Gabelli Dividend Growth Fund 2nd Quarter Commentary

Discussion of markets and holdings

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Aug 04, 2016
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To Our Shareholders,

For the quarter ended June 30, 2016, the net asset value (“NAV”) per Class AAA Share of The Gabelli Dividend Growth Fund increased 1.5% compared with the increase of 2.5% for the Standard & Poor’s (“S&P”) 500 Index. See page 2 for additional performance information.

Performance

The S&P 500 and Dow Jones Industrials market averages closed out the quarter with returns of 2.5% and 2.0% respectively.

The Gabelli Dividend Growth Fund rose 1.5% in the second quarter. Of the ten industry sectors in the S&P 500, seven rose. The strongest performer was the energy sector, which rose 11% as the price of a barrel of oil rose. The next highest returns were in the higher yielding sectors which are the most sensitive to the increased optimism over a more supportive Federal Reserve and lower rates, with the utility and telecommunications gaining 6%.

The top contributors to performance in the Fund in the second quarter were our positions in energy, including Halliburton (1.3% of net assets as of June 30, 2016) and Exxon Mobil (2.1%), and in healthcare, including Pfizer (3.8%), Medtronic (1.7%) and Bristol Meyers (1.3%). MondelÄ“z (2.1%), which made an offer to acquire Hershey that was quickly rejected, was also a top contributor. The contribution of a position to performance is a function of the position’s size and its gains in the quarter.

The S&P 500 dividends increased at a rate of 4.4% in the second quarter over the first. The dividend yield on the S&P 500, of 2.2%, is seventy basis points above the ten year Treasury bond yield of almost 1.5%, giving the choice of stocks over bonds an overwhelming relative, if not absolute, value.

The Economy and Markets

The second quarter began on a fairly firm note in the economy, with solid evidence that the U.S. labour market continues to improve, although at a low level. Employment gains continue to be steady at this low to moderate level, and there have been some gains in average hourly earnings. The final report on the first quarter GDP, delivered in the last week of June, showed the gross domestic product grew at a rate of 1.1% in the first quarter, following a pattern of disappointingly slow first quarters over the past few years.

Spending by consumers picked up in the second quarter, supported by solid growth in income and wage gains. However, weak household spending has been surprising over the past year as consumers had unanticipated extra cash from lower prices at the gas pump and for home heating bills, but failed to direct these savings elsewhere.

The economy expanded 2.4% in both 2014 and 2015. Prior to the Brexit vote, there was already consensus that 2016 would be a slower year, with estimates closer to 2%. This is now being revised down.

The Federal Reserve released the results of its stress test for big banks. These tests measure whether banks have enough capital and controls to survive a worst case scenario. All but one of the largest banks earned an unconditional passing grade in their preparedness to weather another financial crisis. The exception was Morgan Stanley (1.7% of net assets as of June 30, 2016), which also passed, but with conditions to be corrected. Now these banks, even Morgan Stanley, which are overcapitalized, will be able to launch and execute plans to return capital to shareholder in the form of higher dividends and share buybacks.

The balance sheets of the U.S. banks compare favourably to overseas banks, which still have hundreds of millions of dollars in non-performing loans. This has been reflected in the performance of the share prices of the foreign banks, with Barclays Bank, Royal Bank of Scotland, Deutsche Bank, and Credit Suisse, among others, all down by 55% to 65% in the twelve months ending June 30.

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.

Alphabet (GOOG, Financial) (3.4% of net assets as of June 30, 2016) (GOOG – $692.10 – NASDAQ, GOOGL – $703.53 – NASDAQ) is the parent company of Google, which is widely recognized as the world’s leading Internet search engine. Google’s stated mission is to organize the world’s information and make it universally accessible and useful. Google generates revenue by providing advertisers with the opportunity to deliver measurable, cost effective online advertising that is relevant to the information displayed on any given webpage. This makes the advertising useful to consumers as well as to the advertiser placing it. We believe this highly innovative and fast growing company is uniquely positioned to create new market opportunities while maintaining its lead in online search.

Halliburton Co. (HAL, Financial) (1.3%) (HAL – $45.29 – NYSE), based in Houston, Texas, is one of the leading providers of services and products to the energy industry related to the exploration, development, and production of oil and natural gas. With its merger with Baker Hughes blocked by the Department of Justice in May 2016, HAL is now refocusing its attention on cost savings and preparing for the eventual upturn in global exploration and production (E&P) capital budget spending. The company has targeted to reduce $1B in costs globally by the end of 2016. As the market leader in pressure pumping as well as completion equipment and services, HAL is well positioned to benefit from the recovery from higher oil prices and a pickup in drilling activity, first in North American land and followed by international land. With WTI crude prices near $50 per barrel, we expect E&P operators to begin to complete their inventory of drilled but uncompleted wells, followed by new drilling activity in the second half of 2016. Our Private Market Value for Halliburton is $55 per share.

Pfizer Inc. (PFE, Financial) (3.8%) (PFE – $29.64 – NYSE), headquartered in New York City, is one of the world’s largest research based pharmaceutical companies, with sales of $48.9 billion in 2015. The company’s drugs include the blockbusters Enbrel for autoimmune diseases, Lipitor for high cholesterol, Lyrica for pain, and Viagra for erectile dysfunction. The company’s late-stage pipeline includes drugs being developed to treat cancer, cardiovascular disease, and inflammatory conditions. Pfizer also offers consumer healthcare products, including Advil, Centrum, ChapStick, Emergen-C, and Robitussin. In April 2016, the company terminated its planned acquisition of Allergan plc following unfavorable tax regulations from the U.S. Treasury. Pfizer is now considering whether to split the company into two segments, one for high growth innovative pharmaceuticals and one for lower growth/declining established pharmaceuticals, with a decision expected by the end of 2016.

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Mondelez International Inc. (MDLZ, Financial) (2.1%) (MDLZ – $45.51 – NASDAQ) headquartered in Deerfield, is the renamed Kraft Foods Inc. following the tax-free spin-off to shareholders on October 1, 2012 of the North American grocery business. Following the contribution of coffee into a new joint venture, nearly 85% of MondelÄ“z’s $27 billion of revenue is derived from snacking, which includes leading brands such as Oreo, LU and Ritz biscuits, Trident gum and Cadbury and Milka chocolates. On July 2, 2015 MondelÄ“z contributed its coffee business with DE Master Blenders 1753 to form a new coffee company, Jacobs Douwe Egberts. Subsequently, MDLZ exchanged part of its stake in this coffee joint venture for 24% ownership in Keurig Green Mountain, which was acquired by an investor group led by JAB Holding Co. in March 2016. This narrows the company’s product focus, as only 15% of revenue will be outside snacks, mostly 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 and improve margins in the faster growing snack business. On June 30, Hershey (HSY) confirmed that it received and rejected a preliminary indication of interest from MondelÄ“z to acquire HSY for $107 per share in cash and stock, demonstrating MondelÄ“z’s continued interest in pursuing acquisitions while remaining an independent company.

Apple (AAPL, Financial) (5.1%) (AAPL – $95.60 – NASDAQ) designs Macs, arguably the best personal computers in the world, along with OS X, iLife, iWork, and professional software. Apple leads the digital music revolution with its iPods and iTunes online store. Apple has reinvented the mobile phone with its revolutionary iPhone and App Store, and is defining the future of mobile media and computing devices with the iPad and Apple Watch.

JPMorgan Chase & Co. (JPM, Financial) (2.8%) (JPM – $59.22 – NYSE) is one of the oldest financial institutions in the U.S. The firm, with assets of over $2.4 trillion, provides services to millions of consumers, small businesses, and many of the world’s largest corporate, institutional, and government clients. The bank is divided into several reporting segments, including investment banking, commercial banking, financial transaction processing, asset management, and private equity. CEO Jamie Dimon is well regarded among corporate leaders, and he has positioned the company for future growth, despite the recent challenges related to the financial crisis, increased regulations, and low interest rates.

Citigroup Inc. (C, Financial) (2.6%) (C – $41.75 – NYSE) is a leading global bank, with approximately 100 million customer accounts. The firm conducts business in more than 100 countries and jurisdictions. Citigroup provides consumers, corporations, governments, and institutions with a broad range of financial products and services, including consumer banking and credit, corporate and investment banking, securities brokerage, transaction services, and wealth management. The firm is well positioned to capitalize on the growth of global personal wealth.

Medtronic plc (MDT, Financial) (1.7%) (MDT – $75.00 – NYSE) cemented its position as the largest manufacturer of medical devices in the world with last year’s $50 billion acquisition of Covidien. This deal, structured as a tax inversion, should both improve the company’s growth rate and give it better access to its global cash flow. Meanwhile, Medtronic is accelerating its own growth rate through improved management execution and a full pipeline of new heart valves, drug coated balloons, and defibrillators. Medtronic will be the partner of choice for hospitals going forward, and the Covidien deal will allow the company to continue to return at least 50% of its cash flow to shareholders via share buybacks and dividends.

General Electric Co. (GE, Financial) (3.3%) (GE – $26.57 – NYSE) is an industrial conglomerate based in Fairfield, Connecticut, with leading positions in power, energy, healthcare, and aviation equipment, services, and financing. GE has materially downsized its finance business through the 2014 spinoff of Synchrony Financial and the sale of most of its finance verticals. Financial businesses will be retained in healthcare, energy financial services, and aviation to support key industrial businesses. The company recently became the first institution to be de-designated as a Systemically Important Financial Institution (SIFI), providing more balance sheet flexibility and allowing the company to buy back upwards of $50 billion of stock. On the industrial side, GE is integrating its $10 billion acquisition of Alstom’s power assets, broadening its scale and capabilities. It is also ramping up production of its efficient H-turbine for power plants and its LEAP engine for the next generation of fuel efficient narrowbody aircraft. Finally, GE is aggressively building out its digital capabilities, focusing on the remote monitoring and optimization of its installed base. The transformation of GE, now almost complete, is creating a focused industrial company capable of driving high single digit earnings growth while paying a progressive dividend.

ExxonMobil Corp. (XOM, Financial) (2.1%) (XOM – $93.74 – NYSE) is the world’s largest publicly held integrated oil and gas exploration and production company based on market capitalization, proved reserves and production. The company’s exploration and production segment has an active exploration or production presence in 36 countries and production operations in 24 countries. ExxonMobil also owns a diverse portfolio of refining facilities in 14 countries (which include North American, Europe and the Asia Pacific region) and is one of the largest chemical companies in the world. The stock is up more than 40% from its 52 week low as WTI crude prices rebounded from $26/bbl to near $50/bbl currently. The company is targeting 2016-2020 production to be 4.0-4.2 million boe/d, representing flat growth compared to 2015. To weather the lower commodity price environment, XOM is focused on controlling costs and managing capital expenditures. Additionally, it issued $12 billion in bonds to bolster its balance sheet. Finally, ExxonMobil remains committed to paying a reliable and growing dividend. In April 2016, the company increased its annual dividend from $2.92/share to $3.00/share.

Looking Ahead

Markets reacted sharply to the surprise vote by Great Britain’s population to leave the European Union. While the polls had been close, there was broad consensus leading up to the vote that the “remain” side would win. Certainly all world leaders had expressed their hope that Britain would remain, and that leaving would be both disruptive and damaging to the economy. President Obama expressed this on a recent visit to Great Britain as well. Post vote analysis indicated that older and less educated people felt disenfranchised and that their position in society had been eroded due to integration with Europe and voted 60% to leave. Young people said they felt like part of Europe, having grown up at least in part with the integration, and voted 60% to remain.

Comparisons are being drawn to our presidential campaign tone, emotions and divisions, with the majority of older, white and male voters supporting a candidate with no previous political experience who talks about a return to the America of olden days, while younger, diverse and female voters prefer the more experienced candidate.

Wage stagnation has boosted voter vulnerability to populist and nationalistic sentiment in Europe and the United States, which blame both immigrants and other nations for domestic economic problems. In the United States productivity has been slowing, with explanations ranging from the drag of too many regulations to the hangover of the Great Recession to very sluggish corporate and government capital and infrastructure spending. Unless the rate of productivity increases, advanced economies will not be able to raise living standards and pay for the costs of their aging populations.

In the immediate aftermath of the Brexit vote, European leaders used harsh tones in calling for Britain to begin the exit process. This implied that the European leaders are worried about contagion amongst other member states and hoped that the United Kingdom’s misery would act as a deterrent to these nationalist and populist movements that have gathered in France, the Netherlands, and Denmark.

The Brexit vote accelerated a further decline in bond yields as investors looked to invest safely – even at the cost of getting any return. An astonishing $11.7 trillion of global sovereign debt had negative yields at quarter end. Negative yields mean that investors who buy these bonds and hold them to maturity will lose money!

Stocks erased three months of gains in two days, and bonds continued to make record low yields, reflecting gloomy economic outlooks and expectations of more central bank stimulus.

The UK is the fifth largest economy in the world, with $2.7 trillion of gross domestic product (compare this to the United States, with $18.6 trillion). However, there are larger implications for global trade, for a new EU/EK relationship, and for the leadership change in the United Kingdom as Prime Minister David Cameron steps down quickly. These will have a disproportionately larger impact on the world economy.

Companies had pulled back on already low capital spending in the second quarter, awaiting this vote, and have now indicated that they will further hold off on plans amidst this uncertainty. The International Monetary Fund has lowered its Eurozone growth forecast (as it has every year for the past six years) to 1.6% this year and 1.4% for 2017 “mainly due to the negative impact of the UK referendum” and the uncertainty that will dent confidence and increase market volatility.

Current events in Europe will end up damaging U.S. consumer confidence, we just don’t know how much. Business confidence, which had already been weak, is showing further signs of pulling back with multinational companies including Ford, JP Morgan, Airbus and British Air announcing job cuts, lower profits, or both due to Brexit.

Our baseline scenario is one of an uneasy balance between economic fundamentals and financial markets, with already overburdened central banks at the heart of the story.

However, with firm consumer spending, subdued oil prices and expansionary monetary policy, it is hard to see a recession materializing over the next year.

Overall, corporate earnings estimates for 2016 continue to be revised down due to slowing global growth and the strong dollar. Corporate earnings, as represented by the S&P 500, were flat, showing no growth over 2014. Right now, the consensus estimate is for corporate earnings to gain 4% in 2017. Investors are unlikely to reward this sub-par earnings growth with higher valuations.

In Conclusion

We try to invest in companies at good values, some of which are noted in our "Performance" and "Let's Talk Stocks" sections that have good value and the opportunity to grow their earnings and cash flow. We look for those companies that we believe will continue to return cash flow to shareholders through not only dividends but also through reinvestment in their businesses, resulting in greater cash flow and earnings, and higher share price valuation. We look to build a steady component of not only current return from dividend yields, but also a rising dividend pay-out from most of our portfolio in order to contribute to the performance of the Fund. As always, we thank you for your continued confidence in us.

July 14, 2016

Barbara G. Marcin, CFA Portfolio Manager