Gabelli Asset Fund commentary for the second quarter ended June 30, 2015.
To Our Shareholders,
For the quarter ended June 30, 2015, the net asset value (“NAV”) per Class AAA Share of The Gabelli Asset Fund increased 0.4% compared with an increase of 0.3% for the Standard & Poor’s (“S&P”) 500 Index.
Gabelli Asset Fund - Commentary
The second quarter of 2015 saw the return of the dreaded ‘C’ word – contagion, the transmission of a crisis from one country to others. The current vectors for contagion are well known: struggling borrowers such as Greece and Puerto Rico, a decelerating China, and unstable areas of the Middle East. What makes contagion so concerning for the markets is its wildfire-like unpredictability. With 11 million people and $230 billion in GDP (smaller than that of half of the states in the U.S.), Greece may be small, but the impact of a write-off of its debt on the European banking system, the repercussions of its exit from the European political and currency unions, and the precedents it might set for Portugal, Spain, and Italy are unknown. China, of course, is a far mightier country whose slowdown has already dampened the economies of its raw material suppliers, and any signs of social unrest could have unsettling second and third order effects for its neighbors. The U.S. has so far acted as a global fire break, with long awaited signs of wage inflation, but the recovery remains slow, fragile, and vulnerable to derailment by global events or a miscalculation by the Federal Reserve.
The kindling in the spread of any contagion is leverage. Public and private leverage has been employed generously since the 2008 financial crisis. Borrowing by countries and companies can be used intelligently to invest in growth and smooth investment cycles. Too often, too much of it has been squandered by elected officials and Boards of Directors on projects that do not generate adequate returns. The level of debt at any entity may be represented in a number of ways, but the coverage ratio – cash flow divided by debt service costs (e.g., interest expense) – is often most telling. Coverage ratios improve when cash flow rises or interest expense falls, the situation for the last several years in a recovery abetted by the Federal Reserve.
Due to low rates, although U.S. federal debt held by the public stood at a record $13 trillion (74% of GDP) at June 30, 2015, the $200 billion in annual cost to service that debt is lower in absolute terms and as a percentage of GDP (1.3%) than in 2008. The situation is similar for many other countries, U.S. local governments, and corporations globally. But what happens when the business cycle turns and/or interest rates begin rising again? Or worse, what happens when there is a liquidity shock when lenders refuse to roll-over funds as happened in 2008 and is currently the situation in Greece? We are not predicting any of these dynamics, nor are we terribly troubled by the balance sheet management of most borrowers. In some corners of the world under these circumstances, however, contagion could become conflagration.
Due to its dual creative and destructive powers, we consider leverage at the corporate level in selecting securities and constructing portfolios. Ideally we can identify management teams who understand how to prudently deploy debt, i.e., set it at appropriate levels and terms and reinvest in attractive return opportunities. We also make our own judgments about a corporation’s ability to service debt based on factors including the predictability of its cash flows, its economic sensitivity, and reliance upon volatile inputs. As an example, a subscription business such as a broadband provider can shoulder more debt than a cyclical, transactional business such as an auto manufacturer. Ultimately, we weigh leverage against our own return requirements; in general, the more leverage a company supports relative to what we judge to be optimal for the nature of its business, the “riskier” its cash flows and the greater discount to Private Market Value we will require before investment. Conversely, a company generating attractive returns on capital without leverage may be a more enticing investment and may even present an opportunity to boost equity returns further through a gearing of its balance sheet. This discipline in part has helped us to preserve capital in down markets and we believe should do the same if the Greek fire spreads.
Gabelli Asset Fund - Deals, Deals and More Deals
Deal making reached an all-time record – $1.4 trillion – in the second quarter, led by several mega-deals including Charter’s (less than 0.1% of net assets as of June 30, 2015) $80 billion acquisition of Time Warner Cable (TWC) (0.2%). Charter, whose agreement follows the government’s blocking of Comcast’s (0.7%) acquisition of TWC, will utilize financing provided in part by Fund holding Liberty Broadband (0.3%).
Financial engineering, often the precursor to M&A, was especially robust in the second quarter with spin-offs including Edgewell/Energizer (1.5%), Graham Holdings (0.1%)/CableOne and Baxter (0.1%)/Baxalta. John Malone continued his streak of financial engineering with Liberty Global (1.1%), issuing the UK’s first tracker stock, LiLAC, which reflects the performance of the leading Chilean and Puerto Rican broadband providers. Other spin-offs set for the remainder of the year include eBay (0.3%)/PayPal and Madison Square Garden Sports (1.1%)/Entertainment.
Finally, shareholder activism remains a catalyst for change. Following the announcement that activist investor JANA Partners had taken a stake in ConAgra Foods (0.5%), a manufacturer and marketer of food products with a focus in branded, private label, and commercial foods (potato supply and foodservice), new CEO Sean Connolly (formerly of Hillshire Brands) announced ConAgra’s intention to exit the private label business. We have long considered ConAgra an ideal candidate for financial engineering and believe other strategic options may be available to the remaining branded food and potato businesses.
Gabelli Asset Fund - 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 June 30, 2015.
AMETEK Inc. (1.8% of net assets as of June 30, 2015) (AME – $54.78 – NYSE) 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 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 2015, 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 $150-$300 million. The company expects to spend ~$1 billion on acquisitions this year. In Q2 2015 the company purchased two companies, deploying a total of $360 million in capital. The first acquisition, Global Tubes, a leading manufacturer of high precision small diameter tubing, fits within the Electromechanical Group and adds significant metallurgical capabilities to the Specialty Metals division. AME acquired Cognex Corp.’s Surface Inspection Systems Division (SISD) later in the second quarter for $160 million. SISD, within the Electronic Instruments Group, adds high speed surface inspection capabilities to AMETEK’s portfolio. We expect the company to continue its strategic acquisition strategy in the second half of 2015.
Cablevision Systems Corp. (1.2%) (CVC – $23.94 – NYSE) provides broadband, television, and phone service to approximately three million subscribers in the New York metropolitan area. An industry pioneer, CVC has developed the most advanced cable plant in the country and converted over 70% of its subscribers into triple play (video, phone, and broadband) customers. In the process, CVC achieved industry leading average monthly subscription revenues and margins. This peak performance led the company to become a victim of its own success; combined with competition from Verizon FiOS in approximately half of its footprint, Cablevision saw reduced growth and a sagging share price in 2012/2013. The company’s efforts to address these declines appear to be paying off. Management has also been active on the financial front, spinning off Madison Square Garden in February 2010 and AMC Networks (0.5%) in June 2011 and repurchasing over 10% of shares outstanding. Cablevision is now a single-market, pure-play cable operator, which could facilitate an eventual consolidation of the company, in our view.
ConAgra Foods Inc. (0.5%) (CAG – $43.72 – NYSE), headquartered in Omaha, Nebraska, is a manufacturer and marketer of food products with a focus in three areas: branded packaged food products, private label food products, and commercial foods (specialty potato and foodservice). ConAgra’s brands include Healthy Choice meals, Hebrew National hot dogs, Orville Redenbacher’s popcorn, PAM cooking spray, Reddi-whip, and Slim Jim jerky. Private label food was dramatically expanded with the 2013 acquisition of Ralcorp Holdings for $6.8 billion. The deal has not gone well, with the business experiencing integration issues and significant sales declines, all while taking management attention away from the company’s branded business. Following the announcement that activist investor JANA Partners took a stake in the company, new CEO Sean Connolly (formerly of Hillshire) announced ConAgra’s intention to exit the private label business when the company reported earnings on June 30, 2015. We have long considered ConAgra an ideal candidate for financial engineering, and we believe other strategic options may be available to the remaining branded food and potato businesses.
Energizer Holdings Inc. (1.5%) (ENR – $131.55 – NYSE), based in St. Louis, Missouri, is a manufacturer and marketer of battery and lighting products ($1.8 billion of revenue) and personal care products ($2.6 billion), such as Schick-Wilkinson Sword blades and razors, Edge/Skintimate shaving preparation products, Banana Boat sunscreen and Playtex feminine hygiene products. In April 2014, the company announced its intention to split into two publicly traded firms through a tax-free spin-off of the Household division, which was completed on July 1, 2015. As a result, shareholders received one share of Edgewell Personal Care and one share of the household business, Energizer Holdings Inc. This transaction created two leading and focused consumer companies, each with a strong balance sheet and flexibility to reinvest in its respective businesses, repurchase shares and/or make acquisitions. Both businesses may also be attractive acquisition candidates on a standalone basis to either strategic or financial buyers.
Genuine Parts Co. (1.4%) (GPC – $89.53 – NYSE) is an Atlanta based distributor of automotive and industrial replacement parts, office products, and electrical and electronic components. We expect GPC’s well known NAPA Auto Parts group to benefit as an aged vehicle population, which includes the highest percentage of off warranty vehicles in history, helps drive sales of automotive aftermarket products over the next several years. Additionally, economic indicators remain supportive of the company’s industrial and electrical parts distribution businesses amid steady economic expansion. Finally, GPC’s management has shown consistent dedication to shareholder value via share repurchases and dividend increases.
Liberty Global plc (0.8%) (LBTYK – $50.63 – NASDAQ), (0.2%) (LBTYA – $54.07 – NASDAQ) is the leading international cable operator, offering advanced video, telephone, and broadband Internet services. The company operates broadband communications networks in fourteen countries, principally located in Europe under the brands UPC, Unitymedia (Germany), Virgin (UK), Telenet (Belgium), and VTR (Chile). As part of its June 2013 acquisition of Virgin Media, Liberty Global redomiciled in the UK, increasing its strategic flexibility for the future. The company is internationally focused and well positioned to capitalize on the growing demand for digital television, broadband Internet, and digital telephony (VoIP) services in markets across its diverse geographic footprint. In July 2015 Liberty issued the UK’s first tracker stock, known as “LiLAC,” to highlights its properties in Chile and Puerto Rico.
The Madison Square Garden Co. (1.1%) (MSG – $83.49 – NASDAQ) is an integrated sports and media company that owns the MSG networks (MSG/MSG+), the New York Knicks, the New York Rangers, the Radio City Christmas Spectacular, and the iconic New York venue, Madison Square Garden. These evergreen content assets benefit from sustainable barriers to entry and long term secular growth. We believe the now complete Transformation project and the rising value of sports programming, as demonstrated by the NBA’s recent contract renewal with Time Warner Inc. (0.7%) and Walt Disney Co., should dramatically increase MSG’s earnings power through 2018. We also expect the announced separation of Media and Sports to act as a catalyst for shares.
Sony Corp. (2.3%) (SNE – $28.39 – NYSE; SNE – ¥3474.77 – Tokyo Stock Exchange) is a diversified electronics and entertainment company based in Tokyo, Japan. The company manufactures televisions, PlayStation game consoles, mobile phone handsets, and cameras, and it 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 2015. We also think the spinoff of the entertainment assets will be a potential catalyst.
Twenty-First Century Fox Inc. (2.1%) (FOXA – $32.55 – NASDAQ), (0.2%) (FOX – 32.22 – NASDAQ) is a diversified media company with operations in cable network television, television broadcasting, filmed entertainment, and direct broadcast satellite television. Cable networks account for 66% 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.
Gabelli Asset Fund - Investment Scorecard
Top contributors to performance included Cablevision Systems (+23%), which rose with speculation that it would become a target in the ongoing consolidation of the cable industry. DirecTV (1.5% of net assets as of June 30, 2015) (+9%) contributed positively as the probability of its already announced merger with AT&T rose; we expect the deal to close in the third quarter of 2015. Brown-Forman (2.1%) (+23%) reported strong results for Q4 of its fiscal year ended April 30, 2015, driven by continued strength of the Jack Daniel’s brand in the U.S. and internationally. The company also announced a $50 million investment in a new distillery in Ireland, continues to repurchase its own shares, and expects continued strong business momentum in fiscal 2016. Other contributors to performance included Grupo Televisa (0.9%) (+18%), in response to the highly anticipated IPO filing for 38% owned Univision; pest control firm Rollins (1.0%) (+16%), which continues to execute well; and ConAgra (+20%), described above.
The largest detractor from performance was truck maker Navistar International (0.4%) (-23%), which reported lackluster market share gains as it attempts to recover from the poor product decisions of prior management. A soft advertising environment weighed on Interpublic Group (0.6%) (-12%) and Twenty-First Century Fox (-4%). Japanese yogurt firm Yakult Honsha (0.4%) (-15%) pulled back after a strong first quarter. Finally, concerns about industrial demand, particularly in the energy sector, hurt Flowserve (0.9%) (-6%) and Precision Castparts (1.2%) (-5%).
Gabelli Asset Fund - Conclusion
No matter what the external macro environment, our process remains unchanged. We conduct bottom-up research on companies and industries in order to uncover undervalued businesses we would be happy to own for many years. Our Private Market Value (PMV) with a Catalyst™ stock selection process identifies stocks ripe for change, including potential acquisition targets and likely candidates for financial engineering. Overall we remain hopeful that the situations in Greece and China stabilize, that the U.S. economy reaccelerates, and a potential interest rate move is well discounted, but we are prepared for more volatility.
July 11, 2015