To Our Shareholders,
For the quarter ended September 30, 2018, the net asset value (“NAV”) per Class AAA Share of The Gabelli Asset Fund increased 5.1% compared with an increase of 7.7% for the Standard & Poor’s (“S&P”) 500 Index. Other classes of shares are available. See page 2 for performance information for all classes.
Third Quarter Commentary
Markets continued to charge ahead in the third quarter, with the S&P 500 again setting record highs in late September. Financial and economic data continue to support the rally: U.S. second quarter GDP growth registered a blistering 4.2%, the unemployment rate fell to a 49-year low at 3.7% in September, and corporate profits soared, with growth of over 16%. This good news was enough to overlook continued trade tensions, Federal Reserve-driven rising interest rates, and uncertainty around the midterm congressional elections.
This being said, there are always uncertainties and potential pitfalls to both markets and the economy.
We focus on what we call the “Four Ts”:
- Tariffs. Just after quarter end, the Trump Administration announced it had successfully negotiated the USMCA to replace NAFTA. Once ratified, the new agreement would (presumably) lead to an end of trade tensions in North America. Does this mean that the Trump administration will also, after much fiery rhetoric, try to find common ground on trade with the E.U. and China? Time will tell, but it currently appears that any actual economic damage may be short lived.
- Ten Year. The 10-Year Treasury note yielded less than 2.5% at the start of 2018. As of this writing, it yields over 3.2%, as higher interest rates are finally becoming a reality. Are current equity multiples sustainable as interest rates continue to rise?
- Taxes. The U.S. moved to a territorial tax system from a global system for corporations, which when coupled with a 21% corporate tax rate provides a magnet for businesses to locate here. Another plus is the 100% expensing of capital expenditures for both new and used equipment, which drives increased business spending. Clarity on taxes should also allow for more deal making.
- Technology. Winners and losers are being created in a multitude of industries as technology is used to disrupt old business models. Long standing businesses are also employing technology to deepen their economic “moats”, particularly locally-focused service oriented businesses. In the stock market, large cap tech has again been leading growth this year (as for much of the last decade), though tech stock prices started to reflect worries about continued growth after quarter end.
Deals, Deals & More Deals
Worldwide mergers and acquisitions (M&A) activity totaled $3.3 trillion during the first nine months of 2018, an increase of 37% compared to the first nine months of 2017 and the strongest first nine months for global M&A on record. The third quarter, however, registered a 32% decline in transaction value compared to the second quarter of the year. Overall, 34,543 deals were announced worldwide during the first nine months of 2018, down 9% from a year ago, indicating that mega deals are continuing to drive transaction value. We continue to anticipate more small and mid-cap companies participating in the current M&A boom as time goes on, especially as potential targets continue to be created via financial engineering.
Top contributors to performance during the quarter included Sony (2.0% of net assets as of September 30, 2018) (+18%), which reported strong top and bottom line results in its fiscal first quarter driven by its Game & Network Service and Music divisions; Flowserve (1.1%) (+36%), which stands to benefit from sales of pumps and valves into oil & gas, petrochemical, and chemical projects around the world that are now moving forward with the rebound of oil prices; Donaldson (1.2%) (+30%), which reported outstanding results for the company’s fiscal fourth quarter, as strong demand for machinery and industrial filtration equipment helped drive revenues up 10%, while solid execution at the company level helped avoid margin contraction from input costs and strategic investments; Crane (1.2%) (+23%), which reported strong second quarter results, with solid demand across the company’s Aerospace & Electronics, Crane Payment Innovations, Crane Currency and Fluid Handling businesses; and Honeywell (1.7%) (+16%), which continues to benefit from increased aerospace and defense spending, and completed the spin-off of Garrett Motion, its transportation business, after the end of the quarter.
Detractors from performance included Twenty-First Century Fox (3.3%) (-6%) which declined slightly from its highs amid bidding war speculation between Disney and Comcast (0.5%); gold miners Newmont Mining (0.6%) (-20%) and Royal Gold (0.4%) (-17%) which both declined along with the price of gold; Visteon (0.2%) (-28%),”‹ which declined as broader concerns over global automotive production weighed heavily on the supplier base, and impacts from import tariffs are negatively affecting automotive demand in China; and Bank of New York Mellon (1.3%) (-5%), whose shares were impacted by a flattening yield curve and disappointing results from a more stringent CCAR test.
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, 2018.
AMETEK (AME, Financial) (2.1% of net assets as of September 30, 2018) (AME – $79.12 – NYSE) is a diversified supplier of highly engineered equipment used in a broad array of industrial end markets. The company offers a diverse product portfolio including test and measurement, metrology, and precision motion control equipment in addition to specialty materials and aftermarket services. Through July 2018, AMETEK has spent $370 million acquiring three businesses (following $560 million spent on three acquisitions during full-year 2017). As of June 30, 2018, the company had $560 million of cash on its balance sheet and over $700 million of availability on its revolver and management expects to remain active on the acquisition front. Organic sales growth has also been strong, up 8% year-over-year during the first half of 2018 and AMETEK finished Q2 2018 with a record backlog of $1.6 billion.
Brown-Forman Corp. (BFA, Financial) (2.3%) (BFA/BFB – $50.80/$50.55 – NYSE) is a leading global distilled spirits producer. Spirits is an advantaged category that enjoys high margins, low capital requirements, strong free cash flow generation, and good pricing power. The company’s global brands include Jack Daniel’s Tennessee whiskey, Finlandia vodka, Woodford Reserve bourbon, and el Jimador and Herradura tequilas. Jack Daniel’s is one of the world’s most valuable spirits brands, enjoying strong growth both in the U.S. and internationally as consumers increasingly choose to drink American whiskies. The company has also successfully expanded the brand into the fast growing flavored whiskey category. While Brown-Forman does face some near term headwinds from ongoing trade disputes, emerging market sales have returned to growth, and the company is positioned to grow revenues and profits substantially over the next several years, and has significant balance sheet flexibility. While the company is family controlled, we believe that if it ever became available for sale it would be highly coveted by other large global spirits players.
Clear Channel Outdoor Holdings (CCO, Financial) (0.1%) (CCO – $5.95 – NYSE) located in San Antonio, Texas, is an outdoor advertising company with billboards, street furniture, transit, and digital displays in global markets. Outdoor advertising represents 4%-6% of total advertising, reaches consumers outside of the home where the propensity to spend is greater, and it cannot be skipped or blocked. iHeart Communication controls CCO with ~87% of the economic and 99% of the vote. iHeart is currently negotiating a bankruptcy exit with its creditors, which include CCO. CCO has businesses in both the U.S. and international markets that could be attractive to a global outdoor operator. We expect that the exit of iHeart from bankruptcy and distribution of iHeart’s stake in CCO to creditors could be a catalyst for shares.
CNH Industrial NV (CNHI, Financial) (0.8%) (CNHI – $12.01/€10.35 – NYSE/Borsa Italiana), with headquarters in London, England, and Burr Ridge, Illinois, is a global capital equipment manufacturer that was demerged from parent Fiat in 2013. CNHI is unique in that it has leading positions in a variety of global machinery markets. It is best known for its agricultural equipment business, consisting of Case IH, New Holland Agriculture, and Steyr brands. The company’s other businesses include Iveco, a leading global truck and bus manufacturer, as well as Case and New Holland construction machinery. Finally, FPT Industrial provides engines and transmissions for the company’s captive businesses and also sells to other machinery manufacturers. CNHI is well positioned, not only for a cyclical recovery in its agricultural and equipment end markets, but also for significant cash flow generation in the years ahead. We believe CNHI can surface value through financial engineering, with Iveco being a particularly attractive asset for other global machinery manufacturers.
Discovery Communications (DISCA, Financial) (0.8%) (DISCA – $32.00, DISCK – $29.58 – NASDAQ) located in Silver Spring, Maryland, is a global nonfiction media & entertainment company that provides programming to pay-TV distributors through network brands such as the Discovery Channel, TLC, Animal Planet, HGTV, Food Network, and ID. On September 12, 2018, Discovery reached a vMVPD distribution agreement with Hulu and announced a contract renewal with Dish Network which includes carriage on Dish’s Sling TV. In addition to providing ~2.5 million additional subscribers, the agreements highlight the value of Discovery’s content. The news should reduce investor concerns that Discovery is losing relevance in U.S. markets. Separately, management believes 1) Scripps synergies, estimated at $600 million, are tracking ahead of expectations, 2) affiliate fees should see a significant step-up in 2019, and 3) the company will be at or below 4.0x debt to EBITDA by year-end. Discovery has an enviable business model. About 50% of revenue is generated from long-term agreements with pay-TV distributors and the company is exposed to secular growth in the international pay-TV industry. Industry leading margins are especially attractive given the low capital intensity of the cable network business. We expect the acquisition of Scripps Networks to provide meaningful cost synergies as well as improved scale. We also believe Discovery could be an attractive acquisition target for a number of larger media companies given the acceleration in industry consolidation. DISCA trades at 9.0x 2019P EBITDA, which compares favorably to recent transactions: Time Warner was purchased at 13x EBITDA; Disney is paying 15.5x EBITDA for FOX’s assets.
Flowers Foods Inc. (FLO, Financial) (0.2%) (FLO – $18.66 – NYSE) is the second-leading manufacturer and marketer in the fresh bread category. Fresh bakery is one of the largest retail categories generating $24 billion in retail sales. The bread category has undergone considerable consolidation over the last decade as the three largest manufacturers’ branded products represent approximately 51% of the market. Flowers continues to shift its portfolio to faster-growing segments of the baking industry, including premium, specialty, in-store bakery and organics. In 2015, the company acquired Dave’s Killer Bread, which is the leading organic bread brand in the U.S. with nearly 60% market share growing strong double-digits. In conjunction with growing sales, the company is implementing its multiyear cost savings initiatives associated with Project Centennial, which is expected to contribute to EBITDA margin improvement of 250 basis points through 2021.
Flowserve (FLS, Financial) (1.1%) (FLS – $54.69 – NYSE) is a leading manufacturer of pumps, valves, and seals for the oil and gas, chemical, power generation, water treatment, and general industrial markets. Flowserve is benefiting from increasing project activity across its core oil and gas, petrochemical, and chemical end markets in the U.S., Middle East, and Asia. As one of the largest providers of pumps and valves into these end markets, Flowserve stands to benefit from the release of budgetary dollars on these long-cycle capital projects. The company’s operating performance is also beginning to show early signs of improvement under the leadership of CEO Scott Rowe, who took the helm in April 2017.
Madison Square Garden Co. (MSG, Financial) (1.6%) (MSG – $315.32 – NYSE) is an integrated sports and entertainment company that owns the New York Knicks, the New York Rangers, the Radio City Christmas Spectacular, The Forum, and that iconic New York venue, Madison Square Garden. These evergreen content and venue assets benefit from sustainable barriers to entry and long term secular growth. MSG completed the separation of its associated regional sports networks in September 2015, leaving a reliable cash flow stream for MSG to reinvest and repurchase shares. In June 2018, the company disclosed that it was exploring the spin-off of its teams, which we think could further surface value, especially as MSG expands its venue portfolio.
MGM Resorts International (MGM, Financial) (0.4%) (MGM – $27.91 – NYSE) is the Las Vegas-based owner and operator of 17 casino resorts, 73% of an associated REIT MGM Growth Properties (MGP), 56% of MGM China (2282-HK) and 50% of CityCenter Las Vegas. Following a weak 2018, MGM will have easy performance comparisons immediately following the openings of capital projects in Las Vegas and Massachusetts, and as VIP operations ramp at its second Macau casino, MGM Cotai. We continue to believe that an inflection in free cash flow generation, which we expect to begin in the fourth quarter of 2018, is the key to closing a large gap between the current stock price and our Private Market Value estimate, which is based on a sum of the parts valuation of its assets.
Sony (SNE, Financial) (2.0%) (SNE – $60.65 – NYSE) is a diversified electronics and entertainment company based in Tokyo, Japan. The company manufactures image sensors, televisions, PlayStation game consoles, mobile phone handsets, and cameras. It also operates the Columbia film studio and Sony Music entertainment group. We expect growth opportunity in image sensor and game businesses and operational improvements in consumer electronics and entertainment to generate EBITDA growth through 2018. We also think the potential spinoff of the entertainment assets could be a catalyst.
Twenty-First Century Fox Inc. (FOXA, Financial) (3.3%) (FOXA – $46.33, FOX – $45.82 – NASDAQ) is a diversified media company with operations in cable network television, television broadcasting, and filmed entertainment. FOX is in the process of selling the company’s cable, international, and entertainment assets to Disney for $72 billion or ~$38 per share. Following the transaction, FOXA will consist of Fox News and The Fox Broadcasting Company. The company’s concentration in live news and sports programming will be a significant advantage as it negotiates with both traditional and entrant distributors. Pro forma for the Disney transaction, FOXA is trading at 7.2x EBITDA, which we view as attractive.
Viacom (VIA) (0.7%) (VIA – $36.55, VIAB – $33.76 – NASDAQ) 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 (XYL) (1.2%) (XYL – $79.87 – NYSE) 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 expects to generate mid-teens earnings per share growth through 2020 as it accelerates its capital deployment strategy globally. The company is currently building out its infrastructure analytics capabilities as it integrates companies it has acquired in the past several years such as Sensus, Hypack, and Pure Technologies.
As always, we conduct bottom-up research on companies and industries through our proprietary methodology which we call “GAPIC”: Gather, Array, Project, Interpret, and Communicate. As active stock pickers, this is the kind of environment for us to prove our mettle. 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 look for catalysts to surface value, such as industry consolidation, financial engineering, new management, regulatory changes, or a change in cash flow allocation.
October 26, 2018