The company has increased its dividend for over forty consecutive years.
Swedish Match AB (OSTO:SWMA) (1.5%) (SWMA - $34.72 - Stockholm Stock Exchange) produces tobacco products that include snus and snuff, chewing tobacco, cigars, and lights. The company has been benefiting from the growth of the smokeless tobacco market in both Scandinavia and the U.S., as public smoking bans and health concerns are driving consumers to seek alternative tobacco products to cigarettes. In February 2009, Swedish Match created a joint venture with Philip Morris International to sell Swedish snus in markets around the world, taking advantage of Swedish Match’s brands and production capabilities and Philip Morris International’s distribution network. In September 2009, the company sold its South African pipe tobacco business to Philip Morris International for about 1.9 billion SEK, and it is using most of the proceeds to repurchase shares. In October 2010, Swedish Match combined its European and premium cigar portfolios with Scandinavian cigar and pipe tobacco company STG, creating a new company that will benefit from enhanced scale and synergies. The company’s standstill with STG expires in October 2014, after which Swedish Match may opportunistically monetize this asset. As a more focused company, we expect Swedish Match to grow sales and earnings over time as the smokeless tobacco category continues to develop.
Verizon Communications Inc. (VZ) (0.7%) (VZ - $48.93 - NYSE) is one of the world’s leading telecommunications services companies. On February 21, 2014, VZ completed the acquisition of Vodafone’s (0.2%) 45% indirect interest in Verizon Wireless, which was valued at approximately $130 billion. The deal is expected to be immediately accretive to Verizon’s earnings per share by approximately 10%, excluding any non-operating adjustments. Verizon Wireless (VZW) is the largest mobile operator in the U.S. with 103 million retail customers. Verizon expects this transaction to enhance value across platforms and allow the company to operate more efficiently, with continued focus on producing more seamless and integrated products/solutions for its customers. Management believes that full ownership of Verizon Wireless will provide increased opportunities in the enterprise and consumer wireline markets. In April 2014, VZ reported stronger than expected first quarter of 2014 consolidated revenues and EBITDA (driven by wireless outperformance) and reiterated its guidance for top line growth of 4% and adjusted consolidated EBITDA margin expansion in 2014.
Viacom Inc. (VIA) (0.9%) (VIA - $86.75 - NASDAQ) is a pure-play content company that owns a global stable of cable networks, including MTV, Nickelodeon, VH1, BET, and the Paramount movie studio. Viacom’s cable networks generate revenue from advertising sales, fixed monthly subscriber fees, and ancillary revenue from toy licensing, etc. The company benefited from a cyclical rebound in advertising and a shift in audience from broadcast networks to cable. Paramount has posted a series of box office successes, with franchises such as Star Trek, Iron Man, and Transformers. Supported by its strong results and outlook, the company expects to repurchase $6.5 billion of stock over the next two years.
Weatherford International Ltd. (WFT) (1.2%) (WFT - $23.00 - NYSE), based in Houston, Texas, finally resolved its tax accounting problems and various government investigations, which had been on-going for several years. It is now focused on growing its core businesses, enhancing profitability, reducing leverage and improving capital efficiency. The company is targeting total segment operating profit margin to reach 20% by 2016 from 11.3% in 2013 and reducing debt to capitalization from 52% to 25%. It aims to realize $500 million in annualized cost savings and sell four non-core businesses. Also, Weatherford plans to spin off a portion of its international drilling rig business by the end of 2014 or early 2015. All available free cash flow generated and proceeds from asset sales will be used to reduce debt.
Wells Fargo & Co. (WFC) (1.7%) (WFC - $52.56 - NYSE) is a diversified financial services company. Headquartered in San Francisco, California, the firm provides banking, insurance, investments, mortgage, and consumer and commercial finance through more than 9,000 stores and 12,000 ATMs. Wells Fargo serves one in three households in America, and as of December 31, 2013, it had $1.5 trillion in customer assets. Longer term, we expect Wells Fargo to continue to grow market share of domestic deposits due to its strong brand and diversified product base.
While change is constant, the fundamental underpinnings of common stock value investing remain unchanged. Our stock selection process is based on the investment principles first articulated in 1934 by the fathers of security analysis, Benjamin Graham and David Dodd. Their work provided the framework for value investing. Our firm contributed to the academic and empirical research on value investing by introducing the concept of Private Market Value (PMV) with a Catalyst™. This is our proprietary research methodology that focuses on individual stock selection by identifying stocks of firms selling at a discount to intrinsic value per share with a reasonable probability of realizing their PMVs. We define PMV as the price a strategic acquirer would likely be willing to pay for the entire enterprise. Catalysts are specific events or circumstances with varying time horizons that can trigger a narrowing of the difference between the market price of a stock and its estimated PMV per share. Price appreciation can occur instantly, as in the case in an announced takeover, or more gradually over time. There are a variety of catalysts that can cause change. Some general categories include: company specific, industry, regulatory, demographic, political, and economic.
We continue to find good value in many companies that have some combination of long term growth prospects, strong cash flow generation, and good balance sheets as well as shareholder-friendly management teams. We thank you for your investment in the Fund, and we look forward to serving you in the future.
July 8, 2014
Note: The views expressed in this Shareholder Commentary reflect those of the Portfolio Manager only through the end of the period stated in this Shareholder Commentary. The Portfolio Manager’s views are subject to change at any time based on market and other conditions. The information in this Portfolio Manager’s Shareholder Commentary represents the opinions of the individual Portfolio Manager and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. Views expressed are those of the Portfolio Manager and may differ from those of other portfolio managers or of the Firm as a whole. This Shareholder Commentary does not constitute an offer of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this Shareholder Commentary has been obtained from sources we believe to be reliable, but cannot be guaranteed.