Gabelli Equity Income Fund letter to shareholders for the quarter ended June 30, 2014.
To Our Shareholders,
For the quarter ended June 30, 2014, the net asset value (“NAV”) per Class AAA Share of The Gabelli Equity Income Fund increased 4.6% compared with an increase of 5.2% for the Standard & Poor’s (“S&P”) 500 Index. See page 2 for additional performance information.
Gabelli Equity Income Fund: The Quarter in Review
The second quarter of 2014 saw stocks rise once again, adding to the modest gains of the first quarter. The bull market we have been experiencing since March of 2009 has now been going on for sixty-three months, and the S&P 500 has almost tripled in that time. Some might say that those impressive gains are a sign that the market has gone up too far, too fast. However, we think it is more indicative of just how oversold the stock market was during the depths of the great recession. Our economy has been dealing with many problems, not the least of which is polarization in Washington. Although we still have political bickering in the capital, the budget deficit is finally starting to come down, and we no longer need to worry about issues such as a government shutdown. We are hopeful, although not convinced, that the Federal government will do a better job of promoting economic growth in our economy.
The housing market, which collapsed a few years ago during the great recession, has been making a steady comeback. We are starting to see home prices rise across the country and more homes are being built. The construction industry is a major employer, and as the U.S. continues to build more homes in the next few years, as we believe it will, unemployment levels will continue to decrease. We still are not building enough new homes to meet the demands of population growth and new household formation, and we feel the housing recovery will continue for many years to come.
Another bright spot for the economy continues to be the energy sector. In fact, we believe that “fracking” is truly a game changer, and that the U.S. is well on its way to becoming energy independent in the next few years. We already have very low natural gas prices here in North America as a result of fracking, and our energy prices should stay low versus the rest of the world for the foreseeable future. This competitive advantage in energy is a major plus for our manufacturing sector as well, especially for heavy users of energy such as the chemical industry. We are in the camp that believes the U.S. is now in the midst of a manufacturing renaissance – good news for our overall economy.
Along with the improving economy comes less need for monetary easing by the Federal Reserve. The markets, both equity and fixed income, have benefited from QE3, but we are finally nearing the end of QE3 and we expect the program to conclude before the end of the year. Sometime in the first half of 2015, we expect the Fed will start to move short term interest rates up, in a slow, measured manner.
Despite the very impressive performance of the stock market over the past few years, the retail investor has not been adding any meaningful new assets to the stock market. Only in the past year or so have retail flows in domestic stock mutual funds started to turn positive after many years of outflows. For the first six months of this year, domestic equity mutual fund sales have totaled a mere +$2.6 billion. By comparison, international equity flows have been +$55 billion, and fixed income funds flows have been +$49 billion. Although the retail investor may still be somewhat shell-shocked from the financial crisis of a few years ago, corporate America has been a very aggressive buyer of stock over the past few years through buyback programs.
Gabelli Equity Income Fund: Dividends
Dividends are an important element in the historical returns of stocks. They provide current income and a growing income stream over time. In the second quarter of 2014, U.S. companies increased their actual cash payments by $12.6 billion, according to Standard & Poor’s, and the number of companies that increased their dividends was the largest since 1979. There is plenty of room to grow dividends in the future as well. Standard & Poor’s also states that the current dividend payout ratio is about 35%, well below the eighty year median of about 50%. Over the last fifty years, dividend growth has averaged 6%, almost double the rate of inflation.
Corporate America continues to return capital back to shareholders in the form of dividends. Not only are more dividends being paid, but the number of companies paying a dividend continues to increase. At the end of the second quarter, 422 of the companies in the S&P 500 paid a dividend, a level not seen since 1999. All thirty members of the Dow Jones Industrial Average pay a dividend. We believe that, over the next few years, dividends will continue to grow at well above the inflation rate, as has been the case historically.
Gabelli Equity Income Fund: Investment Scorecard
During the second quarter, the S&P 500 was up about 5% on a total return basis, with all ten sectors of the index up. The three best performing sectors were energy, utilities, and technology, each up more than the S&P 500 itself. It is interesting to note that each of these three sectors underperformed the S&P 500 in 2013. The two worst performing sectors in the second quarter of 2014 were financials and discretionary and, again, it is interesting to note that both of these two sectors outperformed the S&P 500 in 2013.
Among the best performing stocks in the portfolio during the second quarter was Hillshire Brands Co (NYSE:HSH) (0.6% of net assets as of June 30, 2014), the maker of Jimmy Dean sausage and other products, which is in the process of being taken over by Tyson Foods (TSN) (less than 0.1%). Another one of our holdings, Covidien plc (NYSE:COV) (0.9%), also did very well in the quarter, as it too is being taken over by a suitor. Other top performers include energy related companies such as Halliburton Company (NYSE:HAL) (0.8%), ConocoPhillips (NYSE:COP) (0.5%), and Weatherford International Plc (NYSE:WFT) (1.2%).
A few of the worst performing stocks during the quarter included JPMorgan Chase & Co. (NYSE:JPM) (0.5%), which announced that its trading business would be soft during the quarter. Another underperformer was Pfizer Inc. (NYSE:PFE) (1.3%), which was trying to merge with another pharmaceutical company, AstraZeneca plc (ADR) (NYSE:AZN) (LON:AZN), but dropped the effort after AstraZeneca’s board rejected Pfizer’s offer.
Gabelli Equity Income Fund: Let’s Talk Stocks
The following are stock specifics on selected holdings of the 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 are presented as of June 30, 2014.
Gabelli Equity Income Fund: Bank of New York Mellon
The Bank of New York Mellon Corporation (NYSE:BK) (1.3%