To Our Shareholders,
Thank you for your investment in the GAMCO Growth Fund.
For the quarter ended December 31, 2016, the net asset value (“NAV”) per Class AAA Share of The GAMCO Growth Fund decreased 0.8% compared with increases of 3.8% and 1.0% for the Standard & Poor’s (“S&P”) 500 Index and the Russell 1000 Growth Index, respectively. See page 2 for additional performance information.
Each quarter of the year had its own storyline. The first quarter was all about falling profits and collapsing oil prices. The second quarter held the shock of the Brexit vote in England, with no shortage of bearish headlines. In the third quarter, the after-shock of the Brexit vote gave rise to unprecedented negative interest rates in Europe and beyond, providing stimulus to help the fragile global expansion. Finally, the fourth quarter was all about the surprising election of Donald Trump and the excitement created by a potentially more pro-business administration.
The new year will have challenges. The year begins with the dollar at a 14 year high and 10 year Treasury yields at their highest since September of 2014. Wage pressures are building as is inflation. The Fed is forecasting it will raise rates three times in 2017. Meanwhile, the impact of Trump’s expected tax cuts, deregulation and infrastructure spending is unlikely to have much, if any, impact before 2018. Policy uncertainty is substantial. Passing and implementing legislation is more difficult that Tweeting. While we hope Trump can successfully reset the economy on a faster growth trajectory, much is now expected and discounted, suggesting the new President’s honeymoon with Wall Street is soon to be strained.
The Economy
The economy struggled out of the gates in 2016 but improved over time as payroll growth and wage increases gave rise to a stronger consumer sector. Fourth quarter growth is expected to slow to 2.2% from 3.5% in the third quarter, resulting in real growth of 1.6% for the year, down from 2.6% in 2015 and the slowest advance since 2011. Going into the election, a small but growing chorus of influential economists feared the growing probability of a recession in 2017. The U.S. economy’s growth rate has been in a secular decline and was becoming more like Europe where taxes and regulations seem to have put a lid on growth at 2%. We were slowly but surely lowering our expectations. Then, on November 8, 2016, everything changed. Or did it?
Among other things, Donald Trump is seen as a force for creative destruction. His administration is expected to perform something akin to electroshock treatment to our lumbering economy. His proposals include substantial tax cuts, tax and trade reform, repealing Obamacare, wholesale banking and industrial deregulation and boosting military and infrastructure spending. While much of what Trump proposes is controversial to certain segments of the public at large, much of Wall Street and the business community have become big fans. In the wake of the election and subsequent stock market rally, business confidence has spiked higher and consumer confidence as surveyed by The Conference Board has risen to a 15 year high. The risk of a recession in 2017 has faded significantly. But can Trump make good on his promise to “make America great again”? Can he deliver the goods and justify the boost to confidence and stocks we are now enjoying? Or will he be a disappointment? Is Donald Trump “all hat and no cattle”?
The bandwagon of optimism born of the election is driving smack into some turbulence as 2017 unfolds. The dollar’s sharp rise will weigh on profits and exports. The back-up in bond yields is and will continue to crimp the recovery in housing. Rising wages will hurt profit margins and profits. Stricter bank lending standards will hamper growth. Expected Fed rate increases could become a problem and much higher healthcare insurance premiums are already a problem. The rate of job creation will slow further as the labor market continues to tighten. These are the issues we know about. What we don’t know yet is what Trump will do on the trade front. Protectionist actions will be met in kind, and the result will be less trade and slower growth. Trade represents 60% of global GDP so this is more important than any of us can probably appreciate.
Policy uncertainty makes it more difficult than usual to forecast economic growth rates. Nevertheless, most currently forecast real GDP growth of 2.2% for 2017, rising to 2.3% in 2018. Let’s hope we can do better than that. Those numbers won’t really “make America great again.” In order to reach the coveted 3% level of growth, we need to boost productivity. That means getting companies to invest in new plant, equipment, research and technology. Ultimately it will come down to growing profits, which have been stagnant for two years, as profits provide the wherewithal to make those important investments. Significant corporate tax reform might be helpful on this front. It should be. Our expectations have been raised. Now we will wait to see if they will be met.
The Markets
Last year got off to a bad start with the market (S&P 500) falling 11% in the first six weeks of the year. It was one of the worst starts in history, attributed to falling earnings and collapsing oil prices. Crude oil (WTI) bottomed on January 20 at $35 per barrel, down over 60% since mid-2014 and over 40% since mid-2015. Investors assumed the worst, that falling crude prices were a negative signal for economic growth. The value of debt issued by many energy companies fell precipitously, creating other concerns of a potential financial accident involving the high yield debt market. By June, crude oil had rallied 50%. The dark cloud of worry dissipated.
The spring was dominated by the Brexit debate in the United Kingdom. Would the UK vote to leave the European Union? There was a media onslaught as a parade of political and economic experts as well as CEOs predicted economic doom if the vote was to leave. The pollsters assured the establishment and the markets that a vote to stay was going to carry the day. As we know, the pollsters were wrong, and leaving the EU was exactly what the UK elected to do. The economic doom has not materialized. The pound sterling has indeed fallen close to 20%, but the stock market has boomed and risen by more than 20%. Meanwhile, most of the economic indicators for the UK are nicely positive. The cheaper pound is encouraging exports and tourism. The weathering of this storm, so far, is fueling concern that France and Italy, to name two, may tip toe down this same path at some point in the next couple of years. The pollsters will say it is unlikely.
The Bank of England (BOE) was so stunned by the Brexit vote and fearful of what might happen that it responded with, you guessed it, more stimulus. The BOE cut the overnight rate to 0.25%, the lowest in its 322 year history. It also reinstituted quantitative easing (rejoining the European Central Bank and the Bank of Japan), driving many sovereign bond yields into negative territory due to the actual shortage of government debt. As investors fled the pound sterling (and therefore, UK gilt bonds), the result was negative yields in abundance, but not in the UK. Even today, in early January, we see negative yields on five year sovereign debt issued by Switzerland, Germany, Finland, Austria, Belgium, the Netherlands, Denmark, Sweden, France, and Japan. So the net result of the Brexit vote was more stimuli in the form of lower rates and a cheaper currency for the UK. Yields on Treasury’s fell too, with the 10-year yield hitting a record low of 1.35% on July 8. The third quarter of 2016 will forever be known as the time global bond yields hit their lowest levels in the history of mankind! Now that is stimulus.
The fourth quarter was simply bizarre. With the election garnering all the attention, pollsters made it clear that Donald Trump was finished. The Donald could go back to hosting The Apprentice. Hillary was all but coronated. The Republican Party appeared to be and was in disarray. The market was comfortable with Hillary and scared of the Donald, who took investors out of their comfort zone. So much so, that in the three days leading up to the election, when Hillary was the expected victor, the S&P 500 rose 2.6%. Early on election night, stock futures soared on the presumption of a Clinton win. It is said that Hillary thought she was going to win until 9 pm. A couple of hours later we all knew she had lost. The map of the United States was redder than any among the “elites” imagined possible. Trump was going to win the electoral vote tally. The Dow Jones Industrial Average futures prices collapsed, falling 800 points. Hillary had lost. The pollsters were wrong again.
The story is old now. Investors quickly warmed to the idea of tax reform and deregulation. The market (S&P) rallied 1.9% in the five days after the election. The Dow, outperforming the broader market, rose 1,579 points, or 8.6%, between November 8 and December 13. In fact, the Dow rose for seven consecutive weeks post-election, finally falling in the final week of the year after advancing 1,642 points. Will investors patiently wait for Trump & Co. to cut taxes, reform the tax code, repeal and replace Obamacare, neuter Dodd-Frank and enact a monster infrastructure bill? That is doubtful. There is too much policy uncertainty and “many a slip twixt cup and lip.” Inflation is rising already and the Trump platform is viewed as inflationary.
Unfortunately, most of the time price-to-earnings ratios move inversely to inflation, implying lower multiples in 2017. The 10 year Treasury is now at 2.40% (the yield reached 2.60% on 12/15/16), having vaulted 135 basis points since the historic July low, also not positive for multiples. Stocks are already selling at 17.6 times expected 2017 operating earnings of $129. Corporate tax reform might provide the needed boost to earnings but we don’t think that will be implemented until 2018. What we do like are growth stocks, many of which did not provide better than market returns in 2016, as investors embraced what had been the previously lagging small cap and value stocks, especially in the frenzied rotation into financials and industrials post-election.
Portfolio Observations
There were no major changes in portfolio emphasis during the fourth quarter. We made new investments in eight companies and sold two positions outright.
We invested in three so-called “tower” companies. These are companies that build cell towers for enabling wireless voice and data communications. They rent space on their towers to the various telephone companies and others in the wireless communications business. Increased investment in towers is required to enable the growing levels of data traffic being streamed to wireless devices. The leading companies we invested in are American Tower (0.7% of net assets as of December 31, 2016), Crown Castle International (0.7%) and SBA Communications (0.3%).
We invested in three capital goods companies due to improving economic growth prospects under the incoming Trump administration. The new holdings are Dover Corp. (0.3%), Parker-Hannifin (0.2%) and Roper Technologies (0.3%). Importantly, the vast majority of revenues these companies generate are derived domestically. We believe this is important given the 10% rise in the dollar since May of last year. We also bought MondelÄ“z (0.6%), which is likely to be the fastest growing processed food company, as well as Qualcomm (0.3%), a leader in wireless chips and chip sets that is smartly acquiring NXP Semiconductors, a leader in chip technologies for security, manufacturing and “the Internet of things.”
We increased a number of positions. The most significant increases were in the holdings of CBS (1.7%), Time-Warner (2.7%), PepsiCo (3.2%), Disney (2.1%), Johnson & Johnson (1.2%), Thermo-Fisher Scientific (1.2%), Zoetis (2.7%) and O’Reilly Automotive (0.9%).
We sold our positions in Constellation Brands and Chipotle Mexican Grill. Aside from realizing some tax loss benefits, the sale of Constellation Brands was due to concern over expected tariffs on imports from Mexico (40% of their business is Mexican beer) and the sale of Chipotle reflects frustration with a longer than expected and yet to materialize turnaround in their fast food business resulting from food borne illnesses in late 2015.
We reduced a number of positions. Among the larger cuts were holdings of Bristol-Myers Squibb (1.0%), Celgene (0.9%), CVS Healthcare (0.7%) and Walgreens Boots Alliance (1.4%). This was spurred by the growing political pressure on drug pricing. Other significant reductions involved General Electric (1.1%), Honeywell (0.8%), PPG (0.4%) and Twenty-First Century Fox (0.4%).
Relative to the Russell 1000 Growth Index, we ended the quarter overweight the technology and consumer discretionary sectors. We were underweight healthcare, consumer staples, materials & processing, producer durables, financial services and utilities. We were market weight energy.
Performance Commentary
Holdings that had the most positive impact on performance for the quarter (based upon price change and the size of the holding) were, in order, Microsoft (5.8% of net assets as of December 31, 2016), Time Warner, UnitedHealth Group (2.8%), Walt Disney, CBS, Snap-on Incorporated (1.4%), Apple (5.9%), Boeing (0.9%), First Republic Bank (0.8%) and Celgene. Hurting us the most for the quarter were Amazon.com (6.3%), Facebook (5.3%), Adobe Systems (3.5%), CVS Healthcare, Amgen (0.9%), Allergan, Nielsen Holdings (0.5%), Constellation Brands, Becton-Dickinson (1.5%) and Visa (1.8%).
For the full year, holdings that helped the most were Microsoft, Apple, UnitedHealth Group, Amazon.com, Time Warner, Comcast (2.3%), Honeywell, Facebook, WhiteWave Foods and CBS Corp. Similarly, hurting us the most for the year were CVS Health, Allergan, Gilead Sciences, Bristol-Myers Squibb, Nike (1.0%), Chipotle Mexican Grill, Regeneron Pharmaceuticals, Novo-Nordisk, Delta Airlines and Amgen.
In Conclusion
We concluded our previous commentary with words of caution about the economic outlook. We second those today. History tells us that the rise in bond yields and the dollar will negatively impact growth and profits. P/E multiples may decline this year if inflation continues to advance. So we remain positioned with a defensive tilt while remaining fully invested. The defensive tilt, which we initiated last summer, hurt us post-election, as the Trump reflation/cyclical trade smoked all comers. We view that emotional trade as directionally correct but premature in magnitude. To effectively discount lower tax rates, tax reform, deregulation initiatives, higher interest rates, large infrastructure and military spending programs and the repeal and replacement of Obamacare all before Trump takes office is asking a lot. It would be nice, but to think this all happens and happens smoothly is most likely naïve, especially if you include potential changes to the terms of trade.
Should team Trump succeed in making the tax and deregulatory changes they desire in 2017, it is a 2018 story in terms of the actual economic impact. Of course the market will discount 2018 expectations in the second half of 2017. So this is going to be an exciting year. The “no drama” years are over. The market might be a bit more ahead of the fundamentals than usual but the longer term outlook for growth has brightened.
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 December 31, 2016.
Amazon.com (AMZN, Financial) (6.3% of net assets as of December 31, 2016) (AMZN – $749.87 – NASDAQ) launched in 1995 as an online book retailer and has evolved into a dominant e-commerce platform. CEO Jeff Bezos guides the company on customer obsession rather than competitor focus and encourages the patience to think long-term. Amazon’s competitive advantage within e-commerce is Amazon Prime, which benefits from a virtuous cycle as the continuously expanding selection of inventory drives traffic, which attracts more sellers, who add yet more selection. Amazon continues to invest in the Prime value proposition (free and faster shipping, free video and music streaming, libraries of free books and magazines, and a host of other benefits) in Bezos’ effort to make it “irresponsible” not to be part of Prime. Prime members spend more than non-Prime customers and their purchasing volume tends to increase over time. In addition to its retailing operations, Amazon pioneered the concept of hyperscale public cloud with its Amazon Web Services (AWS) and continues to be the dominant market share leader in that rapidly growing industry.
Apple (AAPL, Financial) (5.9%) (AAPL – $115.82 – NASDAQ) designs Macs, arguably the best personal computers in the world, along with OS X, iLife, iWork, and professional software. Apple inspired the digital music revolution with the iPod and iTunes, redefined the mobile phone with the iPhone and App Store, invented an entirely new category (tablets) with the iPad, and continues to be at the forefront of mobile technology with the Apple Watch and Apple Pay. Perhaps Apple’s greatest innovation has been its integrated ecosystem, which retains customers and produces a “halo effect” for other Apple devices. Apple’s less cyclical Services business is growing at a 24% run rate and now comprises 14% of total revenue.
Alphabet (GOOG, Financial) (5.9%) (GOOG/GOOGL – $771.82/$792.45 – 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 targeted and measurable advertising. Alphabet’s healthy core search business gives the Company the unique opportunity to pursue new market opportunities within streaming video (YouTube Red), life sciences, self-driving automobiles and a variety of other “moonshot” projects.
Microsoft (MSFT, Financial) (5.8%) (MSFT – $62.14 – NASDAQ), the world’s largest software company, develops, manufacturers, and licenses a range of software products for a variety of computing devices from PC’s to servers to its Xbox game console. While the company’s core desktop operating system and applications software franchise (Windows/MS Office) is maturing, Microsoft is gaining share in the enterprise market and, with its Internet and Xbox efforts, in the consumer markets also. Microsoft’s Azure is a fast growing public cloud service that competes with Amazon’s AWS. The recent acquisition of LinkedIn will allow Microsoft to integrate data from LinkedIn’s economic graph with Microsoft’s professional cloud.
Facebook’s (FB, Financial) (5.3%) (FB – $115.05 – NASDAQ) mission is to give people the power to share and make the world more open and connected. Facebook’s unique cache of user profiles creates a powerful targeted advertising platform. As of September 30, 2016, Facebook had 1.71 billion monthly active users (MAUs) worldwide, including 1.57 billion mobile MAUs. Facebook continues to grow its worldwide user base at a mid-teens rate, largely driven by the proliferation of mobile devices in the emerging markets. Users are spending more time on the platform, driven largely by the recent emphasis on video. Facebook is able to drive pricing power by continuously improving the effectiveness of its ads. Meanwhile, there remains runway to further monetize Facebook properties Instagram, Messenger, and WhatsApp.
Adobe Systems (ADBE) (3.5%) (ADBE – $102.95 – NASDAQ) is the global leader in digital marketing and digital media solutions. Adobe has the most comprehense end-to-end solution for digital marketing. Its tools allow customers to create digital content, deploy it across media and devices, and measure and optimize it over time. Adobe has successfully transitioned from a product-based desktop business to a cloud-based subscription business. Over 80% of total revenue is now recurring and that number is poised to climb higher as 7 million customers worldwide are yet to migrate. The demand for design capabilities continues to rise at a dramatic pace, reflected in Adobe’s large and growing total addressable market of $64 billion in 2019.
MasterCard (MA, Financial) (3.2%) (MA – $103.25 – NYSE) is a technology company in the global payments industry that operates the world’s fastest payments processing network, connecting consumers, financial institutions, merchants, governments, and businesses in more than 210 countries and territories. MasterCard’s products and solutions make everyday commerce activities – such as shopping, traveling, running a business and managing finances – easier, more secure and more efficient for everyone.
PepsiCo (3.2%) (PEP, Financial) (PEP – $104.63 – NYSE) is a leading food and beverage company with a global footprint in over 200 countries. The company’s portfolio includes Frito-Lay, Gatorade, Pepsi-Cola, Quaker and Tropicana. As consumer demand continues to shift towards nutritious products, PepsiCo is responding by improving the nutritional profile of many of their products by reducing sodium, added sugars and saturated fat.
UnitedHealth Group (UNH, Financial) (2.8%) (UNH – $160.04 – NYSE) is one of the largest and most diversified managed care companies in the United States. It’s high growth Optum services business provides wellness and care management programs, financial services, information technology solutions and pharmacy benefit management (PBM) services to an additional 115 million customers.
Time Warner (TWX, Financial) (2.7%) (TWX – $96.53 – NYSE) is a diversified media company with operations in cable networks through HBO, TNT, TBS and CNN, and film & television production. Time Warner owns cable networks that benefit from contractually recurring revenue, high margins and low capital intensity. In October, AT&T and Time Warner announced that they had entered into a definitive agreement under which AT&T will acquire Time Warner in a stock-and-cash transaction valued at $107.50 per share. We believe the deal will close and expect limited downside should the deal get blocked.
January 12, 2017
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.
