To Our Shareholders,
For the quarter ended December 31, 2016, the net asset value (“NAV”) per Class A Share of The Gabelli Value 25 Fund increased 2.0% compared with increases of 3.8% and 8.6% for the Standard & Poor’s (“S&P”) 500 Index and the Dow Jones Industrial Average, respectively. See page 2 for additional performance information.
Value Investing “Remains Great” Still
Whether it was the Chicago Cubs breaking a 108 year curse to bring home a championship, the United Kingdom defying the odds makers in a vote to exit the European Union, or a gilded New York real estate developer turned reality show star capturing the hearts of Rust Belt Americans, and consequently the White House, 2016 certainly qualifies as an unusual year. The world, depending on your perspective, has been turned upside down or right side up. Everything from longstanding political beliefs to consumer preferences for food and entertainment has shifted. In markets, the long bull market in bonds is ending, and Value appears poised to beat Growth for the first time since 2008. Through these tumultuous times, you can rest assured that at least two things will not change: our implementation of fundamental, bottom-up stock research, combined with the time-tested Private Market Value with a CatalystTM methodology, and our commitment to superior client service.
The Year In (P)review
While 2016 was marred by continued unrest in the Middle East and terror incidents around the world, the U.S. presidential election dominated the national conscience to such an extent that it impacted football ratings and retail spending. A conclusion to this quadrennial process (some might say ordeal) and greater political certainty would likely have sparked a market rally no matter who was elected, but the 5% rise in the S&P 500 since November 8 has the potential to rank as the largest market post-election move for a new president since the 1961 inauguration of JFK. The so-called “Trump Rally” has been fueled by the potential for increased fiscal stimulus, lower corporate and individual taxes, and deregulation. Taken together, these elements could drive U.S. GDP growth well above 2%, deferring the inevitable end to the current ninety month old expansion.
Corporate tax reform has been on the Washington agenda for many years, but with the Executive and Legislative branches in the hands of one party, it could finally become a reality. With many details to be reconciled, a reduction in corporate tax rates from 35% to 25%, or even lower, combined with a change to the current global system that taxes profits wherever they are earned, should lead to higher earnings. Similarly, a reduction in individual tax brackets and rates has the potential to stoke consumption and increase the incentive for work. Both of these reforms will have to be accompanied by offsetting limits to deductions, including the potential elimination of the deductibility of corporate interest expense, which could have broad consequences and somewhat limit the impact of lower rates. Increased fiscal stimulus, in the form of increased infrastructure and defense spending should also boost GDP growth, but may be limited by Republican concerns about the size of the deficit and the practical scarcity of shovel-ready projects. Finally, a rollback in the regulatory creep of the Obama years seems most assured. A redesign of the healthcare system, a loosening of Dodd-Frank rules governing the banking system, a lighter touch toward Internet regulation, a different approach to domestic energy production and transportation, and a more accommodative vision for anti-trust enforcement appear to have awakened the animal spirits of the business community.
Trump as President
Trump will make mistakes, as all Presidents do. For better or worse, our federal constitutional system, with the checks and balances of Congress and the courts, and power dispersed through the states modulates change by design. As we witness the evolution of candidate Trump into President-elect Trump, he has gathered some controversial but well-seasoned advisors, and seems humbled by the majesty of the office. Three areas bear continued watching. Protectionism is bad for consumers and businesses alike, but “free” trade is not always “fair” trade, and doesn’t mean that the President shouldn’t attempt to negotiate better deals with our trading partners. Second, a geopolitical crisis is a near certainty over the next four years – how will Trump balance a desire to project a strong America with a distaste for foreign entanglements? Lastly, it is worth noting that candidates who are populists are usually not unwaveringly pro-business; CEOs in all sectors should be alert for Twitter bombs, the modern form of jawboning, such as those lobbed by the incoming President at the pharmaceutical industry and several defense contractors.
Tailwinds and Headwinds
President Trump will inherit several interrelated macroeconomic shifts that were already in motion before the election and accentuated by its aftermath: higher interest rates, a stronger dollar, and increased inflation expectations. The ten-year U.S. Treasury note rose from a low of 1.4% in July to 2.5% at the time of this writing, while the dollar has strengthened against its trade weighted basket by about 5% over the same time frame. The Federal Reserve has signaled a willingness to raise rates multiple times in 2017. A divergence in monetary policy from still dovish central banks in Europe and Japan, not to mention a fraying of the European Union, will continue to propel the dollar and reduce the competitiveness of U.S. exports, an outcome neither Chairman Janet Yellen nor the new administration will relish. A tightening labor market and the promised fiscal stimulus may however, force the hand of the Fed. With all else equal, higher interest rates and accelerating inflation are bad for all asset classes, including equities. But all else is never equal. The question is whether GDP, and consequently, earnings growth will accelerate enough to overcome the natural governors of higher rates (felt in the form of higher borrowing costs) and inflation (felt in the form of reduced purchasing power). Put simply, earnings estimates for S&P 500 may be revised upward, but may not overcome the pressure of a reduction in the market multiple, which at over 17x is already above historical norms.
Much as it is foolish to underestimate the dynamic nature of the economy, one cannot generalize changes in the political economic environment to all industries. This has spurred a “Great Rotation” in the equity market markets, especially since the election, from Growth to Value, non-cyclical to cyclical, and large cap to small cap stocks. To the extent that financial companies are overrepresented in value indices, all of these shifts can be understood as the pendulum swinging to those companies most levered to tax reform and domestic stimulus and least exposed to currency and trade disruptions. Indeed the FANG stocks (Facebook, Amazon, Netflix, Google/Alphabet (0.2% of net assets as of December 31, 2016)) that dominated returns in 2015 trail the market slightly this year (up a weighted average ~8.7%) and appear out of favor both in Washington and on Wall Street. What remains to be seen is whether the virtuous (vicious if you are a Value investor) cycle of flows into passive ETFs and these names has been broken.
(Y)our Portfolio: Deals, Deals & More Deals
We believe we are generally well positioned for almost any economic environment, including the inflationary one described above. Our holdings tend to be domestically focused, with strong franchises and often pricing power. We have never been top-down allocators trying to chase every trend. Rather, we rely on fundamental bottom-up research, informed by our view of the shifting political economic tides. We purchase and hold securities trading at discounts to their Private Market Values appropriate for their level of risk, and seek to identify one or more catalysts that could close that valuation gap. Industry consolidation, financial engineering (e.g. spin-offs), changes in management, and changes in regulation are just a few catalysts in which the portfolio is rich.
2016 in Brief
Spinoff activity was healthy in 2016, though down from 2014 and 2015. Notable spinoffs in the portfolio include the separation of Hertz’s equipment rental unit (HERC) from the car rental business; the spinoff of Honeywell’s (2.7% of net assets as of December 31, 2016) nylon business, AdvanSix; the spinoff of Johnson Controls’ (1.0%) automotive interiors business, Adient; and the continued transformation of ConAgra under CEO Sean Connolly, with its spinoff of potato processor Lamb Weston.
As could be expected, Dr. John Malone contributed to our list of new securities with the spin-off of Liberty Expedia (0.1%) from Liberty Ventures and the issuance of three new tracker stocks: Liberty SiriusXM (0.8%), representing a 64% stake in SiriusXM radio; Liberty Brave (0.3%), representing ownership of the Atlanta Braves baseball club and related real estate; and Liberty Media (0.1%), accounting for a variety of public and private assets including a 35% stake in Live Nation Entertainment. It is worth noting that prior spins provide fertile ground for deals, as illustrated by the involvement of a spin-off parent or child in so many transactions below.
We were the beneficiaries of another strong year of mergers and acquisitions (M&A) as well. Two deals announced in 2015 involving significant holdings – the long-awaited purchase of Cablevision and Carl Icahn (Trades, Portfolio)’s purchase of Pep Boys – closed during 2016. January began with Johnson Controls agreeing to acquire Tyco International in a $14 billion stock deal. This was followed in February by Apollo’s agreement to acquire ADT, the home security spinoff of Tyco, for $42 in cash. Both transactions have closed. Other announced deals include Couche-Tard’s $48.53 cash offer for CST Brands (0.6%), the convenience store spinoff of Valero, and German chemical manufacturer Lanxess AG’s $33.50 cash offer for Chemtura (0.2%).
The biggest merger of the year belongs to AT&T, which, after acquiring satellite distributor DIRECTV from us in 2015, set its sights on leading content producer and serial financial engineer Time Warner (2.5%). AT&T has agreed to pay $107.50 in cash and stock in a transaction that will garner scrutiny in Washington, but we think is likely to succeed. Finally, at the time of this writing, there is speculation that 3G Capital and Berkshire Hathaway/Warren Buffett (Trades, Portfolio) have identified their next meal in the global food space – Mondelez (1.0%), which was formerly part of 3G’s current acquisition vehicle, Kraft-Heinz.
In our view, more accommodative regulatory agencies, a potential windfall of repatriated offshore cash, and historically low but prospectively higher interest rates should continue to drive M&A and benefit our style of investing.
Investment Scorecard
The largest contributor to performance in 2016 was CBS Corp. (7.6% of net assets as of December 31, 2016) (+25%), which, despite suspending a potential tie-up with Viacom (5.7%), continued to perform very well as a standalone content company under Leslie Moonves. As discussed above, Time Warner (+52%) agreed to be acquired by AT&T for $107.50 in cash and stock and was a strong contributor to performance. Companies exposed to infrastructure investment such as Xylem (2.0%) (+36%), aerospace and defense spending such as Crane Co (1.8%) (+54%) and Honeywell (+15%), and improving energy fundamentals such as Circor (2.0%) (+54%) and National Fuel Gas (2.7%) (+36%) performed well. Finally, despite a pullback late in the fourth quarter, gold miner Newmont Mining (3.2%) (+90%) was up sharply for the year.
Detractors from performance included U.S. media companies Viacom (-10%) and AMC Networks (1.1%) (-30%). Mexico-based Grupo Televisa (1.1%) (-23%) and Fomento Economico (“Femsa”) (1.1%) (-16%) suffered over concerns about the peso and the outlook for Mexican growth under President Trump. Liberty Interactive (1.1%) (-27%), the owner of multichannel shopping network QVC, suffered its first quarterly sales decline in the U.S. in nearly seven years.
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 30, 2016.
CBS Corp.(7.6% of net assets as of December 31, 2016) (CBS–$64.65–NYSE) (CBS, Financial) 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.
Honeywell International Inc.(2.7%)(HON–$115.85–NYSE) (HON, Financial) 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.
Mondelez International Inc.(1.0%)(MDLZ – $44.33 –NASDAQ) (MDLZ, Financial), headquartered in Deerfield, Illinois, is the renamed Kraft Foods Inc. following the tax-free spin-off to shareholders of the North American grocery business on October 1, 2012. Following the contribution of coffee into a new joint venture, nearly 85% of MondelÄ“z’s $27 billion of revenue is derived from snacking, including leading brands such as Oreo, LU and Ritz biscuits, Trident gum, and Cadbury and Milka chocolates. On July 2, 2015 MondelÄ“z combined its coffee business with D.E 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 including 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 confirmed that it received and rejected a preliminary indication of interest from MondelÄ“z to acquire Hershey for $107 per share in cash and stock, demonstrating MondelÄ“z’s continued interest in pursuing acquisitions while remaining an independent company.
NationalFuelGasCo.(2.7%)(NFG – $56.64 –NYSE) (NFG, Financial) is a diversified natural gas company. NFG owns a regulated gas utility serving the region around Buffalo, New York, gas pipelines that move gas between the Midwest and Canada and from the Marcellus to the Northeast, gathering and processing systems, and an oil and gas exploration and production business. NFG’s regulated utility and pipeline businesses, as well as its California oil production business, provide stable earnings and cash flows to support the dividend, while the natural gas production business offers significant upside potential. While natural gas prices have been depressed over the past few years, NFG’s ownership of 800,000 net acres in Pennsylvania, including 780,000 acres in the Marcellus Shale, holds enormous natural gas reserve potential and the company has proven to be among the lower cost producers. We continue to expect above average long term earnings and cash flow growth from improving gas prices, growing gas production and strategically located pipeline expansion. The company has increased its dividend for 46 consecutive years. In addition, NFG is considering corporate restructuring alternatives, including an MLP of its midstream assets.
SonyCorp.(3.2%)(SNE–$28.03–NYSE) (SNE, Financial) 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 2018. We also think the spinoff of the entertainment assets could be a catalyst.
Time Warner Inc. (2.5%) (TWX – $96.53 – NYSE) (TWX, Financial), located in New York, New York, is a diversified media company with operations in cable networks through HBO, TNT, TBS & CNN, and film & television production. We like the company’s cable networks, high margins and low capital intensity. We believe the AT&T-Time Warner transaction will close, and expect limited downside were the government to block the deal.
Twenty-First Century Fox Inc.(1.3%)(FOXA–$28.04–NASDAQ),(0.5%)(FOX–$27.25–NASDAQ) (FOXA, Financial) is a diversified media company with operations in cable network television, television broadcasting, filmed entertainment, and direct broadcast satellite television. Cable networks account for 70% of the company’s EBITDA, and benefit from contractually recurring affiliate fees and exposure to the fast growing global pay television market. We also expect the company to benefit from rising demand for premium content, driven by emerging distribution platforms such as Netflix, retransmission revenue, and aggressive share repurchases.
Viacom Inc. (5.7%)(VIA–$38.50–NASDAQ) (VIA, Financial) is a pure-play content company that owns a global stable of cable networks, including MTV, Nickelodeon, Comedy Central, VH1, BET, and the Paramount movie studio. Viacom’s cable networks generate revenue from advertising sales, fixed monthly subscriber fees, and ancillary revenue from toy licensing, etc. We believe a low valuation and M&A potential outweigh the secular risks of cord-cutting.
Xylem Inc.(2.0%)(XYL–$49.52–NYSE) (XYL, Financial) is a global leader in the design, manufacturing, and application of highly engineered technologies for the transportation, treatment, measurement, 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. XYL is expected to generate 8%-12% earnings per share growth through 2020, as it accelerates its capital deployment strategy globally. The company recently acquired Sensus, a leading manufacturer of smart metering equipment and technologies, for $1.7 billion.
Conclusion
Although 2016 has left prognosticators with egg on their faces and eating crow, 2017 promises to be another eventful year, with key votes among European Union members and the unfolding of policies at home. Those who bemoan the election of Donald J. Trump should take solace and those who cheer his election should take pause - the president’s authority extends only so far. Neither the economic cycle nor the curse of demographics can be repealed, and factors such as interest rates, debt levels, and productivity respond only marginally to the party in power. America has been and remains great, but could always be better. Likewise, we strive for continuous improvement. As always, we thank you for your trust and we look forward to what the future brings.
Postscript
In closing, we thought you would enjoy Alexis de Tocqueville’s description of presidential elections from his classic Democracy In America (1835) as you reflect on the year that has been and the vibrancy of our American experiment.
For a long while before the appointed time has come, the election becomes important and, so to speak, the all-engrossing topic of discussion. Factional ardor is redoubled, and all the artificial passions which the imagination can create in a happy and peaceful land are agitated and brought to light…
As the election draws near, the activity of intrigue and the agitation of the populace increase; the citizens are divided into hostile camps, each of which assumes the name of its favorite candidate; the whole nation glows with feverish excitement; the election is the daily theme of the press, the subject of private conversation, the end of every thought and every action, the sole interest of the present. It is true that as soon as the choice is determined, this ardor is dispelled, calm returns, and the river, which had nearly broken its banks, sinks to its usual level; but who can refrain from astonishment that such a storm should have arisen?
In de Tocqueville’s native tongue, plusçachange,plusc’estlamêmechose.
January 6, 2017
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.
