- By Holly LaFon
To Our Shareholders,
Thank you for your investment in The GAMCO Global Growth Fund.
For the quarter ended December 31, 2017, the net asset value ("NAV") per Class I Share of The GAMCO Global Growth Fund increased 6.5% compared with an increase of 5.7% for the Morgan Stanley Capital International ("MSCI") All Country ("AC") World Index. See page 2 for additional performance information.
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- ADBE 15-Year Financial Data
- The intrinsic value of ADBE
- Peter Lynch Chart of ADBE
It's a familiar refrain. Stocks rose last quarter - the ninth consecutive quarterly gain - on the back of rising earnings, continued low interest rates and better than expected growth in Europe and Asia. Adding some torque to the market's advance was enthusiasm over the tax reform package passed just before Christmas. The corporate tax cut element of this package will boost earnings by several percentage points in 2018. With the loss of the SALT (state and local tax) deduction, not all individual tax payers will benefit, but the boost to earnings, incentives to invest (via full expensing of certain capital expenditures items) and repatriate foreign profits are likely to elevate the slope of trend line GDP growth, at least for a bit. Investors appear delighted with this fiscal policy cocktail as both the economy and stock market exited 2017 with substantial confidence and momentum.
According to the Bloomberg Economic Survey, the consensus estimate for real GDP growth in 2018 is 2.6%. This compares to a likely growth rate of about 2.4% for 2017. Three months ago economists were expecting growth of 2.3% in 2018. We suspect the positive revision of expectations from 2.3% to 2.6% will be further elevated to a number closer to if not exceeding 3.0%. The likely boost to capital investment from tax reform is the primary factor responsible for our more optimistic view of 2018 growth, although wage and employment gains, along with the lower individual tax rates, will provide an assist to consumer spending as well. This does not mean to suggest we are on the cusp of returning to 3.0% or greater trend line growth. While a few quarters or a year at that level can be achieved with an important assist from tax reform, anything more requires a meaningful increase in productivity growth and that remains elusive.
Current expectations for S&P earnings in 2018 are about $148, up from $146 last quarter. This compares to operating earnings of about $134 in 2017 (still to be reported at this writing). Positive revisions to expectations are likely here too. A number higher than $150 is not out of the question for 2018. So earnings growth this year of at least 10% is likely and 15% or more is doable. This level of earnings growth provides a tailwind for the economy, especially with new capital investment incentives. At 4.1%, the unemployment rate cannot be expected to drop much further. Given the low unemployment rate, annualized wage rate gains should accelerate to 3% and eventually 4%. Typical recessions - as if anything is typical anymore - are usually preceded by 4% gains in wages.
Given the economy's healthy trajectory, it is no surprise the Federal Reserve Board is expected to continue on its course to normalize interest rates. This involves raising short-term rates and shrinking its $4.5 trillion balance sheet (a move now referred to as QT or quantitative tightening). The Federal Reserve is currently expected to raise rates 3 times in 2018, possibly 4 if the economy or inflation runs hot. The first increase is expected in March. The big unknown is at what interest rate level does the tension between stocks and bonds become too much? How high does the 10 year Treasury yield have to go before the stock market cries uncle? For the last 4 years the 10 year Treasury has mostly traded in the 2.0% to 2.6% yield band, has averaged 2.2% and is currently 2.5%.
At the end of 2013 when the 10 year yield briefly hit 3.0%, the forward PE (price to earnings ratio) on the S&P was about 15. It's about 18 now. Given continued ultra-low rates abroad (the German 10 year yields 0.40% and the Japanese version yields 0.05%), demand for Treasuries may keep a lid on the 10 year yield even as the Federal Reserve tightens in response to rising growth or inflation expectations.
We must be skeptical of any attempt at precision forecasting as far as the stock market is concerned. That goes for our forecasts as well. While there is no doubting the stock market's momentum entering 2018, a 5% pullback could happen anytime. We are already at a record 14 months plus since the last 5% drop, an event that we usually see 3 times each year. The complacency exhibited by stocks over the past year is remarkable and should not be expected to continue. We still have not had as much as a 3% fall since before the 2016 election. Feeling good today, which we do, has little if any bearing on how we will feel in May or July, let alone November.
We must not lose sight of the historical nature of this bull market. This is the second longest bull market in history (and the third longest economic expansion). If the market's advance continues into September, it will be the longest bull market in history, surpassing the roaring bull of 1990's fame (think dot com bubble). Slow and steady economic growth with historically low interest rates - engineered to a degree - has been the not so secret sauce of this bull market run. Is the market's slow and steady diet becoming not so slow? How long can we keep consumer price inflation in a bottle? Does financial asset inflation, which we have had aplenty, imply anything for consumer prices?
The S&P has returned 387% (price change plus reinvested dividends) since March 9, 2009. We have some concerns. The Federal Reserve is intent on removing liquidity from the economy and valuations are historically high unless we are at a "new normal" for interest rates and 10 year yields don't go much above 3% (currently 2.5%). The total stock market capitalization as a percentage of GDP has only been higher in the dot com bubble that peaked in early 2000. Surely this is at least the top of the 8th inning for this gracefully aging bull market? Other major central banks are a step or two behind the Federal Reserve but for how long? How long until they are all in tightening mode?
The European Central Bank (ECB) has begun to reduce stimulus and the Bank of Japan (BOJ) is likely to follow suit before the year is out. Should yields rise overseas, as quantitative easing (QE) recedes, Treasuries may lose some appeal and pressure stocks. Trump talks tough on trade and may induce a trade war. Trump barks at North Korea and taunts them with the possibility of war. While the stock market has liked Trump's deregulation and tax reform policies, it won't like a trade war, let alone a shooting war with North Korea or anyone else.
Don't forget the yield curve. Wall Streeters delight in sharing their yield curve insights. Should we view the ongoing flattening of the yield curve with alarm (the spread between 2 and 10 year Treasury yields has fallen from 291 basis points in 2010 to 50 basis points in early January)? Should the yield curve actually invert, which typically only happens prior to recession, alarms will ring on Wall Street. One does not take an inverted yield curve lightly, but we aren't there yet. And then there is the Mueller investigation, which could represent a Black Swan of sorts and could lead to a Constitutional crisis. Such a crisis could be triggered by Trump himself should he fire Mueller or Deputy Attorney General Rod Rosenstein.
We eliminated ten holdings during the quarter and added four for a net reduction of six, making for 72 issues in the portfolio. We sold NextEra Energy to better prepare for higher interest rates as NextEra is particularly sensitive to changes in rates. Celgene was sold to cut back on higher beta health care in what is likely to be a more difficult market environment this year. General Electric was sold when we determined a significant dividend cut was likely amid growing concern regarding the company's earnings quality, a concern that grew during the quarter after the release of third quarter earnings. EOG Resources and Schlumberger were sold due to lack of confidence in their sustainable earnings growth. CK Hutchison was sold due to concerns of slowing growth in China and its related debt bubble. Liberty Global was eliminated to reduce overall media exposure. Reckitt Benckiser and Roche were sold due to disappointing earnings growth. Lockheed Martin was sold due to its valuation, which we deemed to be fully priced for the near term.
We established new positions in Rockwell Automation (1.1% of net assets as of December 30, 2017), Palo Alto Networks (0.3%), Danone (1.0%) and Adidas (1.4%). Rockwell is a leading supplier of products that are used in helping to run and manage highly automated factories. Based in Milwaukee, Rockwell received a takeover bid from Emerson Electric during the quarter which the company rejected. Palo Alto Networks, based in Santa Clara, is arguably the leading provider of cybersecurity software for the enterprise market. Cybersecurity software will be a fertile growth market for many years to come as threats from both state sponsored and private computer hackers continue to grow at a frightening pace. Danone, the French yogurt maker, has a portfolio of leading natural and organic food brands. Danone solidified its leading position in dairy with the acquisition of WhiteWave in April 2017. Danone is tracking ahead of schedule in delivering EUR300 million in synergies. Adidas has been a market share gainer in North America, where it has made a splash with its retro-style Stan Smith sneaker. The company has a long runway to drive earnings growth as it brings its North American operating margins in-line with peers.
We trimmed three positions: Bristol-Myers Squibb (0.3%), Comcast (0.5%) and Charter Communications (0.4%). We increased a number of positions with the biggest increases being in the holdings of Disney (1.5%), Starbucks (1.5%), Nike (0.8%), Home Depot (2.1%), Alibaba (3.7%), First Republic Bank (0.8%) and UnitedHealth Group (2.9%). At quarter's end we were overweight (relative to the MSCI All Country World Index) Health Care, Technology and Consumer Discretionary. We were underweight Energy, Materials, Telecommunication Services and Utilities. We were essentially neutral in Consumer Staples, Real Estate and Industrials. From a cyclical perspective, we regard our positioning as modestly defensive with respect to stock selection while maintaining what is essentially a fully invested position given our skepticism with respect to market timing.
Our relatively positive fourth quarter performance was driven by some of our largest holdings. Holdings with the most positive impact on performance for the quarter (based upon price change and the size of the holding) were, in order, Tencent (4.9%), Microsoft (3.8%), Fanuc (3.4%), Adobe (2.7%), Alphabet (4.2%), UnitedHealth (2.9%), Home Depot (2.1%), Amazon (2.3%), Sherwin-Williams (1.8%) and LVMH (2.8%). The largest detractors from performance were, in order, Celgene, First Republic Bank, Liberty Global, Swatch Group (2.0%), Charter Communications, Reckitt Benckiser, Jardine Matheson (1.9%), Comcast, Adidas (1.4%), and CK Hutchison.
For the full year, the stocks with the most positive impact on performance were, in order, Tencent, Facebook (4.5%), Keyence (3.7%), Adobe, Alphabet, Microsoft, LVMH, Alibaba, Amazon, and Visa (2.2%). Likewise, the most negative contributors for the year were, in order, Schlumberger* Celgene*, O'Reilly Auto*, AutoZone*, Subaru*, General Electric*, Adidas, WPP*, Snap-on* and BP*.
We have mixed emotions about this year. Both the economy and stock market enter the year with good momentum. Expectations are high, however, begging the question as to can they be met? The Federal Reserve is withdrawing liquidity and wants to normalize interest rates. It is hard to see price/earnings multiples expanding from already lofty levels while the Federal Reserve is slowly removing the punch bowl. Investors are on a tax cut high of sorts in early January. Earnings expectations have ratcheted higher, increasing the odds of disappointment. Market volatility has been historically low. We must believe volatility will rise. China's growth appears to be slowing. What are the implications for Japan, its largest trading partner? Has Europe's growth rate peaked? Can the reality of the tax package live up to its billing? What are the unintended consequences?
As good as investors feel today, we expect them to feel less good within six months. Will Trump's trade policy maneuvers hurt global growth and dampen investor sentiment? Protectionist measures, if enacted, are unlikely to achieve their desired ends because other countries retaliate. Are we being too downbeat? That's possible. We were surprised at the market's unrelenting rise last year. Maybe we are all underestimating the impact on growth from tax reform. It's possible the bull market rises through September, becoming the longest bull market in history. Maybe the Federal Reserve sees growth slowing and backs off.
We will continue to manage the portfolio with a defensive growth tilt. We know we can't call the market with precision. We want you to understand our thinking on the major issues we expect to confront this year. History tells us we shouldn't actually feel relaxed about stocks when so many others feel good about them. In the context of what will be a nine year bull market come March, we know we are in the late innings. But in those late euphoric innings of a bull market, stocks can rise materially. A skeptic could fairly ask if last year was in fact the euphoric advance we speak of. The answer is yes but some will argue that it didn't meet the definition of a euphoric rise. We don't know, last year was the eighth year of a bull market and Boeing rose 90%, NVIDIA 81%, Amazon 55%, Facebook 53%, Alphabet 46%, MasterCard 46% and we could go on. This market doesn't owe us anything.
Our focus will be on our companies' earnings expectations both for 2018 and 2019, the direction and level of inflation and interest rates and the slope of the yield curve. At the risk of sounding repetitive, we want to thank you again for your investment in the fund and wish you good health and higher stocks in 2018!
The accompanying chart presents the Fund's holdings by geographic region as of December 31, 2017. The geographic allocation will change based on current global market conditions. Countries and/or regions represented in the chart and discussed in this commentary may or may not be included in the Fund's future portfolio.
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. dollar equivalent terms are presented as of December 31, 2017.
Adobe Systems (ADBE) (2.7% of net assets as of December 31, 2017) (ADBE - $175.24 - NASDAQ) is the global leader in digital marketing and digital media solutions. Adobe has the most comprehense end-to-end solution for digital marketing. Its tools allow customers to create digital content, deploy it across media and devices, and measure and optimize it over time. Adobe has successfully transitioned from a product-based desktop business to a cloud-based subscription business. Over 80% of total revenue is now recurring and that number is poised to climb higher as 7 million customers worldwide are yet to migrate. The demand for design capabilities continues is rising at a dramatic pace, as reflected in Adobe's large and growing total addressable market of $64 billion in 2019.
Alibaba (BABA) (3.7%) (BABA - $172.43 - NYSE) operates the largest global ecommerce system and is a primary beneficiary of the growing, consumer-driven, middle class in China. In addition to the portfolio of ecommerce marketplace portals, Alibaba's ecosystem includes the largest third-party payment service provider in China (Alipay), online marketing technology platforms, and hyperscale public cloud computing similar to Amazon's AWS.
Alphabet (4.2%) (GOOG)(GOOG/GOOGL - $1046.40/$1053.40 - NASDAQ) is the parent company of Google, the world's leading internet search engine. The company benefits from a powerful competitive moat in one of the best secular markets, digital advertising, in which Google maintains ~45% market share.The company generates revenue by providing advertisers the opportunity to deliver targeted and measurable advertising. Alphabet's healthy core search business has allowed the company to pursue new market opportunities such as streaming video (YouTube Red), life sciences (Verily), autonomous driving (Waymo) and a variety of other "moonshot" projects.
Facebook's (4.5%) (FB)(FB - $176.46 - NASDAQ) mission is to give people the power to share and make the world more open and connected. Facebook's unique cache of user profiles creates a powerful targeted advertising platform. As of September 30, 2017, Facebook had 2.1 billion monthly active users (MAUs) worldwide. Facebook continues to grow its worldwide user base at a mid-teens rate, largely driven by the proliferation of mobile devices in the emerging markets. Users are spending more time on the platform, driven largely by the recent emphasis on video. Facebook is able to drive pricing power by continuously improving the effectiveness of its ads. Meanwhile, there remains runway to further monetize Facebook properties Instagram, Messenger and WhatsApp.
FANUC (TSE:6954) (3.4%) (6954.T - $240.16/?27,060 - Tokyo Stock Exchange) manufactures factory automation systems, equipment and robots, including robots used in precision assembly and injection molding machines. The company's tools are primarily used in the machine tool and automotive industries, with customers including OEMs GM, Ford and Volkswagen.
KEYENCE (3.7%) (TSE:6861) (6861.T - $560.20/?63,120 - Tokyo Stock Exchange) - Japan) has steadily grown since 1974 to become an innovative leader in the development and manufacturing of industrial automation and inspection equipment worldwide. Products consist of code readers, laser markers, machine vision systems, measuring systems, microscopes, sensors, and static eliminators. Today, KEYENCE serves over 200,000 customers in 70 countries around the world.
LVMH (2.8%) (LVMH.P - $294.44/EUR245.40 - Euronext Paris) is a leading luxury brand with a balanced portfolio of products and diverse geographical revenue. The unique portfolio is comprised of Wines & Spirits, Fashion
- Leather Goods, Perfumes & Cosmetics and Watches & Jewelry. Approximately 27% of revenue is derived from Asia, where the brands are resonating well, especially amongst the Chinese.
Microsoft (3.8%) (MSFT) (MSFT - $85.54 - NASDAQ) is the world's largest software company and develops software products for computing devices ranging from PC's to servers to its Xbox game console. Microsoft is transitioning to a subscription business with high recurring revenue. The transition from Office to cloud-based Office 365 is resulting in user base growth and per user pricing lift. Microsoft's Azure is emerging as a rapidly growing public cloud winner behind Amazon's AWS. The recent acquisition of LinkedIn will allow Microsoft to integrate data from LinkedIn's economic graph with Microsoft's professional cloud.
Tencent Holdings (HKSE:00700) (4.9%) (700HK- $51.97/HKD 406.00 - Hong Kong Stock Exchange), headquarted in Shenzen, is one of the largest internet companies in the world and the biggest computer game publisher in the world. The company infiltrates every aspect of digital life for the mobile-first Chinese consumer. Its offerings include social network platforms, instant messaging services, e-commerce marketplaces, online video games, mobile payment applications and online advertising. As of December 31, 2016, Tencent's QQ web portal had 868 million monthly active users (MAUs); the Weixin and WeChat apps, combined, had 889 million MAUs; Qzone, its social media network, had 638 MAUs.
UnitedHealth Group (UNH) (2.9%) (UNH - $220.46 - NYSE) is one of the largest and most diversified managed care companies in the United States. Its high growth Optum services business provides wellness and care management programs, financial services, information technology solutions and pharmacy benefit management (PBM) services to an additional 115 million customers.
January 26, 2018
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.
*No longer held as of December 31, 2017
This article first appeared on GuruFocus.
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- ADBE 15-Year Financial Data
- The intrinsic value of ADBE
- Peter Lynch Chart of ADBE