To Our Shareholders,
For the quarter ended December 31, 2018, the net asset value (NAV) per Class A Share of The Gabelli Value 25 Fund decreased 14.3% compared with decreases of 13.5% and 11.3% for the Standard & Poor’s (S&P) 500 Index and the Dow Jones Industrial Average, respectively. Other classes of shares are available. See page 2 for additional performance information for all classes.
Introduction
For most of the last decade we have lived in what has often been termed a “Goldilocks economy.” Much as the fair-haired, home-invading subject of the children’s story found one bowl of porridge to be “just right,” economic growth and inflation has been neither too hot nor too cold1. During this time, coordinated action by the world’s central banks kept interest rates near zero and the prices of nearly all asset classes high. The U.S. economy is in its 113th month of expansion, seven months short of the record. Until the fourth quarter stumble, U.S. equities were 119 months into the longest-ever bull market, led mostly by growth stocks riding a global wave of technological innovation and expanding prosperity. Except for growth scares in 2011, 2015, and perhaps one day in November 2016, market volatility has been low and its upward trajectory largely uninterrupted. There are signs, however, that the narrative may be changing, as a turn in the aging business cycle may be accompanied by a wholesale shift in socio-political regimes from globalism to nationalism and capital to labor. Populism is on the march around the world with long-term effects that are unclear, but unlikely to be positive for equities. As in the story, the bears will eventually return home; their timing and mood is uncertain, as is how much of this eventuality the market has already discounted. Against this backdrop we believe bottom-up, fundamental stock selection of the type we have practiced for over 40 years remains more important than ever.
Barron’s 2019 Roundtable
Mario J. Gabelli, our Chief Investment Officer, has appeared in the prestigious Barron’s Roundtable discussion annually since 1980. Many of our readers enjoyed the inclusion of selected and edited comments from Barron’s Roundtable in previous reports to shareholders. As is our custom, we are including selected comments of Mario Gabelli (Trades, Portfolio) from Barron’s 2019 Roundtable Part 1 and Part 2, published on January 12 and January 19, 2019, respectively.
[Read this section here.]
The Political Economy of 2018
The most salient issue for the market is growth - with corporate tax cuts behind us and little slack left in the economy, real growth will almost certainly slow from the 3.4% posted in Q3 2018. That does not necessarily imply a recession, defined as two consecutive quarters of contraction, is on the immediate horizon. How far above or below the approximately 2% real growth that population and productivity gains suggest is “just right” depends on many factors including what we have described variously as Three T’s: Trade, Treasuries, and Trump.
Trade
President Trump made “fair trade” the centerpiece of his election campaign, and he has thus far made good on his promise to challenge the prevailing post-war “free trade” orthodoxy (however illusory that reality might have been). Hope for a trade deal with China rose when the administration renegotiated NAFTA, now called USMCA (the initials of its U.S., Mexican and Canadian signatories), the market understandably zags with each hint that a China deal could emerge, since China accounts for nearly half of the $600 billion U.S. trade deficit and remains our thirxd largest export destination. The situation takes on even greater significance due to China’s role as an engine for global growth. China is slowing as it faces domestic structural imbalances. Pressure from President Trump exacerbates those issues, but a deal will not solve them nor heal the lasting damage done to the Sino-American symbiosis.
Treasuries
Also critical to the outlook for the economy and stocks are the level and trajectory of interest rates. Since the Federal Reserve began its taper four years ago in October 2014, the ten-year U.S. Treasury rate breached 3% this year for the first time since 2013, standing now just below that level. Higher interest rates have real world impacts – they make the purchases of new homes, cars, capital equipment, and companies more expensive to finance. All else equal, higher rates reduce the value of risk assets by making the alternative home for capital, “riskless” Treasuries, more attractive. The term structure of interest rates (aka the yield curve) has also been ascribed predictive powers. Inverted curves – situations in which the two-year yield exceeds the ten-year yield – have predicted all nine recessions since 1955, albeit with two false positives and a wide variation in timing. The virtually flat yield curve today thus worries some observers.
Trump
While there has always been a healthy interplay between markets and political figures, President Trump’s twitter habit, unpredictability, and the potential legal challenges to his presidency have made him more of a focus than past leaders. Among the concerns for the next two years is how a Democratic Congress with no interest in helping Trump get re-elected approves the USMCA, a debt ceiling extension, and further fiscal stimulus, especially when the ask may be a tweak to the tax cuts. Interestingly, the War on Tech (i.e., privacy and anti-trust investigations of Facebook, Google, Amazon, and others) seems to be one of the few issues with bipartisan support and worth watching in 2019. Geopolitical disruption is not unique to the U.S.: if and how the U.K. exits the European Union, the precarious positions of leaders in Germany, France, and Italy, not to mention the typical entanglements in the Middle East, also remain a focus.
Skeptics Could Be Wrong If Things Go Right
Not all news – whether real or fake – is bad, of course. In fact, many economic indicators are quite strong, with 3.7% unemployment the lowest since the tumult of 1969, record consumer net worth ($109 trillion), and interest rates and inflation that, viewed over a longer time frame, remain quite tame. The Federal Reserve and the President are probably not past the point of no return, and still have not lost policy control: President Trump, who possesses a keen sensitivity to the stock market, could resolve the trade war and the Fed could blink on 2019 rate hikes. That would leave reason to believe the expansion could continue and that the current state of the market is the pause, like the previous ones in this cycle, that refreshes.
Mr. Market
Causation, Correlation or Neither
The S&P 500 finished 2018 down 4.4% and the small capitalization Russell 2000 index was down 11%, with each off 13.5% and 20.2% in the fourth quarter, respectively. The performance of the S&P 500, dominated by six technology stocks (Facebook, Amazon, Netflix, Google, Microsoft, and Apple – the “FANGMA”) that comprise 15% of its weight, masked the more significant declines posted by a broader group of stocks. Approximately two-thirds of stocks in the S&P 500 are negative this year with one-third down more than 20%. Even the vaunted FANGMA is now 25% off its highs, adding credence to the notion that the global growth trend may be broken. “Buy the Dip” has morphed to “Sell the Rip.”
Market declines of this magnitude could be expected to impart a negative wealth effect, i.e. consumers with slimmer brokerage statements feeling less inclined to make discretionary purchases, which could exacerbate an economic slowdown, but market declines are more often simply a precursor, not a trigger, of recessions. Since 1929, there have been sixteen bear markets with most, though not all, pacing a recession by approximately one year, with the recession-less crash of October 1987 a notable exception. It is also worth stating that the market does not equal the economy. Just as some have suggested Wall Street prospered without much of Main Street over the last decade, the reverse could conceivably prove true.
Valuation Today vs. Five Years Out
In any case, stocks are already pricing a slowdown and/or higher rates. A flat year-to-date equity market compared with estimated EPS gains of 22% in 2018 and 8% in 2019, implies a contraction in forward multiples from 18x at the end of 2017 to roughly 15x today. That is at the low end of historical multiples during periods with inflation in the 0%-3% area. This suggests that the market as a whole does not appear expensive. We do not buy the “market,” but we are finding a lot of bargains in individual stocks recently.
Rx for Investors
What is an investor in a choppy environment, lacking a reliable crystal ball, to do? Historically, it has proven foolish to attempt to time the market, especially based on macroeconomic data. In 2009, for example, the market rallied 36% between its bottom in March and the June end to the recession. None of this is to suggest investors should ignore their positioning in an evolving environment.
Indeed, we believe we are poised to capitalize from change. Historically, we have gravitated toward companies with characteristics such as pricing power, stable cash flows, solid managements, and resilient balance sheets – factors which may not have been appreciated in a zero inflation, easy money world. Higher interest rates and greater market volatility substantially increase the cost of capital even for the large internet companies. Combined with a possible economic slowdown, this should flush excess capital from the system, eliminating many of the seemingly disruptive companies backed by venture capital and accommodative capital markets to the benefit of those with truly sound business models and actual cash flow rather than the promise of future cash flow. Finally, a change in market structure over the last decade, with an estimated 15% of U.S. equities managed passively, could accentuate any downside as withdrawals from ETFs retrace what was relentlessly bought on the way up. Our portfolio, which tends not to resemble what is represented in the popular ETFs, should be less susceptible to those forces, and the volatility a rush to the exit could cause would present buying opportunities for active managers who conduct old fashioned research to uncover value.
Deals, Deals & More Deals
Deal activity slowed through the year as political uncertainty weighed, but the underpinnings for mergers (low interest rates and a lack of organic growth opportunities) remain and the potentially waning days of the present administration may encourage activity sooner rather than later. Spin-offs rebounded in 2018 (26 by our count), including two by Honeywell and one pre-takeover spin-off by KLX. Notable upcoming announced separations include Madison Square Garden’s spin of its sports teams, Twenty-First Century Fox’s pre-deal spin of its news and broadcast assets, and three-way spins by DowDuPont and United Technologies. As discussed in the past, we like spin-offs because they not only tend to surface value but often serve as the source of new ideas for the Fund..
Investment Scorecard
After strong performance in 2016 and 2017, 2018 was mostly forgettable from a stock perspective. On the positive side was the bidding war for large, long-time holding Twenty-First Century Fox (3.5% of net assets as of December 31, 2018) (+41% return) where the Walt Disney Co. prevailed over Comcast (1.3%) for Fox’s global entertainment assets. That deal was itself facilitated by judicial clearance of the acquisition by AT&T of former holding Time Warner. Outside of M&A, the Fund saw strong performance from sports/live entertainment investments in Madison Square Garden (5.3%) (+27%) and Liberty Braves (0.9%) (+12%), financial technology provider MasterCard (1.3%) (+25%), Japanese media/technology firm Sony Corp. (6.1%) (+8%), and automotive parts retailer O’Reilly (0.9%) (+43%). Less economically sensitive holdings, such as waste disposal firms Republic Services (4.2%) (+9%) and Waste Connections (1.6%) (+5%), added stability to the Fund.
The largest detractors from performance were media firms CBS (6.4%) ( -25%) and Viacom (5.2%) (-18%), both controlled by Sumner Redstone. Each company was impacted by industry level concerns about changing consumer behavior within pay-TV and exposure to a cyclical slowdown in advertising. CBS was hurt by the departure of CEO Les Moonves in the wake of sexual harassment allegations while uncertainty around a combination of the two firms remains an overhang, albeit one that could be resolved in short order. Industrial stocks with economic and trade sensitivity, including truck-maker Navistar (1.0%) (-39%), diversified manufacturers Circor (0.6%) (-56%), Crane (2.0%) (-18%) and CNH Industrial (0.8%) (-30%) also hurt the Fund. DISH Network (1.1%) (-48%), which has accumulated the largest swath of unused spectrum in the U.S., was a final “good idea at the time.” Financial leverage, additional spectrum supply and a potentially dwindling number of partners for a spectrum build are challenges DISH will have to overcome in 2019.
Conclusion
In our Q4 2017 letter we expressed surprise that a strong market was overlooking what seemed to be mounting risks late in the economic cycle. As many of those challenges - trade disputes, higher interest rates, political discord - play out, we wonder if the market is now ignoring what continue to be decent corporate fundamentals. Ultimately our job is to do the work on the microeconomic elements of each company and industry we cover, examine how the changing macroeconomic environment impacts those variables and make buy and sell decisions that balance the resulting opportunities and risks. Since the bears inevitably come home in each cycle, we have always erred on the side of capital preservation and that will especially be the case going forward. Children’s stories don’t always have happy endings, but they serve as cautionary examples that we have heeded well.
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 31, 2018.
Aerojet Rocketdyne Holdings Inc. (AJDR, Financial) (2.7%) (AJRD – $35.23 – NYSE), based in El Segundo, California, is a manufacturer of aerospace and defense products and systems for defense and space applications. The manufacturing operation is a leading technology based designer, developer, and manufacturer of aerospace and defense products for the U.S. government, including the Department of Defense and NASA. AJRD also manufacturers products for other governmental contractors and the commercial sector. The company also has significant real estate holdings, including significant land holdings east of Sacramento, California. AJRD is in the process of gaining governmental approvals to optimize the value of the land.
Bank of New York Mellon Corp. (BK, Financial)(3.6%) (BK – $47.07 – 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 December 2018, the firm had $33.1 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. We believe BK is also well positioned to grow earnings in a rising interest rate environment, given its large customer cash deposits and significant loan book
Honeywell International Inc. (HON, Financial)(3.1%) (HON – $132.12 – NYSE) operates as a diversified technology company with highly engineered products including turbine propulsion engines, auxiliary power units, aircraft brake pads, environmental control systems, engine controls, communications and navigation systems, sensors, building automation, catalysts and absorbents, process technology for the petrochemical and refining industries, and warehouse automation equipment and software. 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.
Madison Square Garden Co. (MSG, Financial) (5.3%) (MSG – $267.70 – 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. The company announced that it would spin-off of its teams in the middle of 2019, which we think could further surface value, especially as MSG expands its venue portfolio.
Newmont Mining Corp. (NEM, Financial) (4.1%) (NEM – $34.65 – 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 5.2 million ounces of gold and 120 million pounds of copper in 2018, with approximately 70% of this production coming from the United States and Australia. Newmont undertook company-wide cost cutting measures during the period 2013 – 2017, 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.
Republic Services Inc. (RSG, Financial) (4.2%) (RSG – $72.09 – NYSE), based in Phoenix, Arizona, became the second largest solid waste company in North America after its acquisition of Allied Waste Industries in December 2008. Republic provides nonhazardous solid waste collection services for commercial, industrial, municipal, and residential customers in forty states and Puerto Rico. Republic serves more than 2,800 municipalities and operates 191 landfills, 207 transfer stations, 348 collection operations, and 91 recycling facilities. Since the Allied merger, Republic has benefited from synergies driven by route density, beneficial use of acquired assets, and reduction in redundant corporate overhead. Republic is committed to its core solid waste business. While other providers have strayed into alternative waste resource technologies and strategies, we view Republic’s plan to remain steadfast in the traditional solid waste business positively. We expect continued solid waste growth acquisitions, earnings improvement, and incremental route density and internalization growth in already established markets to generate real value in the near to medium term, highlighting the company’s potential.
Ryman Hospitality Properties Inc. (RHP, Financial) (2.1%) (RHP – $66.69 – NYSE) is the owner/operator of four large convention-centric hotels under the Gaylord brand. It also owns the Opryland brand and entertainment complex in Nashville, the city of its origin. As such, it has benefited from the growth in country music and consumer preference for live entertainment. The company’s hotels are group-focused, and bookings have remained strong due to a steady economic expansion in the United States and limited supply growth within the group-focused hotel market segment. Future growth will come from new hotels (likely established as joint ventures) and investment into existing properties as well as development of live entertainment venues. The company, which is structured as a REIT (real estate investment trust), provides a tax efficient dividend stream underwritten by the consistency of its cash flow. In time, we expect management to unlock additional value by executing a tax-free spin-off of the entertainment business.
Sony Corp. (SNE, Financial) (6.1%) (SNE – $48.28 – NYSE) is a diversified electronics and entertainment company based in Tokyo, Japan. The company manufactures image sensors, PlayStation videogame consoles, mobile devices, consumer electronics, and mirrorless and professional cameras. It also operates the Columbia film studio and Sony Music entertainment group and hold majority ownership of Sony Financial Services. We expect growth opportunity in image sensor and game business, and operational improvements in consumer electronics and entertainment to generate EBITDA growth through 2020.
Twenty-First Century Fox Inc. (FOXA, Financial) (2.5%) (FOX/FOXA – $47.78/$48.12 – NASDAQ) is a diversified media company with operations in cable network television, television broadcasting, and filmed entertainment. We expect FOX to complete the transaction with Disney early in 2019. On November 19, 2018, Disney received approval from Chinese regulators to acquire FOX’s assets. Given ongoing trade tensions with the United States, some investors were concerned the deal could be held up for political reasons. With Department of Justice and European approval obtained, Brazil is left as the final jurisdiction remaining to make a decision. Even prior to obtaining Chinese approval, Disney felt confident the deal would close “meaningfully earlier” than the original target of June 2019. New Fox, the collection of assets not sold to Disney, will consist of: 1) Fox News, the most watched cable news channel in the U.S.; 2) The Fox Broadcast Network, one of the Big Four broadcast networks with substantial portfolio of sports rights, including the NFL and MLB; 3) FS1, the national sports network launched in 2013 to compete with ESPN; and 4) other cable networks such as the Big Ten Network. The company will be highly reliant on news and sports programming, which is watched live and not subject to the kind of ratings pressure seen in general entertainment networks. Given the “must carry” nature of both the Fox Broadcast Network and Fox News, we expect the company will be able to grow affiliate fees from distributors substantially faster than its peers.
Viacom Inc. (VIA, Financial) (5.2%) (VIA – $27.81 – 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. We believe a low valuation and M&A potential outweigh the secular risks of cord-cutting.
January 23, 2019
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.
