Value Investing

Gabelli Q3: Opportunities In M&A Amid Dearth Of Value

To Our Shareholders,

For the quarter ended September 30, 2013, the net asset value (“NAV”) per Class AAA Share of The Gabelli Asset Fund increased 6.7% compared with an increase of 5.2% for the Standard & Poor’s (“S&P”) 500 Index. See page 2 for additional performance information.

Gabelli Q3: Opportunities In M&A Amid Dearth Of Value

Déjà Vu All Over Again

The third quarter was marked by events that have become all too familiar over the last few years: the Fed continued its program of quantitative easing, the economy improved (albeit slowly), tensions flared in the Middle East, Washington seems to be at an impasse, and of course, markets rose substantially, with the S&P up over 5% for the quarter.

While the backdrop is well known at this point, the details are slightly different. The Fed surprised markets when, instead of starting its tapering process of cutting back on bond purchases, it decided to continue with its current level of $85 billion per month. While this event was celebrated by markets, it in some ways led to even more uncertainty, since the infamous taper will have to begin at some unknown point in time and it also shows that the Fed isn’t convinced the economy is on a strong footing yet. Further complicating matters, Larry Summers, thought of as one of the favorites to succeed Ben Bernanke as Fed Chairman, withdrew from the running – an event that also sent markets upward, since the frontrunner for the job became (presumably dovish) Fed Vice Chairman Janet Yellen, who was formally nominated shortly after quarter end. While liquidity is the lifeblood of markets, one wonders whether continually adding more will simply increase the pain down the road, when current policies must be unwound.

At the end of the quarter, the attention turned to events in Washington. While markets shrugged off the federal government shutdown that started on October 1, the potential of the United States bumping up against the Federal debt ceiling was beginning to look more possible, if not likely, as of the writing of this letter. While we expect a deal to be reached before or just after this happens, the potential of these events to rattle markets that have essentially coasted upward for the first three quarters of the year is a distinct possibility.

Despite all of these macro factors influencing the markets, our process remains the same since the Fund’s inception. Our stock selection is driven by fundamental, bottoms up research conducted globally by our team of analysts and portfolio managers. We seek quality companies trading at a material discount to Private Market Value with catalysts in place to surface value. As long as we have a margin of safety, we are willing to hold stocks for a very long time and will seek to use volatility (either in individual stocks or the market) in order to add to positions at more attractive prices. While the market has done well this year, we continue to believe that equities remain the most attractive asset class relative to other options, and are prepared to use any pullback due to the debt ceiling debate or other unforeseen events in order to increase our holdings in the best opportunities we have available.

Deals, Deals, and More Deals

In August, Verizon Communications Inc. (0.3% of net assets as of September 30, 2013) announced it would buy Fund holding Vodafone’s (0.1%) stake in Verizon Wireless in a $130 billion transaction. We believe this transaction may serve as a catalyst for more global telecom industry M&A and demonstrates that strategic acquirers are increasingly warming to the idea of stepping up to take advantage of the extremely attractive financing environment to pursue deals. Notwithstanding the political and macro uncertainty, we believe the Fifth Wave of takeover activity since World War II is growing in momentum, and many of the Fund’s holdings are potential takeover candidates.

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 percentage of net assets and their share prices stated in U.S. dollars or U.S. dollar equivalent terms are presented as of September 30, 2013, except as noted.

American Express Co. (1.5% of net assets as of September 30, 2013) (AXP – $75.52 – NYSE)(AXP) is the largest closed loop credit card company in the world. The company operates its eponymous premiere branded payment network and lends to its largely affluent customer base. American Express has 104 million cards in force and over $63 billion in loans, while its customers charged nearly $900 billion of spending on their cards in 2012. The company’s strong consumer brand has allowed American Express to enter the deposit gathering market as an alternate source of funding, while the company’s affluent customers have picked up spending. Longer term, American Express should capitalize on its higher spending customer base and continue to expand into other payment related businesses like corporate purchasing, while also growing in emerging markets. Similarly, the company is looking at the growing success of social media as an opportunity to expand its product base and payment options.

AMETEK Inc. (1.7%) (AME – $46.02 – NYSE)(AME) is a leading global manufacturer of analytical instruments for the process, aerospace, and industrial markets, and a leading producer of electric motors and blowers for the floor care and outdoor power equipment markets. In the near term, the company continues to experience significant growth in its longer cycle businesses in the aerospace, power generation, and process industries. Longer term, the company continues to make acquisitions to augment growth. In the Electronic Instruments Group, AMETEK expects one half to two thirds of its revenue growth to come from acquisitions. The company is focused on acquiring differentiated businesses with revenues of $30-$100 million. Differentiated businesses compete on the basis of product capability, have higher growth rates, and offer superior returns. In the Electromechanical Group, AMETEK’s key strategy is to reduce costs by increasing efficiency and moving noncore operations to low cost countries such as Mexico, the Czech Republic, and China.

Amgen Inc. (0.2%) (AMGN – $111.94 – NASDAQ)(AMGN) is one of the largest biotechnology companies in the world, with medicines for cancer, kidney dialysis, osteoporosis, and other conditions. Given its large size and mature product portfolio, revenue growth has slowed, but the company has been able to cut costs and repurchase shares to sustain double digit earnings per share growth. Earlier this year, Amgen offered to acquire Onyx Pharmaceuticals Inc. (less than 0.1%) to bolster its oncology portfolio, with Nexavar for liver cancer and Kyprolis for blood cancers. On Aug 25, after a brief auction, Amgen agreed to pay $125 per share, or $10.4 billion, for Onyx. While initially dilutive to earnings, this acquisition provides significant visibility into Amgen’s future, with two blockbuster drugs that could eventually generate over $5 billion in annual sales.

Diageo Plc. (1.2%) (DEO – $127.08 – NYSE)(DEO) is the leading global producer of alcoholic beverages, with brands including Smirnoff, Johnny Walker, Ketel One,