Yahoo Finance The Gabelli Value 25 Fund Inc. 2nd Quarter Shareholder Commentary
- By Holly LaFon
To Our Shareholders,
For the quarter ended June 30, 2017, the net asset value ("NAV") per Class A Share of The Gabelli Value 25 Fund increased 0.4% compared with increases of 3.1% and 4.0% for the Standard & Poor's ("S&P") 500 Index and the Dow Jones Industrial Average, respectively. See page 2 for additional performance information.
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The intrinsic value of BK
Politics, the Economy and the Markets
Stocks performed strongly during the first half of 2017. The S&P 500 Index rose 8.2% before dividends, despite a seemingly endless amount of noise from Washington and abroad. Markets responded positively to the election of Donald Trump in late 2016, partly in anticipation of a relaxation of the regulatory regime, reformation of corporate and individual taxes, and additional stimulus. To date, progress has only been made on the first of these items, which raises the possibility that what the market really desires is slow and incremental change, i.e., business as usual in Washington. Or perhaps the dissonance between the market's march forward and Washington's lurch sideways is an indication that fiscal policy really isn't as impactful as some believe.
Indeed, the most powerful market levitating force from Washington over the last decade did not originate from the White House or the Capitol, but from the Eccles Building - home to the Federal Reserve. Through open market activity and three rounds of quantitative easing (QE), the Federal Reserve slashed short term interest rates from 4.5% before the 2008-2009 financial crisis to nearly zero, lifting asset prices everywhere. The Federal Reserve began tapping the brakes by tapering QE in October 2014, and has now raised rates four times, the latest of which took the Federal Reserve Funds rate to a range of 1.0%-1.25% in June 2017. The Federal Reserve has indicated it will begin shrinking its balance sheet later this year, and current expectations are for one additional quarter point increase in 2017 and three in each of 2018 and 2019, which would put the Federal Reserve Funds rate at 3.0%, still well below the prior peak.
Over the long term, the Federal Reserve's "normalization" of rates is healthy for the economy, but the timing of this process has been the subject of debate, given lackluster GDP growth and a lack of inflation. The last two rate hike cycles ended in market dislocations in 2001 and 2007, but the circumstances in each were very different from today. A future recession may be unavoidable, but it need not be triggered by the Federal Reserve anytime soon. What is unquestionably unavoidable is that monetary policy has gone from being a tailwind to being a headwind for the economy and the market. Further increases in stock prices are more likely to be driven by better earnings versus multiple expansions, as had been the case over the last several years. Ironically, some sources of future earnings growth - lower taxes, defense and infrastructure investment, and a general rekindling of a propensity to spend - depend on the events taking place a few blocks east of the Federal Reserve, so it remains worth watching what happens this summer in the swamp.
Deals, Deals & More Deals
Worldwide merger and acquisition (M&A) activity rose 2% to $1.6 trillion in the first half of 2017, as a vibrant Europe offset a 16% decline in U.S. M&A volume. Activity in the U.S., concentrated in the Energy, Healthcare, and Real Estate sectors, may have been impeded by uncertainty around tax reform and unfamiliarity with new faces at the Department of Justice and other regulatory agencies. We believe these elements will soon fall into place, and that the solid underpinnings of the Fifth Wave of M&A continue to exist.
Among the deals announced in the second quarter was Amazon's purchase of Whole Foods Inc. for $42 per share in cash. After several years of underperformance, Whole Foods Inc. faced, and initially resisted, pressure from activist Jana Partners (Trades, Portfolio). It appears that founder and CEO John Mackey was eventually persuaded to sell because of the benefits of continuing to grow the chain with the cover and support of Amazon. This deal had far reaching repercussions, as fears that Amazon would increase competition and deflationary pressures weighed on grocers, pharmacies, food distributors, and consumer goods companies, among others. While Amazon's impact remains to be seen, we do believe its presence underscores the need for consolidation in the food space. Having shown a willingness to invest aggressively in the brick and mortar world, Amazon could also become an acquirer of other retailers and distributors.
Conclusion
While valuations are somewhat elevated and interest rates are rising, we see some cause for continued optimism, as employment and the housing market are improving, and the consumer remains healthy. We continue to believe we are well positioned for almost any economic backdrop by focusing on companies possessing pricing power, skilled management, and flexible balance sheets that trade at meaningful discounts to the Private Market Values. Our investment environment remains catalyst rich with financial engineering and still low borrowing costs, driving acquisition activity.
Investment Scorecard
Several industrial firms were contributors to performance in the second quarter, including aircraft engine maker Rolls-Royce (1.2% of net assets as of June 30, 2017, +24%), Honeywell (3.0%, +8%) and water solutions company Xylem (1.6%, +11%). Sony (4.3%, +13%) performed well in anticipation of a strong summer movie slate and inclusion of its chips on the next iPhone release. Liberty Interactive (1.2%, +23%), owner of multi-channel retailer QVC, rebounded from a disappointing performance in 2016 and announced it would convert from a tracking stock to an asset-based security later in 2017. Subsequent to the quarter, Liberty announced it would purchase rival HSN Inc., which should fuel future profit growth. Finally, H&R Block (0.8%, +34%) posted an excellent 2016 tax season, reducing customer declines while also cutting costs.
Detractors from performance included media companies Viacom (5.4%, -22%), CBS Corp. (7.3%, -8%), Twenty-First Century Fox (1.2%, -12%) and Scripps Networks (0.6%, -12%) where concerns that a slowdown in advertising would add to pressures from a possible acceleration in cord cutting. The perception of further encroachment by Amazon into auto parts hurt retailers including O'Reilly Automotive (0.4%, -19%); subsequent to the quarter O'Reilly fell sharply after reporting Q2 same store sales grew 1.7% versus expectations of 3%+. Although mindful of Amazon's potential impact, we believe a warm winter was the biggest factor in O'Reilly's "miss" and continue to believe the stock is attractive.
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, 2017.
Bank of New York Mellon Corp. (BK) (3.1% of net asset as of June 30, 2017)(BK-$51.02-NYSE) is a global leader in providing financial services to institutions and individuals. The company operates in more than 100 markets worldwide and strives to be the global provider of choice for investment management and investment services. As of March 2017, the firm had $30.6 trillion in assets under custody and $1.7 trillion in assets under management. Going forward, we expect BK to benefit from rising global incomes and the cross border movement of financial transactions. We believe BK is also well positioned to grow earnings in a rising interest rate environment, given its large customer cash deposits and significant loan book.
CBS Corp. (CBS)(7.3%)(CBS-$64.81-NYSE) operates the CBS television network and the premium cable network Showtime. It also owns 29 local television stations and 130 radio stations. We believe that CBS has a number of opportunities to generate incremental non-advertising revenue from the sale of existing content through its over-the-top platforms, online video distributors and retransmission agreements with traditional distributors. In addition, we expect a continued recovery in advertising to contribute to earnings growth. Finally, we believe that financial engineering, including the split-off of its radio business, could act as a catalyst for shares.
Diageo plc (DEO) (3.01%) (DEO - $119.83 - 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 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. (DISH) (2.2%)(DISH-$62.76-NASDAQ) is the fourth largest pay television provider in the U.S., serving approximately 14 million subscribers through its original satellite business and newer Sling internet delivered over-the-top offering. Founder Charlie Ergen owns approximately half of DISH's shares. DISH has accumulated a significant spectrum position at attractive prices. DISH could monetize its spectrum through a sale of the spectrum or the whole company, or, more likely, a partnership with an existing wireless operator or new entrant to the industry such as Amazon.
Edgewell Personal Care Company (EPC) (1.7%)(EPC-$76.02-NYSE) based in St. Louis, Missouri is the renamed Energizer Holdings, Inc. following the tax-free spin-off to shareholders of the household products division on July 1, 2015. Edgewell generates approximately $2.3 billion of revenue through its principal businesses: wet shaving, including Schick-branded razors and blades; Edge and Skintimate shaving preparation and private label shaving products; sun care, including the Banana Boat and Hawaiian Tropic brands; feminine care, Playtex and o.b. tampons and Carefree and Stayfree liners and pads; and infant care, utilizing the Playtex and Diaper Genie brands. As a pure-play personal care company, Edgewell competes in high-margin, attractive categories with leading brands. We expect management to focus on improving margins through product mix, restructuring savings and operating leverage, which should afford it flexibility to reinvest in growth opportunities. The company has approximately $1.2 billion of net debt providing management with sufficient flexibility to invest in internal growth, make acquisitions and/or repurchase shares. EPC is a likely acquisition target as a multinational competitor with an extensive global infrastructure would benefit from scale, international expansion and cost synergies.
Newmont Mining Corp (NEM) (2.9%)(NEM- $32.39- NYSE) based in Denver, Colorado, is one of the largest gold mining companies in the world. Founded in 1921 and publicly traded since 1925, NEM is the only gold company included in the S&P 500 Index and Fortune 500. We expect the company to produce approximately 5.3 million ounces of gold and 120 million pounds of copper in 2017, with approximately 70% of this production coming from the United States and Australia. Newmont undertook companywide cost cutting measures during the period 2013 - 2016, lowering its average unit costs base by over 20% during this period. The company has sold non-core assets and has deployed the proceeds from these sales into repaying debt and building new projects which it expects will generate superior rates of return for shareholders. Given Newmont's largely fixed cost base, every increase (or decrease) in the gold price will flow directly to the company's bottom line.
Sony Corp. (SNE) (4.3%)(SNE-$38.19-NYSE) is a diversified electronics and entertainment company based in Tokyo, Japan. The company manufactures televisions, PlayStation game consoles, mobile phone handsets, and cameras. It also 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 2017. We also think the spinoff of the entertainment assets could be a catalyst.
Swedish Match AB (SWMA.ST) (3.7%)(SWMA - $35.22/SEK296.70 -Stockholm Stock Exchange) produces tobacco products that include snus and snuff, chewing tobacco, cigars, and lights. The company has been benefiting from the growth of the smokeless tobacco market in both Scandinavia and the U.S., as public smoking bans and health concerns are driving consumers to seek alternative tobacco products to cigarettes. In October 2010, Swedish Match combined its European and premium cigar portfolios with Scandinavian cigar and pipe tobacco company STG, creating a new company that should benefit from enhanced scale and synergies. In February 2016, STG went public via an IPO on the Copenhagen Stock Exchange, with Swedish Match partially monetizing its stake. In January, Swedish Match further sold down its holdings in STG to 9% of the company, and we expect further sales in coming years. As a more focused company, we expect Swedish Match to grow sales and earnings over time, as the smokeless tobacco category continues to develop. We also believe the company could be an attractive takeover candidate for a global tobacco company that wants to increase its presence in the smokeless segment.
Xylem Inc.(XYL) (1.6%)(XYL-$55.43-NYSE) is a global leader in the design, manufacturing, and application of highly engineered technologies for the transportation, treatment, measurement, and testing of water. The company is expected to benefit from favorable long term fundamentals in the water industry, driven by scarcity, population growth, aging of the infrastructure, and the need to improve water quality. Further, with a large installed base of pumps and systems, the company is well positioned to increase aftermarket revenue, which currently represents roughly 40% of total revenues. XYL expects to generate mid-teens earnings per share growth through 2020 as it accelerates its capital deployment strategy globally. The company is currently integrating its $1.7 billion acquisition of Sensus, a leading manufacturer of smart metering equipment and technologies.
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.
Warning! GuruFocus has detected 5 Warning Sign with BK. Click here to check it out.
The intrinsic value of BK
