To Our Shareholders,
For the quarter ended September 30, 2016, the net asset value (“NAV”) per Class A Share of The Gabelli Value 25 Fund increased 2.5% compared with increases of 3.9% and 2.8% for the Standard & Poor’s (“S&P”) 500 Index and the Dow Jones Industrial Average, respectively. See page 2 for additional performance information.
Third Quarter Commentary
Global equity markets rose in July, shaking off concerns about the implications of the UK’s “Brexit” vote to leave the European Union. Since that time, markets finished the quarter virtually unchanged (though with some increased volatility along the way), as investors are likely waiting for the outcome of the upcoming U.S. presidential election. While economic data, earnings reports and a potential rise in interest rates are being watched closely, the election is the one topic dominating the news cycle 24/7 — on television, in print and on social media. While most of the attention-grabbing headlines are related to personal behavior and insults, the election has real implications on the stock market in a wide variety of areas, including corporate and personal tax rates, trade agreements, infrastructure spending, and healthcare. Any potential changes to policy will also highly depend on whether the electoral and legislative branches remain divided. Therefore, even if one of the presidential candidates seems likely to win, we won’t know the impact on stocks until all the votes are tallied.
In September, the Federal Reserve opted to leave interest rates unchanged until after the election, yet indicated a strengthening case for a raise before year-end. In the meantime, interest rates remain near record lows, fueling continued merger and acquisition (M&A) activity, which we discuss further on. Additionally, financial engineering continues to be used by companies in order to surface value. Equipment rental company Herc Holdings began trading on July 1, 2016 after being spun off from Hertz. In July, Liberty Ventures (0.3% of net assets as of September 30, 2016) completed its spin-off of CommerceHub (less than 0.1%). Another spin-off in process is Adient, the automotive interiors business of Johnson Controls (1.1%), which is expected to be completed before the end of the year.
Deals, Deals & More Deals
The value of announced worldwide M&A was $796.2 billion during the third quarter and $2.4 trillion through September 30, 2016. While down from a year ago, the overall level of M&A activity is still quite high by historic standards.
In the Fund, M&A activity was a contributor to performance. In August, convenience store operator CST Brands (0.7% of net assets as of September 30, 2016) agreed to be acquired by Couche-Tard for $48.53 per share in cash following a lengthy exploration of strategic alternatives. In September, specialty chemical manufacturer Chemtura (1.2%) announced it agreed to be acquired by private German chemical company Lanxess AG for $33.50 per share in cash. Finally, truck manufacturer Navistar (0.8%) rose significantly following the announcement that Volkswagen agreed to buy a 16.6% stake in the company, in what could be a first step towards an outright acquisition of Navistar.
We believe the ingredients of a robust M&A environment – low cost of financing, low global GDP growth, synergy-driven industry consolidation, and the availability of many new pure-play companies due to financial engineering – continue to be in place.
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 September 30, 2016.
Bank of New York Mellon Corp. (BK, Financial) (2.4% of net assets as of September 30, 2016) (BK – $39.88 – 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 June 30, 2016, the firm had $29.5 trillion in assets under custody and $1.7 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.
CBS Corp. (CBS, Financial) (6.5%) (CBS – $54.91 – NYSE) operates the CBS television network and the premium cable network Showtime. It also owns 29 local television stations and 130 radio stations. We believe that CBS has a number of opportunities to generate incremental non-advertising revenue from the sale of existing content through its OTT platforms, online video distributors and retransmission agreements with traditional distributors. In addition, we expect a continued recovery in advertising to contribute to earnings growth. Finally, we believe that financial engineering, including the split-off of its radio business, could act as a catalyst for shares.
Diageo plc (DEO, Financial) (2.9%) (DEO – $116.04 – NYSE) is the leading global producer of alcoholic beverages, with brands including Smirnoff, Johnny Walker, Ketel One, Captain Morgan, Crown Royal, J&B, Baileys, Tanqueray, and Guinness. The company has a balanced geographic presence in both mature and emerging markets, and it benefits from the trend of consumers around the world trading up to premium products. Over the past several years, Diageo made acquisitions that enhanced its presence in emerging markets: a majority stake in United Spirits, the leading spirits producer in India, Mey Icki, the leading spirits company in Turkey; Shui Jing Fang, a leading Chinese baiju producer; Ypioca, the leading cachaca producer in Brazil; and an increased stake in Halico, the leading domestic spirits producer in Vietnam. While economic conditions in emerging markets have caused some of these investments to struggle recently, the long term fundamentals of the spirits industry remain very favorable, and Diageo will be one of the largest beneficiaries of industry growth.
Edgewell Personal Care Company (EPC, Financial) (1.9%) (EPC – $79.52 – NYSE) based in St. Louis, Missouri is the renamed Energizer Holdings, Inc. following the tax-free spin-off to shareholders of the household products division 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, 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, as well its ability to accelerate international expansion.
Honeywell International Inc. (HON, Financial) (2.8%) (HON – $116.59 – NYSE) operates as a diversified technology company with highly engineered products, including turbine propulsion engines, auxiliary power units, turbochargers, brake pads, environmental and combustion controls, sensors, security and life safety products, resins and chemicals, nuclear services, and process technology for the petrochemical and refining industries. One of the key drivers of HON’s growth is acquisitions that increase the company’s growth profile globally, creating both organic and inorganic opportunities. The company recently acquired Elster Industries, a leading provider of thermal gas solutions, smart meters, software and data analytics for the commercial, industrial and residential heating market. Elster’s gas business offers products in high demand among natural gas customers and brings a strong, global distribution network and numerous cross-selling opportunities for existing HON technologies to new customers. Elster’s gas, electric, and water meters are highly valued for their reliability, safety and accuracy. The company maintains an installed base of more than 200 million meter modules deployed over the course of the last 10 years that generate significant recurring revenues. We believe acquisitions such as Elster should drive meaningful and sustained growth for HON spurred by global energy efficiency initiatives and natural resource management.
Johnson Controls, Inc. (JCI) (1.1%) (JCI – $46.53 – NYSE), based in Milwaukee, Wisconsin, is a diversified industrial company undergoing significant financial engineering. On October 1, Johnson Controls merged with Tyco International, creating a global leader in Buildings and Energy Storage solutions through the combination of JCI’s HVAC and Building Controls business and Tyco’s Fire, Security, and Safety Products and Services. The combined entity will also retail JCI’s highly profitable automotive battery business, while spinning to shareholders its automotive seating and interiors business (to be named Adient) on October 31.
Newmont Mining Corp. (NEM, Financial) (3.5%) (NEM – $39.29 – NYSE) based in Denver, Colorado, is one of the largest gold mining companies in the world. Founded in 1921 and publicly traded since 1925, NEM is the only gold company included in the S&P 500 Index and Fortune 500. We expect the company to produce approximately 5.1 million ounces of gold and 320 million pounds of copper in 2016, with over 70% of this production coming from Australia and Nevada. Newmont undertook company wide cost cutting measures during the period 2013 – 2015, lowering its average unit costs base by over 20% during this period. The company has sold non-core assets and has deployed the proceeds from these sales into repaying debt and building new projects which it expects will generate superior rates of return for shareholders. Given Newmont’s largely fixed cost base, every increase (or decrease) in the gold price will flow directly to the company’s bottom line.
Sony Corp. (SNE, Financial) (3.7%) (SNE – $33.21 – 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.
Xylem Inc. (XYL, Financial) (2.6%) (XYL – $52.45 – 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 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. The company recently announced its $1.7 billion acquisition of Sensus, a leading manufacturer of smart metering equipment and technologies.
Investment Scorecard
Top contributors to performance during the quarter included Sony (+13%), which rose as its PS4 video game system gained market share and investors look forward to the expected introduction of its virtual reality system for the Playstation in October; Xylem (+13%), which agreed to acquire Sensus, a global leader in smart meters, for $1.7 billion in cash; and Navistar (+50%), which announced a strategic alliance with Volkswagen (VW), through which VW will acquire a 17% stake in Navistar. The takeover of Chemtura, described above, also contributed meaningfully.
Detractors from performance included media companies Twenty-First Century Fox(1.0% of net assets as of September 30, 2016) (-10%), Viacom Inc. (6.2%) (-7%) and AMC Networks (1.2%) (-14%) which were all plagued by concerns over declining television viewership and reduced advertising expectations. Liberty Interactive (1.1%) (-21%), parent of the QVC home shopping network, declined as it signaled negative third quarter sales trends in the U.S. QVC had not posted a decline in sales since the second quarter of 2009; consumer fatigue, poor merchandizing, and distractions related to the election and Olympics – not a permanent secular change in behavior – likely contributed to the disappointment. Finally, Telephone & Data Systems (0.7%) (-8%) declined amid concerns about increasing competitive intensity related to the iPhone 7 launch.
Conclusion
Volatility has increased recently in markets, and likely will continue up until (and after) the U.S. presidential election in November. We continue to seek high-quality companies trading at a discount to Private Market Value – the price an informed industrialist would pay to own an entire business – and hope to use any opportunity “Mr. Market” provides to us. We also look for catalysts to surface value, such as industry consolidation, financial engineering, new management, regulatory changes, or a change in cash flow allocation. Finally, we see a continuation of the "Fifth Wave" of takeover activity, which should continue to result in several fund holdings being targets.
October 17, 2016
Note: The views expressed in this Shareholder Commentary reflect those of the Portfolio Managers only through the end of the period stated in this Shareholder Commentary. The Portfolio Managers’ views are subject to change at any time based on market and other conditions. The information in this Portfolio Managers’ Shareholder Commentary represents the opinions of the individual Portfolio Managers 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 Managers 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.
