To Our Shareholders,
For the quarter ended June 30, 2019, the net asset value (NAV) per Class AAA Share of The Gabelli Asset Fund increased 3.7% compared with an increase of 4.3% for the Standard & Poor's (S&P) 500 Index. Other classes of shares are available. See page 2 for additional performance information for all classes.
An Economic Rorschach Test
Swiss psychologist Hermann Rorschach created his eponymous ink-blot exam in 1921. In the classical test, an administrator records the responses to ten abstract images, hoping to illuminate the subject's motivations, inner conflicts, and modes of perception. The current political climate has certainly served as its own ink-blot test, with the President trumpeting an economy "better than it has been in decades" and those opposed highlighting stagnant wages and growing inequality.
We, of course, attempt to array and interpret macro and micro economic data in as objective a manner as possible, but that makes conclusions about the direction of the economy no less confounding. On one hand, July 2019 marked the 121st month of consecutive growth in the U.S. - the longest expansion on record. At 3.7%, unemployment is the lowest since the 1960s, household wealth is at a record, and housing growth remains solid, all while inflation remains tame. On the other hand, indicators of global manufacturing health are rolling over, international regions including China are slowing markedly, and the yield curve is partially inverted (i.e., the yield on 3-month U.S. Treasury Bill currently exceeds that on the 10-year Treasury note) which historically has preceded recessions (again, dependent on your frame of reference). Trade disputes with Europe, China, and Mexico have weighed on corporate confidence and on earnings for importers, who cannot fully pass along increased costs, and exporters, who find their products disadvantaged by retaliatory tariffs.
As of this writing, a deal with China appears back on track. However, the President is nothing if not unpredictable. Equally compelling cases may be made for the President striking a deal to declare victory and maintain economic momentum into the 2020 election, or not striking a deal to run on the same issue. Likewise, the Chinese could either seek a quick resolution to maintain economic stability or take their chances with a future Democratic administration. Federal Reserve Chairman Jerome Powell apparently shares an uncertain view of these ink-blots, and has thus signaled the U.S. central bank will provide an "insurance cut" to interest rates in July, with more to follow late this year despite a robust economy. Monetary history would suggest that easing will extend the expansion (the stock market thinks so), but what if the Fed's fears are well-founded? Or worse, what if the President parlays this financial flexibility into a policy mistake? Although the odds of catastrophe appear small at this time, unfortunately the potential for a future Fed rescue are diminished with starting rates so low.
The Markets: A View on Value
The major U.S. stock market indices posted their strongest first half gains since 1997 as strength in April and June offset a sharp decline in May. The market rebound since late 2018 can be attributed to excessive economic pessimism triggering the "Trump put" (continued trade talks) and the "Powell put" (the signal of lower interest rates). Each of these elements have supported rising multiples in the face of what is likely to be weak earnings growth for the remainder of this year. After briefly compressing late in 2018, the market is again selling at about 17 times earnings, higher than average but not alarmingly stretched, given tame inflation and low interest rates.
Value investing can be its own psychological test, not just because many followers of Graham & Dodd have had their mental well-being challenged in a decade-old momentum market, but because perceptions of what makes a cheap stock can vary. Popular distinctions between growth and value, made using absolute measures of price-to-earnings or price-to-book, are inadequate. Unlike momentum or technical investors, growth and value investors tend to be rooted in fundamentals. In general, value investors seek to buy assets at a discount to their worth today, while growth investors seek assets that will appreciate meaningfully in worth. Growth can be a component of value, an attribute that may itself be priced cheaply or dearly. Some stocks may appear conventionally expensive but in actuality offer bargains when adjusting for the quality of their franchises or the high return on investment opportunities available to them. When evaluating a security, we rely on our accumulated compounded knowledge of select industries to filter noise and divine hidden assets and sources of growth. If we can acquire shares in those businesses at a large enough discount to what an informed buyer would pay to own the entirety of the business (Private Market Value), we may be interested. Despite a clouded outlook, we see a lot of intriguing situations today.
Deals, Deals, Deals
During the first half of 2019, global deal volume declined 12% to $2 trillion, but volume in the U.S. grew 19% to over $1 trillion. Large transactions in healthcare, energy, and technology led the way, with the sales of specialty pharma company Allergan (0.1% of net assets as of June 30, 2019) to AbbVie, Anadarko Petroleum (less than 0.1%) to Occidental, fiber provider Zayo (less than 0.1%) to EQT, and utility El Paso Electric (0.6%) to a private infrastructure fund benefiting the Fund. One major combination announced in 2018 that continues to wind its way through the approval process is that of Sprint (0.1%) and T-Mobile (less than 0.1%); the terms of that transaction, especially whether it includes the participation of DISH Network (0.5%), will have long term ramifications for U.S. telecommunications. We believe merger and acquisition (M&A) could earn a second wind in the second half of 2019, underpinned by lower rates and a desire to close deals before a possible change of administrations in 2021. The Fund is poised to capitalize in industries undergoing consolidation.
The largest contributor to returns in the second quarter was Sony Corp. (1.9% of net assets as of June 30, 2019) (+22%). Fears about how traditional video game console providers would fare in the world of cloud gaming were outweighed by strong music industry performance and a growing addressable market for Sony's image sensors. In addition, activist shareholder Third Point returned with ideas for how the company can surface additional value. Resilient consumer spending helped Mastercard (1.5%) (+11%) and American Express (1.3%) (+11%) while capital spending aided industrials such as Flowserve (1.2%) (+14%), Ametek (2.7%) (+8%) and Idex (1.3%) (+11%). Finally, The Walt Disney Co. (1.7%) (+24%), purchaser of Twenty-First Century Fox's (0.5%) entertainment business, unveiled a compelling direct-to-consumer video offering to go with a strong film and park attraction slate.
Swedish Match (1.5%) (-15%) was the largest detractor from performance in the quarter, giving back most of its first quarter gains due to concerns about pending restrictions on sales of flavored cigars. Other consumer staples holdings Edgewell Personal Care (0.2%) (-39%), Kikkoman (0.8%) (-11%) and Energizer (0.4%) (-19%) also detracted from performance as certain legacy brands struggled to grow in mature markets, along with concerns about increased financial leverage from acquisitions. Bank of New York Mellon (1.1%) (-14%) and State Street (0.3%) (-16%) declined as lower interest rates would reduce the interest income they generate. Finally, Mexican broadcaster and cable operator Grupo Televisa (0.3%) (-25%) dropped amidst concerns about the health of the Mexican economy and after the company delayed a potential spin-off of its cable business.
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, 2019.
American Express Co. (NYSE:AXP) (1.3% of net assets as of June 30, 2019) (AXP - $123.44 - NYSE) 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. As of March 2019, American Express has 114 million cards in force and nearly $82 billion in loans, while its customers charged $1.2 trillion of spending on their cards in 2018. 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, such as 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 (NYSE:AME) (2.7%%) (AME - $90.84 - NYSE) is a diversified supplier of highly engineered equipment used in a broad array of industrial end markets. The company offers a diverse product portfolio including test and measurement, metrology, and precision motion control equipment in addition to specialty materials and aftermarket services. Organic sales growth has remained strong thus far this year, up 5% year-over-year in Q1 2019 and the company finished March with a record backlog of $1.7 billion. After spending a total of $1.1 billion acquiring six businesses in 2018, AMETEK currently has $368 million of cash and nearly $1 billion of availability on its revolving credit facility that it expects to further deploy on additional acquisitions this year. The company has begun to target software- and Internet of Things-based businesses that will allow AMETEK to leverage the vast amounts of measurement and instrumentation data that it collects for customers to provide more recurring, service-based offerings.
Deere & Co. (NYSE:DE) (1.5%) (DE - $165.71 - NYSE) headquartered in Moline, Illinois, is a leading global manufacturer of machinery for agricultural, construction, and forestry usage. Its dominant position in North American agricultural equipment markets optimally positions the company for what is expected to be an increase in demand for agricultural equipment both in the near term given cycle dynamics as well as for the long term, as global population and income growth drive crop demand in the coming decades.
Fox Corporation (NASDAQ:FOX) (0.5%) (FOX/FOXA - $36.53/$36.64 - NASDAQ), headquartered in New York, New York, owns a high quality collection of cable and television networks focused on news and sports content. Fox News remains a powerful brand and the most watched news channel. Given Fox News' high ratings, live viewing, and position as sole provider of right leaning news, we expect the company is in an excellent position to demand increased affiliate fees from distributors. While still small, the company launched Fox Nation, an OTT news service meant to serve as an add-on service for highly engaged Fox News viewers. News is typically watched live which, should limit cannibalization from SVOD alternatives, such as Netflix and Amazon Prime. News viewership in general, and Fox news in particular, benefit from increased political engagement associated with a more contentious political cycle. We expect Fox News will be a beneficiary of a potentially extended 2020 political cycle. Fox Broadcast Network should benefit from substantial retransmission revenue growth over the next three years. We expect the Fox Broadcast Network could generate an incremental $1 billion of contractually recurring retransmission and reverse compensation revenue over the next three years. The Fox Broadcast Network broadcasts substantially more sports programming than competing networks. The channel features both Sunday and Thursday Night football broadcasts, Major League Baseball, FIFA, NASCAR, and United States Golf Association (USGA) events. Fan engagement and live viewing has made sports programming highly valuable to channels in retransmission renegotiations. The spin-off of Fox Corporation was a taxable event, which resulted in a step-up in the company's tax basis. FOX expects to be able to shield $1.5 billion of taxable income per year for 15 years, which should result in a net cash benefit of approximately $360 million per year. At a 10% discount rate, we estimate the net present value of the tax shield at $2.7 billion or ~$4.40 per share.
Genuine Parts Co. (NYSE:GPC) (1.7%) (GPC - $103.58 - NYSE) is an Atlanta, Georgia-based distributor of automotive and industrial replacement parts, 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.
Madison Square Garden Co. (NYSE:MSG) (1.6%) (MSG - $279.94 - NYSE) is an integrated sports and entertainment company that owns the New York Knicks, the New York Rangers, the Radio City Christmas Spectacular, The Forum, and that iconic New York venue, Madison Square Garden. These evergreen content and venue assets benefit from sustainable barriers to entry and long term secular growth. MSG completed the separation of its associated regional sports networks in September 2015, leaving a reliable cash flow stream for MSG to reinvest and repurchase shares. In June 2018, the company announced that it was likely to spin-off of its teams, which we think could further surface value, especially as MSG expands its portfolio to include Spheres venues in Las Vegas and London.
MasterCard Inc. (NYSE:MA) (1.5%) (MA - $264.53 - NYSE) is one of the largest electronic payments processing companies, providing services in more than 210 countries and territories. It continues to capitalize on the strong secular global trend of moving to electronic payments from traditional paper. For all of 2018, clients charged approximately $4.3 trillion. At the end of December 2018, cards in force totaled over 1.8 billion. Longer term, MasterCard is well positioned to increase revenue due to global growth in personal incomes, rapid increase in commerce, and movement to electronic payments.
Republic Services Inc. (NYSE:RSG) (1.8%) (RSG - $86.64 - NYSE) based in Phoenix, Arizona, became the second largest solid waste company in North America after its acquisition of Allied Waste Industries in December 2008. Republic provides nonhazardous solid waste collection services for commercial, industrial, municipal, and residential customers in 40 states and Puerto Rico. Republic serves more than 2,800 municipalities and operates 190 landfills, 207 transfer stations, 351 collection operations, and 86 recycling facilities. Since the Allied merger, Republic has benefited from synergies driven by route density, beneficial use of acquired assets, and reduction in redundant corporate overhead. Republic is committed to its core solid waste business. While other providers have strayed into alternative waste resource technologies and strategies, we view Republic's plan to remain steadfast in the traditional solid waste business positively. We expect continued solid waste growth acquisitions, earnings improvement, and incremental route density and internalization growth in already established markets to generate real value in the near to medium term, highlighting the company's potential.
Sony (NYSE:SNE) (1.9%) (SNE - $52.39 - NYSE) is a diversified electronics and entertainment company based in Tokyo, Japan. Sony manufactures the PlayStation videogame consoles and games, operates the Sony/Columbia film studio, and Sony Music entertainment. It also manufactures image sensors, mobile devices, consumer electronics, and mirrorless and professional cameras. It holds majority ownership of Sony Financial Services. We expect growth in consoles/game, music, and image sensors, and a rebound in the filmed entertainment division. We expect operational improvements in consumer electronics to generate EBITDA growth through 2020.
Walt Disney (NYSE:DIS) (1.7%) (DIS - $139.64 - NYSE) is a diversified media company, with operations in cable network television, television broadcasting, filmed entertainment, theme park operation, and consumer products. With leading intellectual property across brands like Pixar, Marvel, and Star Wars, Disney is well positioned to develop its previously announced direct-to-consumer product Disney Plus, creating a true competitor to Netflix. We also expect the company's parks and resorts business to grow materially over the medium term as recent investments begin to generate a return. While facing the secular threat of cord-cutting, the company's legacy cable properties ESPN, ABC, and the Disney Channel should continue to generate cash sufficient to fund Disney's investment in its OTT service.
At this writing, U.S. markets may be hitting record highs, but they barely exceed their place nine months ago. Sell-offs in late 2018 and in May are reminders that volatility can be violent and can return unexpectedly, especially as the interest rate regime turns, the next elections approach, and the cycle ages. The market can be perplexing, but we will continue to try to make sense of the blots, dots, or whatever data we can obtain to aid in the picking of stocks that should deliver superior risk-adjusted returns over the long run.
August 2, 2019
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.
This article first appeared on GuruFocus.
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