To Our Shareholders,
For the quarter ended June 30, 2016, the net asset value (“NAV”) per Class AAA Share of The Gabelli Asset Fund increased 3.3% compared with an increase of 2.5% for the Standard & Poor’s (“S&P”) 500 Index. See page 2 for additional performance information.
Keep Calm and Carry On
Annualizing the S&P 500’s first half return of 3.8% would suggest 2016 is shaping up to be a solid if not average year. Even casual market observers would note however that it has been anything but boring. We began 2016 with two dates circled: June 23 – the date of the British referendum to leave the European Union (EU) – and November 8 – the date of U.S. elections. To the surprise of many bettors, Britain did in fact vote to leave the EU, the so-called “Brexit,” setting off a 10%+ decline in the British pound versus the dollar and losses in bourses around the world as economists forecast a recession in the UK and possibly elsewhere.
With 2015 GDP of $2.8 trillion, the UK is the fifth largest economy in the world (though roughly only the size of California) and an important trading partner for the U.S. and the EU. We have little doubt that will remain the case outside the EU. Indeed, after a period of adjustment and negotiation with the EU, there is a strong argument that a sovereign UK could be better off not just politically but economically; the rebound in UK stock averages to above pre-Brexit levels would indicate as much. There will be winners (exporters helped by a weaker pound) and losers (the financial sector with the potential loss of frictionless access to the common market) among not just British corporations but countries as well.
Much of the concern surrounding Brexit is for its unintended consequences for the continent and global trade. Already there is a race to determine which country will hold a referendum to leave the EU next (or at least a race to name those campaigns) with “Frexit,” “Quitaly,” “Outstria,” “Departugal,” “Beljump” and “Czech-out” already discussed. In reality very few EU members possess both the constitutional mechanism and motivation to leave. The EU is likely to remain intact but its complexion without the Anglicizing force of the UK will certainly change as Germany will shoulder an ever greater portion of the burden of immigration and the poor financial state of the periphery.
Whether Brexit is representative of a global “anti-global” wave and hurts or helps the populist/outsider campaign of presumptive Republican nominee Donald Trump is another open question. The campaigns in the U.S. are likely to reinforce why summer has long been known as the political “silly season.” We are braced for more surprises. Given Brexit’s come from behind win, the market is unlikely to fully discount any particular outcome in November, ensuring continued market volatility. We may or may not have a better sense of the future political landscape by the next quarterly update.
In the face of global uncertainty, we remain focused on bottom-up fundamental stock picking. That is not to say stock selection takes place in a vacuum. Rather we gather and array macro observations that we use to inform our micro analysis of discrete businesses. We combine these with insights into industry dynamics, including possible policy outcomes (e.g. Obamacare, defense spending, Federal Communications Commission decisions, Dodd-Frank financial regulation) to arrive at ranges of earnings and valuations and possible catalysts for companies within our global coverage. We tend to gravitate toward firms with sustainable competitive moats and predictable and/or recurring cash flows. In each case however, we seek an appropriate discount to Private Market Value and Catalyst before purchase.
Deals, Deals and More Deals
Deal activity rebounded from a slow first quarter as announced U.S. M&A increased 44% year-on-year to $222 billion. Several industries within our core competency saw evidence of ongoing consolidation. One of the most active areas was consumer staples, where Mondelez (0.7% of net assets as of June 30, 2016) disclosed an unsolicited offer for Hershey, and Post (0.4%) was said to be in talks to acquire ConAgra’s (0.7%) Lamb Weston unit. Notably, after the quarter and after Brexit, Danone (0.6%) agreed to acquire health and wellness company WhiteWave Foods (0.1%), itself the product of financial engineering in 2013. John Malone continued his prolific financial engineering during the quarter as Liberty Media separated into three tracker stocks: Liberty SiriusXM (0.5%), representing a 64% stake in SiriusXM radio; Liberty Braves (0.1%), representing ownership of the Atlanta Braves baseball club and related real estate; and Liberty Media (0.1%), accounting for a variety of public and private assets including a 35% stake in Live Nation Entertainment (0.3%).
Dr. Malone was also involved on both sides of Lionsgate’s long anticipated Q2 agreement to purchase premium cable network Starz (0.1%), with the combined company likely to serve as a platform for additional consolidation within the content area.
Brexit and other political uncertainties may dampen large cross-border in the near term. However, domestic deals are unlikely to be impacted and certain acquirers may find their currency goes further in certain countries. The underpinnings of what we have termed the Fifth Wave of M&A - cheap financing and scarce organic growth opportunities - remain intact and are unlikely to change.
Investment Scorecard
As might be expected in a tumultuous quarter, consumer staples names performed particularly well with General Mills (1.3% of net assets as of June 30, 2016) (+13%), Energizer (0.6%) (+28%), Swedish Match (1.3%) (+10%) and Mondelez (+14%) among the top contributors. Domestic oriented, stable cash generators Waste Management (1.0%) (+13%), Republic Services (1.2%) (+8%) and Rollins (1.0%) (+8%) also performed strongly. The Fund’s holdings in safe haven gold miners Newmont Mining (0.8%) (+48%), Royal Gold (0.4%) (+41%) and Barrick Gold (0.2%) (+64) continued their sharp ascent.
Brexit negatively impacted performance through holdings with large UK exposures such as Liberty Global (0.7%) (-12%), Discovery Communications (0.7%) (-12%) and Twenty-First Century Fox (2.2%) (-3%). While a UK recession could reduce advertising spending for Discovery and Fox, their affiliate fees and the broadband and pay-TV subscription businesses of Liberty Global should be resilient. Economically sensitive industrial firms Ametek (1.7%) (-8%), BorgWarner (0.2%) (-28%), Dana (0.2%) (-25%) and Navistar (0.2%) (-17%) were a drag on performance. Finally, we await Alere’s (0.3%) (-18%) issuance of 2015 financials which should allow it to consummate its announced purchase by Abbott Labs.
Let’s Talk Stocks
The following are stock specifics on selected holdings of our 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 share prices are listed first in United States dollars (USD) and second in the local currency, where applicable, and are presented as of June 30, 2016.
Bank of New York Mellon Corp. (BK, Financial) (1.0% of net assets as of June 30, 2016) (BK – $38.85 – NYSE) is a global leader in providing financial services to institutions and individuals. The company operates in more than one hundred markets worldwide and strives to be the global provider of choice for investment management and investment services. As of March 31, 2016, the firm had $29.1 trillion in assets under custody and $1.6 trillion in assets under management. Going forward, we expect BK to benefit from rising global incomes and the cross border movement of financial transactions. BK is also well positioned to grow earnings in a rising interest rate environment, given its large customer cash deposits and significant loan book.
Brown-Forman Corp. (BF.A, Financial)(2.4%) (BF/A – $108.03 – NYSE; BF/B – $99.76 – NYSE) is a leading global distilled spirits producer. Spirits is an advantaged category that enjoys high margins, low capital requirements, strong free cash flow generation and good pricing power. The company’s global brands include Jack Daniel’s Tennessee whiskey, Finlandia vodka, Woodford Reserve bourbon, and el Jimador and Herradura tequilas. Jack Daniel’s is one of the world’s most valuable spirits brands, enjoying strong growth both in the U.S. and internationally as consumers increasingly choose to drink American whiskies. The company has also successfully expanded the brand into the fast growing flavored whiskey category. While Brown-Forman does face some near term headwinds from negative foreign currency exposure (over half of sales come from outside the U.S.), the company is positioned to grow revenues and profits substantially over the next several years, and has significant balance sheet flexibility. While the company is family controlled, we believe that if it ever became available for sale it would be highly coveted by other large global spirits players.
Edgewell Personal Care Co. (EPC, Financial) (1.4%) (EPC – $84.41 – NYSE) based in St. Louis, Missouri, is the personal care division of Energizer Holdings, which split its personal care and household products divisions on July 1, 2015. Edgewell generates approximately $2.3 billion of revenue through its principal businesses: wet shaving, including Schick-branded razors and blades, Edge and Skintimate shaving preparation and private label shaving products; sun care, including the Banana Boat and Hawaiian Tropic brands; feminine care, including Playtex and o.b. tampons and Carefree and Stayfree liners and pads; and infant care, utilizing the Playtex and Diaper Genie brands. As a pure-play personal care company, Edgewell competes in high-margin, attractive categories with leading brands. We expect management to focus on improving margins through product mix, restructuring savings and operating leverage, which should afford it flexibility to reinvest in growth opportunities. The company has approximately $1.2 billion of net debt providing management with sufficient flexibility to invest in internal growth, make acquisitions and/or repurchase shares. EPC is a likely acquisition target as a multinational competitor with a strong international infrastructure would benefit from scale, cost synergies, and the opportunity to accelerate international expansion.
Flowserve Corp. (FLS, Financial) (1.0%) (FLS – $45.17 – NYSE) is one of the largest global pump companies, serving the petroleum, chemical, and power industries. The company’s products include engineered and industrial pumps, automated and control valves, actuators, and seals. About 40% of FLS revenues are derived from the oil and gas industry, and should benefit from the refurbishment of the aging refineries in developed countries and the first time build out of the infrastructure in developing nations around the world. Further, oil companies are bringing up dirtier, heavier, and harder to access crude from thousands of feet below ground, as the cleaner, lighter, and easier to obtain crude that is closer to the surface is depleted. This demands more highly engineered pumps, valves, and seals that can work under very high pressure, high temperature, or underwater, boding well for FLS products.
Madison Square Garden Co. (MSG, Financial) (0.9%) (MSG – $$172.51 – NYSE) is an integrated sports and entertainment company that owns the New York Knicks, the New York Rangers, the Radio City Christmas Spectacular, The Forum, and that iconic New York venue, Madison Square Garden. These evergreen content and venue assets benefit from sustainable barriers to entry and long term secular growth. MSG completed the separation of its associated regional sports networks in September 2015, leaving a reliable cash flow stream for MSG to reinvest and repurchase shares.
McKesson Corp. (MCK, Financial) (0.1%) (MCK – $186.65 – NYSE) is one of the three largest drug wholesalers in the world and has been expanding aggressively outside the U.S. through the acquisition of Celesio and several other European companies. McKesson recently announced an innovative divestiture of its information technology businesses; it will merge it with privately owned Change Healthcare and the combined company will go public next year. In its core wholesaling business, the company has stabilized its performance after several contract losses, recently signing a large new contract with Walmart. McKesson retains a balanced capital return policy that invests first in its core business but then returns a significant amount of cash to shareholders via dividends and share repurchases, which has helped the company post superior long term growth and returns.
Rollins Inc. (ROL, Financial) (1.0%) (ROL – $29.27 – NYSE) provides pest control services to nearly two million residential and commercial customers throughout North America primarily under the Orkin and Western Pest brand names. Its services are critical to homeowners and commercial establishments alike, in both expansionary and recessionary times. The company has benefited from growth in the commercial service area and mosquito and bed bug treatments. At the same time, the company has controlled costs through more efficient scheduling and routing. Rollins has been taking advantage of its strong balance sheet to make tuck-in acquisitions. It has also begun franchising more operations outside the U.S. Founded in 1901, Rollins is majority owned by members of the Rollins family.
Ryman Hospitality Properties Inc. (RHP, Financial) (0.2%) (RHP – $50.65 – NYSE) is a Nashville, Tennessee based REIT that owns convention hotels in Nashville, Tennessee; Orlando, Florida; Dallas, Texas; and Washington, D.C. Other assets include the iconic Opryland, the famous Ryman Auditorium, the General Jackson Showboat, and Nashville based radio station WSM-AM. With property manager Marriot’s operational issues resolved, the team is focused on taking advantage of strong convention bookings trends, seeking to drive margin expansion by increasing occupancy and room rates. Finally, as the leading country music entertainment brand, the potential monetization and spin-off of the Entertainment assets, including the Grand Ole Opry, also remains a significant catalyst for RHP shares.
Sony Corp. (SNE, Financial) (1.0%) (SNE – $29.35 – NYSE) is a diversified electronics and entertainment company based in Tokyo, Japan. The company manufactures televisions, PlayStation game consoles, mobile phone handsets, and cameras. It also operates the Columbia film studio and Sony Music entertainment group. We expect the new PlayStation launch and operational improvements in consumer electronics and entertainment to generate EBITDA growth through 2017. We also think the spinoff of the entertainment assets could be a catalyst.
Twenty-First Century Fox Inc. (FOXA, Financial) (2.1%) (FOXA – $27.05 – NASDAQ), (0.1%) (FOX – $27.25 – NASDAQ) is a diversified media company with operations in cable network television, television broadcasting, filmed entertainment, and direct broadcast satellite television. Cable networks account for 70% of the company’s EBITDA, and benefit from contractually recurring affiliate fees and exposure to the fast growing global pay television market. We also expect the company to benefit from rising demand for premium content, driven by emerging distribution platforms such as Netflix, retransmission revenue, and aggressive share repurchases.
Waste Management Inc. (WM, Financial) (1.0%) (WM – $66.27 – NYSE) is the largest non-hazardous waste collection and disposal company in the United States. The company collects waste for commercial, industrial, municipal, and residential customers throughout the United States, and operates 249 landfills, 297 transfer stations, 104 recycling facilities, and 122 landfill gas-to-energy facilities. WM has focused on improving profitability by increasing return on capital and cash flow at each of its operations, through cost cutting and price increases. In addition, the company is looking for new environmentally friendly ways to increase returns from garbage, such as landfill gas. The company has a history of returning its strong cash flow to shareholders, both through dividends and its large share repurchase program.
Xylem Inc. (XYL, Financial) (1.2%) (XYL – $44.65 – NYSE) is a global leader in the design, manufacturing, and application of highly engineered technologies for the transportation, treatment, and testing of water. The company is expected to benefit from favorable long term fundamentals in the water industry, driven by scarcity, population growth, aging of the infrastructure, and the need to improve water quality. Further, with a large installed base of pumps and systems, the company is well positioned to increase aftermarket revenue, which currently represents roughly 40% of total revenues. Xylem’s attractive business mix also generates strong cash flow, which is expected to support acquisitions across geographies and end markets and increase returns to shareholders. XYL is expected to generate 8%-12% earnings per share growth through 2020 as it accelerates its capital deployment strategy globally.
Conclusion
Notwithstanding what seems like a steady stream of crises and an inordinate number of unusual events, we have experienced more trying times in even the recent past – hot wars, terror attacks, and the disintegration of the Soviet Union. The departure of the UK, which has always retained its own currency, from what was essentially a trade confederacy is unlikely to alter the course of global history. We remain primed for further change. Eventually the current economic expansion will end, but for the moment the U.S. consumer appears robust and corporate profits solid, albeit not growing. Central banks around the world, including the U.S. Federal Reserve, continue to be accommodative. Against this dichotomous backdrop of volatile markets and placid fundamentals, we continue to find opportunities.
July 13, 2016
