To Our Shareholders,
For the quarter ended June 30, 2015, the net asset value (“NAV”) per Class A Share of The Gabelli Value 25 Fund Inc. decreased 0.2% compared with an increase of 0.3%, and a decrease of 0.3% for the Standard & Poor’s (“S&P”) 500 Index and the Dow Jones Industrial Average, respectively. See page 2 for additional performance information.
Gabelli Value 25 Fund – Second Quarter 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 Value 25 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 $80 billion acquisition of Time Warner Cable (TWC). Charter, whose agreement follows the government’s blocking of Comcast’s (1.2%) acquisition of TWC, will utilize financing provided in part by Fund holding Liberty Broadband (0.7% of net assets as of June 30, 3015).
Financial engineering, often the precursor to M&A, was especially robust in the second quarter with spin-offs including Edgewell/Energizer (1.7%), Graham Holdings (1.1%)/CableOne and Baxter/Baxalta. John Malone continued his streak of financial engineering with Liberty Global (2.7%), 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 (0.7%)/PayPal and Madison Square Garden Sports (3.3%)/Entertainment.
Gabelli Value 25 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.
Diageo plc (3.0% of net assets as of June 30, 2015) (DEO – $116.04 – NYSE) is the leading global producer of alcoholic beverages, with brands including Smirnoff, Johnny Walker, Ketel One, Captain Morgan, Crown Royal, J&B, Baileys, Tanqueray, and Guinness. The company has a balanced geographic presence in both mature and emerging markets, and it benefits from the trend of consumers around the world trading up to premium brand products. Over the past several years, Diageo made acquisitions that enhanced its presence in emerging markets: a majority stake in United Spirits, the leading spirits producer in India, Mey Icki, the leading spirits company in Turkey; Shui Jing Fang, a leading Chinese baiju producer; Ypioca, the leading cachaca producer in Brazil; and an increased stake in Halico, the leading domestic spirits producer in Vietnam. While economic conditions in emerging markets have caused some of these investments to struggle recently, the long-term fundamentals of the spirits industry remain very favorable, and Diageo will be one of the largest beneficiaries of industry growth.
DISH Network Corp. (1.4%) (DISH – $67.71 – NASDAQ) is the third largest pay television provider in the U.S. with approximately 14 million subscribers. As a satellite operator unburdened by local franchising requirements and wired plants, DISH can market and deliver video extremely efficiently across the entire country. As founder of the