To Our Shareholders,
Thank you for your investment in the GAMCO Growth Fund.
For the quarter ended September 30, 2017, the net asset value (“NAV”) per Class I Share of The GAMCO Growth Fund increased 4.5% compared with increases of 4.5% and 5.9% for the Standard & Poor’s (“S&P”) 500 Index and the Russell 1000 Growth Index, respectively. See page 2 for additional performance information.
Fueled by low interest rates, improving earnings, and economic expansion in Europe and Asia, the stock market (S&P) continued its near historic advance in the third quarter. Equity prices were also bid up as investors pivoted their attention from health care to tax reform. While there is some increased visibility into what a tax bill may look like, we are hesitant to speculate on a major corporate tax cut. Many important details are unresolved and policy uncertainty has been the hallmark of this administration. Meanwhile, geopolitical developments regarding North Korea, Iran and trade deserve our full attention.
The Economy
According to the Bloomberg Economic Survey, the consensus estimate for real GDP growth this year remains at 2.2%. GDP grew at 1.2% and 3.1% in the first and second quarters, respectively, and is expected to moderate to 2.6% and 2.4% in the third and fourth quarters, respectively. Forecasts for 2018 are for steady growth of about 2.3%. S&P earnings per share estimates for this year have edged higher from $130 to $132 versus $117 from the prior year, implying a 13% year-over-year earnings gain for the S&P. Consensus estimates for 2018 earnings have remained unchanged at $146, which would represent a 10.6% advance.
While the hurricanes that hit Texas and Florida in the third quarter did extensive damage and will temporarily soften employment numbers, the rebuilding activity will actually boost growth in the fourth quarter. Economic growth has remained fairly consistent across many industries. However, labor shortages are clearly having an impact, especially on small businesses, leading to what are surely overdue wage rate increases for many. A small regional airline in the New York area gave some pilots a 30% raise overnight. The owner of a craft brewer and bakery in Boston told me he cannot find enough people to properly staff his operations. In short, the economy is doing pretty well overall but labor shortages are surfacing and policy uncertainty remains a wild card.
The Federal Reserve commenced raising interest rates in December of 2015 and has now raised rates four times. The Federal Reserve has telegraphed another rate hike for December and began the long process of reducing its balance sheet this October. We simply point out that economic growth is slower than usual for the Federal Reserve to be tightening. Inflation is lower (sub 2%) and public and private debt is at record levels. Consequently, rising rates should have a more immediate impact on growth, creating tension for the stock market in a shorter time frame than in most tightening cycles.
The Markets
Large cap growth stocks suffered from profit taking and sector rotation in September, limiting gains for the quarter. Smaller cap stocks and banks excelled as the so-called reflation trade returned with a vengeance. Investors priced in higher interest rates, which benefits financials, and a corporate tax cut, which benefits smaller companies disproportionately. This change in market leadership is temporary and likely to last only a month or two. While the economy is in reasonably good shape, growth is slowing at the margin and tax cuts have yet to be legislated. If legislation is passed, it is more likely to be a 2018 event.
The stock market has now booked gains for eight consecutive quarters. As mentioned last quarter, we are overdue for a pullback. With the VIX (volatility index) at multi-year lows, the market is so complacent it is spooky. We have not seen as much as a 3% pullback since last November’s election. Let’s review — historically, the stock market has a 10% drawdown every year. The last one was in August of 2015. The market has a 15% correction, on average, every two years. The last one was in October of 2011. Heck, we usually get three 5% hiccups every year. We had four in both 2015 and 2016. We have had none in 2017. We’ve now gone a record 335 days without a 5% correction.
We now have varying degrees of headline risk with North Korea, Iran, Turkey, Russia, China, and Mexico, to name the most obvious. Trade deals are in jeopardy. The Federal Reserve is tightening. We don’t know who the Federal Reserve’s chair will be after Janet Yellen’s term expires in January. The seemingly chaotic atmosphere in the White House could prompt the departure of more cabinet members. The President has the lowest approval ratings in history and has undermined many of his supposed GOP allies, making it hard to see how much of anything will get accomplished. A Special Counsel is investigating past and present members of the Trump political apparatus. The House and Senate Intelligence committees are performing their own investigations. And yet, the stock market has taken everything in stride. In my thirty nine years on Wall Street, I have never seen such a complacent market and that does make me concerned.
As I write in early October, the 10 year Treasury is yielding 2.34%, the same level as 22 months ago when the Federal Reserve made the first of its four tightening moves. If GDP growth is 2.2% with rates this low, how quickly would we grow if longer rates rose 1 percentage point? Most investors expect upward pressure on longer rates as the Federal Reserve shrinks its balance sheet. Any upward pressure on rates this year will result in slower growth next year.
The S&P is selling at 19.3 times this year’s earnings estimate of $132 and 17.5 times the 2018 estimate of $146. On this metric, this is the most expensive stock market since early 2000, the start of a bear market. Higher multiples can be justified by our low interest rate environment, but it is hard to make the argument that the market is cheap. Valuation, on its own, is rarely a catalyst for a correction. But with the backdrop of a tightening Federal Reserve, daily geopolitical drama, an ongoing Special Counsel investigation, and potentially lofty expectations for tax legislation, one could say the current environment is catalyst rich for profit taking.
Portfolio Observations
We sold nine holdings and added eleven for a net change of plus two, making 56 issues in the portfolio. We sold C.R. Bard, which is merging with Becton Dickinson, which we own. We sold Amgen and Mondelez due to disappointing top-line growth. Ulta Beauty, Henry Schein and CVS were sold due to our concerns over potential disruption from Amazon. With weakening long term fundamentals in broadcast and cable TV, we sold CBS and Twenty-First Century Fox. Finally, we sold EOG Resources at a nice profit as we are less bullish than most on oil and gas prices.
New holdings were specifically targeted toward clean energy utilities (NextEra Energy (1.0% of net assets as of September 30, 2017), Avangrid (1.0%)), aerospace & defense (Lockheed Martin(1.6%)), global media content & distribution (Netflix (0.7%)), semi-conductor manufacturing equipment (Applied Materials (0.7%)), semi-conductors for gaming, virtual reality, artificial intelligence (NVIDIA (1.1%)) and the iPhone (Broadcom (1.0%)), e-commerce payments (PayPal (1.4%)) and industrial conglomerates (GE (1.0%)), Parker-Hannifin (1.5%) and Roper Technologies (1.0%).
We trimmed a number of holdings with the largest reductions at Starbucks (1.5%), Comcast (3.0%), Abbott Labs (1.0%), Charter Communications (0.9%) and Nike (0.6%). We also added to a number of holdings, including Honeywell (1.1%), Sherwin Williams (1.5%), Boeing (1.9%), Visa (2.5%), Humana (2.0%) and Home Depot (3.0%). At quarter’s end, we were overweight (relative to the Russell 1000 Growth Index) health care, financial services and utilities. We were underweight producer durables, materials, energy, consumer staples and consumer discretionary. We were essentially neutral in technology.
Performance Commentary
Holdings that had the most positive impact on performance for the third quarter (based upon price change and the size of the holding) were, in order, Facebook (5.9% of net assets as of September 30,2017), Mastercard (3.9%), Apple (6.5%), Microsoft (5.5%), Boeing (1.9%), Visa (2.5%), Charter Communications (0.9%), Abbvie (1.1%), Thermo Fisher Scientific (1.6%) and Abbott Labs (1.0%). Holdings that hurt us the most for the quarter were, in order, Starbucks, Ulta Beauty, Nike, Henry Schein, PepsiCo (2.9%), Comcast, Regeneron (0.5%), Broadcom, CBS and Crown Castle International (2.0%).
In Conclusion
Last quarter our biggest concern was the potential for a trade war. Trump’s bark has been worse than his bite, at least so far, and that is a good thing. The ramped up sanctions on North Korea may be helping to lower the rhetoric and threat there and that too is a positive. Clearly China is trying to help. The global economy is doing better and that reduces, but does not eliminate, the risk of a near term material slowdown in the U.S. Politically, the next milestone for the Republicans is tax reform. Meaningful tax reform which includes a corporate tax cut would be well received by investors. The market may actually really need this in order to sustain today’s lofty valuations. While I have warned you of the risk of a near term correction in stocks, that is me exercising prudence. Stocks continue to offer the best projected total return over the longer term, but think 5% to 7% market returns and not 8% to 10%. Over the past 10 years, the S&P compounded at just over 7% (that includes the 2008-2009 bear market).
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 percentages of net assets, and their share prices are stated as of September 30, 2017
Amazon.com (AMZN, Financial) (3.3% of net assets as of September 30, 2017%) (AMZN – $961.35 – 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 is long-term oriented. 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). 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 within that rapidly growing industry.
Alphabet (GOOG, Financial) (5.7%) (GOOG/GOOGL – $959.11/$973.72 – NASDAQ) is the parent company of Google, 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. The company generates revenue by providing advertisers with the opportunity to deliver targeted and measurable advertising. Alphabet’s healthy core search revenue allows the company to pursue new market opportunities such as streaming video (YouTube Red), life sciences (Verily), autonomous driving (Waymo) and a variety of other “moonshot” projects
Apple (AAPL, Financial) (6.5%) (AAPL – $154.12 – NASDAQ) designs computers, mobile phones and other hardware, along with personal 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, Apple Pay and Apple Music. Perhaps Apple’s greatest innovation has been its integrated ecosystem, which retains customers and produces a “halo effect” for other Apple devices. At about 11% of total revenue, Apple’s less cyclical Services business is growing at a 20% run rate and is accretive to margins.
Charter Communications (CHTR, Financial) (0.9%) (CHTR – $363.42 – NASDAQ) is the second largest cable operator in the United States and a leading broadband communications services company. Charter provides video, Internet and voice services to over 26 million residential and business customers. Additionally, Charter sells advertising inventory to local and national advertising customers. Charter offers fiber-delivered communications and managed IT solutions to larger enterprise customers. Charter recently expanded its footprint and market share with acquisition of the Time Warner Cable and Brighthouse assets.
Comcast (CMCSA, Financial) (3.0%) (CMCSA – $38.48 – NASDAQ) is a global media and technology company that operates Comcast Cable and NBCUniversal. The cable business is the largest provider of high-speed internet, video and voice services under the XFINITY brand. The broadcast television business consists primarily of NBC and Telemundo. Comcast also produces filmed entertainment under Universal Pictures and Dreamworks Animation. Lastly, Comcast operates Universal theme parks. Comcast recently introduced Xfinity Mobile, which is its wireless initiative aimed at driving bundling and increasing customer retention.
Facebook (FB, Financial) (5.9%) (FB – $170.87 – NASDAQ), whose 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 December 31, 2016, Facebook had 1.9 billion monthly active users (MAUs) worldwide, including 1.7 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.
MasterCard (MA, Financial) (3.9%) (MA – $141.20 – 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.
Microsoft (MSFT, Financial) (5.5%) (MSFT – $74.49 – NASDAQ) is the world’s largest software company and develops software products for computing devices ranging from PC’s to servers to its Xbox game console. 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 with Microsoft’s professional cloud.
PepsiCo (PEP, Financial) (2.9%) (PEP – $111.43 – 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 its products by reducing sodium, added sugars and saturated fat.
UnitedHealth Group (UNH, Financial) (4.3%) (UNH – $195.85 – NYSE) is one of the largest and most diversified managed care companies in the United States. Its 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.
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.
