Gabelli Gold Fund 3rd Quarter Shareholder Commentary

Review of gold and gold holdings

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Nov 17, 2016
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To Our Shareholders,

For the quarter ended September 30, 2016, the net asset value (“NAV”) per Class AAA Share of the Gabelli Gold Fund, Inc. decreased 0.4% compared with a decrease of 3.7% for the Philadelphia Gold & Silver (“XAU”) Index. See page 2 for additional performance information.

Gold and gold equities continued their strong performance from the first half of the year with the XAU Index peaking at over 114 on August 11. Since the middle of August both the gold price and gold equities have declined as the dollar strengthened in the exchange market. By the end of the quarter, the XAU Index had declined by about 18% from its recent high. The gold price made a twelve month high in early July at $1,374 per ounce. By the end of September, the gold price had fallen by 4.2% from its high to close the quarter at $1,315.75 per ounce. For the quarter, the gold price fell by about seven dollars per ounce which is a little over half of one percent.

Gold bullion ETFs continued to accumulate gold during the quarter, albeit, at a slower rate. For the third quarter, according to Bloomberg, gold ETFs added over 2.5 million ounces to end September with 65.34 million ounces. This compares with the addition of almost six million ounces in the second quarter. This tends to support the idea that the recent weakness in the gold price is mostly due to position adjustments in the gold futures market commonly referred to as the gold paper market.

Our Approach

We invest in attractively valued gold equities with a focus on gold producing companies. We are fundamental, research driven investors and follow gold producing, as well as exploration and development companies on a global basis and across all market capitalizations. We pay particular attention to the quality of a company's operating mines and exploration and development properties. Valuation is an important part of our investment methodology and we apply a variety of valuation metrics in our stock selection process. We seek to maintain close contact with the managements of potential and current Fund investments. We are long term investors and generally the Fund is fully invested and does not hedge currencies or use derivatives.

Global Allocation

The accompanying chart presents the Fund’s holdings by geographic region as of September 30, 2016. The geographic allocation will change based on current global market conditions. Countries and/or regions represented in the chart may or may not be included in the Fund’s future portfolio.

HOLDInGS By GeOGRAPHIC ReGIOn

North America 63.8%

Europe 20.5%

Asia/Pacific Rim 9.5%

South Africa 5.4%

Latin America 0.8%

The reasons to own gold, in our view, have not changed over the past few years and certainly not over the past few months. If anything, they have grown stronger. We believe the fragility of current monetary arrangements is becoming more visible. This will become more evident should the current economic recovery fail to become sustainable and self supporting. If this is the case, global central banks will likely respond by increasing their interventions and not, as is currently discounted by most investors, embarking on a policy towards normalizing monetary policy. Gold should then perform well as investors seek portfolio hedges. Gold is the ultimate savings instrument. It has no counter party risk, is rare, always liquid and has a track record of a few thousand years of maintaining its value.

The Bretton Woods system of the dollar being the reserve currency and in turn dollars held as reserves by foreign central banks being convertible into gold ended in 1971. Since then currencies have freely floated and while national treasuries and central banks own gold, their currencies have not been convertible into gold. This has led to decades of inflation as central banks have tolerated money supply growth. And has been accompanied by an inexorable rise in levels of debt. Global debt levels have never been higher. For example, government debt in the United States rose by $1.4 tn to $19.6 tn in the most recent fiscal year which ended in September. This is much higher than the nominal expansion of the economy.

Central banks, in response to the global financial crisis, introduced a number of policy initiatives which are highly unorthodox and largely unprecedented. They have reduced interest rates to zero and purchased massive amounts of assets in order to prevent a deflationary bust at the time of the financial crisis. However, that occurred over seven years ago and since then, central banks have done more and more rather than scale back. So this raises the question of whether they are able or have the will to normalize monetary policy. The Federal Reserve (Fed) has spent the last nine months fussing about whether to raise rates by twenty five basis points. They talk like Hawks but act like Doves.

The desired and actual effect of these interventions has been to lift asset values which has largely benefitted those that own financial assets and who, it is hoped, will then spend some of their profits to spur economic growth. However, there are likely to be some costs to these policies and it is too early to know what the price is. Zero interest rates will likely give rise to a misallocation of capital as well as keeping insolvent businesses in operation. Further, savers have been punished and their response, unsurprisingly, has been to save more. The artificial and mispricing of money will likely result is distorted price signals traveling throughout the economy.

More recently, markets have entered the world of negative interest rates. A number of central banks including the European Central Bank and the Bank of Japan have pay banks to borrow money. Now highly indebted governments and corporations are paid to borrow. By early October, the two year bond of thirteen governments carried a negative yield. This list includes both Spain and Italy. Swiss, Japanese, and German ten year bonds have a negative yield. Italy, with a challenging public sector debt ratio and sluggish growth, just successfully floated a 50 year bond at a rate of less than 3% which was heavily oversubscribed. In Europe, the current interest rates structure appears to be causing some stress for the banking industry as evidenced by the problems in the Italian banking sector and the challenges being faced by Deutsche Bank. It is probably reasonable to assume that other European banks are in some distress.

Despite all the central bank interventions the economic recovery has been, when compared to other recoveries, anemic. Does this shallow recovery mean it can last much longer or has the monetary stimulus brought forward demand from the future compared with history the U.S. economic expansion is already lengthy? If the U.S. economy stutters will the Fed ease monetary policy? At the current time the narrative emanating from the Fed is that rate hikes are coming as part of the effort to normalize monetary policy. Interestingly, in the past, current measures of the real economy has caused the Fed to ease not tighten.

Any small loss in investor confidence in the Fed and other central banks is positive for gold. In general, investors believe that the global economy is recovering and that monetary stimulus can be withdrawn without causing much economic or financial disruption. If, as we believe, this narrative changes, even in a small way, gold should perform well.

Investment Scorecard

In a broadly flat gold equities market most of the big stock price moves among our portfolio holdings occurred for company specific reasons. The top performers, among holdings in excess of 1% of the portfolio at the end of September were Klondex (1.6% of net assets as of September 30, 2016) (+58.9%), Hochschild Mining (2.5%) (+56.6%), Wesdome Mines (1.6%) (+32.6%), and Mag Silver (1.6%) (+19.9%). For example, Hochschild experienced a successful startup of a new mine with costs coming in lower than expected largely due to better than expected ore grades and Wesdome performed well due to some exciting exploration results near one of their mines that is currently not producing gold.

Many of the bigger, more financially levered, gold producers gave up some of their large year to date gains. Barrick Gold (2.8%) is one such example. The stock of the world's largest gold miner declined by 17.7% during the quarter yet is up 140% for the first nine months of the year. However, some of our portfolio holdings suffered negative news. Oceana Gold (1.7%) was informed by the Philippine authorities that an audit of their mine showed that they were noncompliant in some areas. This came as a surprise as the company had indicated that the audit had not revealed any issues. Their Philippine mine is an important asset and their share price declined by 21.0% during the quarter. We expect the issues to be resolved and have taken the recent share price weakness to add to our position.

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.

Acacia Mining (LSE:ACA, Financial) (1.6% of net assets as of September 30, 2016) (ACA – $6.45 | £4.98 – London Stock Exchange) is a London listed gold mining company with three mines in Tanzania. The company was formerly called African Barrick, and Barrick is still a large shareholder of Acacia. Acacia is in the process of transforming its two largest assets, the Bulyanhulu and North Mara mines. Bulyanhulu is beginning to mine higher grade material, and operating costs have been reduced at the mine, leading to higher production at lower unit costs. At North Mara, the company is beginning to mine an underground portion of the orebody. Currently a dividend paying stock, the amount of the dividend paid should increase as the company executes operationally.

Agnico-Eagle (AEM, Financial) (6.5%) (AEM CN – $54.08 | $70.95 CAD – Toronto Stock Exchange), is a mid-tier gold producer with operations in Canada, Mexico, and Finland. The company is the dominant operator in the Val d’Or region of Northern Quebec, and the only gold producer in the Canadian sub-Arctic region. The company is in the process of delineating a new discovery in the Arctic region which could serve to extend the life of its large Meadowbank mine. Agnico is also delineating a deposit in Mexico which could be its third mine in the country. The company has a strong balance sheet and low unit cash costs which should allow it to comfortably complete these new projects while continuing to return cash to shareholders in the form of a dividend.

Detour Gold (TSX:DGC, Financial) (3.7%) (DGC CN – $21.75 | $28.54 CAD – Toronto Stock Exchange), is a single asset company based in Toronto, with its sole operating mine in northern Ontario. The Detour Lake mine is a large, bulk tonnage open pit operation which is currently the biggest gold mine in Canada. The mine’s cost base is largely fixed, with labor and electricity being large components, both are priced in Canadian dollars. The company is generating free cash flow, and will use a portion of this cash to pay down convertible debt which will come due in 2017. We expect the company to pay dividends to shareholders once the balance sheet has been sorted.

Hochschild Mining (LSE:HOC, Financial) (2.5%) (HOC – $3.75 | £2.90 – London Stock Exchange), is a Peruvian based gold and silver miner. The company has one mine in Argentina and three mines in Peru. Hochschild are experts in mining high-grade underground vein systems. The company’s newest mine, Inmaculada in Peru, will be its biggest and most cash flow generative asset. As Inmaculada begins to produce over the coming months, the company will be able to use cash flow from the mine to pay down debt and explore around its sites. We expect excess cash to be distributed to shareholders in the form of a dividend.

Klondex Mines (KLDX, Financial) (1.6%) (KDX – $5.75 | $7.54 CAD – Toronto Stock Exchange) is a mining company with two mines in Nevada and a development project in Manitoba. The company’s Fire Creek mine in Nevada is a high grade, small tonnage deposit. The Midas mine is near Fire Creek, and both mines feed a single processing facility near the Midas site. Klondex recently agreed to acquire a third property in Nevada called Hollister. Hollister could be a third source of feed for the centralized Nevada processing facility. All of the mines in Klondex’s portfolio are relatively short-life, and will require meaningful exploration spending to extend their lives. If exploration efforts are successful, Klondex will be a low cost producer with meaningful free cash flow generation at current gold prices.

MAG Silver (MAG, Financial) (1.6%) (MVG – $15.07 | $19.77 CAD – Toronto Stock Exchange) owns 44% of one of the highest quality silver deposits in the world. The Juanicipio project in Zacatecas, Mexico is adjacent to Fresnillo plc’s (7.1%), namesake silver mine. Having Fresnillo as the 56% majority partner and operator of the mine limits development risk for the asset, and should allow for the project to be financed with little trouble. Once operational, Juanicipio should be highly cash flow positive. A new discovery on the Juanicipio property has the potential to either extend the mine’s life or increase production at the project meaningfully.

Northern Star Resources (ASX:NST, Financial) (1.7%) (NST – $3.57 | $4.66 AUD – Australian Stock Exchange) is a Western Australia based mining company with three primary operating mines in Western Australia. The company acquired operating mines in the region from Barrick Gold and Newmont Mining (3.6%) during the downturn in the cycle when these two companies were selling assets to pay down over-levered balance sheets. The company has been successful in reducing costs at these operations and extending mine lives through exploration. Northern Star is a meaningful free cash flow generative company at the current Aussie dollar gold price, and pays a dividend to shareholders.

Osisko Gold Royalties (OR, Financial) (0.7%) (OR CN – $10.95 | $14.36 CAD – Toronto Stock Exchange) is a Montreal based gold royalty company which owns royalties on the two largest gold mines in Quebec, namely the Malartic mine in the Abitibi region, and the Eleonore mine in the James Bay region of northern Quebec. Osisko has a cash balance and generates meaningful amounts of free cash flow through producing royalties. The company is deploying this cash in very early stage development deals whereby it is able to fund exploration and development of projects, primarily in Canada, in exchange for equity stakes in the development companies and the opportunity to finance mine development through acquiring future royalties on future mine development.

Tahoe Resources (TAHO) (3.0%) (THO – $12.82 | $16.82 CAD – Toronto Stock Exchange) owns the Escobal mine in Guatemala, one of the largest primary silver mines in the world. Tahoe also owns two assets in Peru. One is an operating mine and one is a development project. The combined company will be cash flow generative, and be able to finance the build of its next project with free cash flow from its two producing assets and cash on its balance sheet. The company recently completed the acquisition of Ontario-based Lakeshore Gold. Tahoe aims to expand Lakeshore’s mineral inventory through an aggressive exploration program. If successful, the company will likely expand plant capacity on site and grow production. Tahoe pays a dividend, and we expect this will increase if the prices of gold and silver rise.

Torex Gold (TSX:TGX) (2.5%) (TXG CN – $21.63 | $28.38 CAD – Toronto Stock Exchange) is a development company with a project in Guerrero, Mexico. The company recently completed construction of its Limon/Guajes project on time and on budget. Once at full commercial production, the company should produce over 300,000 ounces of gold per year at unit cash costs in the lower half of the cost curve. The company has a second deposit near its current operation which can be its second mine. In developing its second deposit, the company has the ability to double production to 600,000 ounces while funding development with free cash flow from its first mine.

Conclusion

The recent uptick in the gold price has given gold mining companies the opportunity to grow cash flow which they have used to pay down debt and undertake required development work and exploration. Cash flow has also been helped by reduced mining costs due to lower energy prices and weaker local currencies for those miners that operate outside the United States (please see the attached report following our attendance at the Denver Gold Show). There has been the occasional dividend increase. For example, portfolio holding Hochschild Mining paid a 1.4 cent dividend to shareholders during the quarter. The last cash dividend the company paid was 2.6 cents in June 2013.

In a higher gold price environment we believe that gold companies will have the ability and desire to reward shareholders with meaningful cash distributions. In this event, we believe gold equities will attract interest from increasingly income starved investors. A meaningful increase in dividends paid by gold companies may help to reduce the current very high level of gold equity volatility. It is hard to reconcile the idea of gold equities being a form of financial insurance that could perform well when other financial assets decline in price when their day to day share price volatility is so high. But their inherent earnings leverage should decline with higher gold prices assuming costs remain the same. This may also help to lower share price volatility. Investing in gold stocks does require an acceptance of big price moves over a short period of time. However, due to their inherent earnings leverage, we believe the potential gain in gold equities in a higher gold price environment is considerable.

October 21, 2016

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.