To Our Shareholders,
For the quarter ended March 31, 2014, the net asset value ("NAV") per Class AAA Share of The Gabelli Asset Fund increased 0.9% compared with an increase of 1.8% for the Standard & Poor's ("S&P") 500 Index. See page 2 for additional performance information.
An Unchanged Process in an Ever-Changing World
Stocks rose modestly in the first quarter of 2014, despite the largely negative geopolitical and macroeconomic events that dominated the headlines.
The long term implications of the Russian Federation's annexation of Crimea are still yet to be determined. Will Russia make a similar move in other provinces in Ukraine or attempt to reclaim other parts of the former Soviet Union that are now independent countries? What will be the economic impact to Russia and its main trading partners? The short term effect has been for the Russian stock market to decline 9%, along with a 6% decline in the Russian ruble.
Other emerging market currencies also fell in the first quarter, most notably the Venezuelan bolivar, which underwent a massive "stealth" devaluation when the embattled government introduced a secondary currency exchange market known as SICAD II; the Argentine peso (–18%) and the Brazilian real (–4%) also declined during the quarter. U.S. based multinationals with significant operations in these markets will have a headwind to reported results this year, as profits in these countries must be translated back into U.S. dollars at a lower exchange rate. We also are watching developments in other important markets closely, including China dealing with a slightly slower but perhaps more sustainable growth rate and Japan continuing its attempt to re-inflate under the leadership of Prime Minister Shinzo Abe and Governor of the Bank of Japan Haruhiko Kuroda.
Back in the U.S., the economy continues to expand – albeit slowly. GDP growth was 2.6% in the fourth quarter of 2013, and unemployment held relatively steady at 6.7% at the end of March 2014. Much of the country experienced nearly unprecedented cold temperatures, as well as several severe snowstorms, for much of the first quarter. While the reduced consumer spending and cancelled travel that resulted may have an impact on first quarter earnings, we expect that most expenditures will ultimately be delayed rather than eliminated altogether. Janet Yellen was sworn in as Chair of the Board of Governors of the Federal Reserve System during the quarter. While we expect Ms. Yellen to continue most of the policies of her predecessor, we note that she also seems committed to continuing the so-called "taper," as the pace of open market asset purchases was reduced to $55 billion per month starting in April, from $85 billion in December 2013. This gradual withdrawal of stimulus has not led to a decline in asset prices – yet.
Deals, Deals, and More Deals On a positive note, deal-making activity increased substantially during the first quarter, with worldwide mergers and acquisitions (M&A) value growing 36%, net of competing bids, to $756 billion. Within these figures, we note that cross border transactions were up 86% to $245 billion. We believe that we will see more of these kinds of transactions as the "Fifth Wave" of takeover activity since World War II continues to build momentum. In January, Fund holding Beam, Inc. (0.9% of net assets as of March 31, 2014) agreed to be acquired by Suntory Holdings, a leading Japanese beverage company, for $83.50 per share in cash. The deal price was a 25% premium to BEAM's $67 closing price and represents just over 18x our 2014 EBITDA estimate of approximately $850 million. While the multiple is fairly full, it is consistent with our estimate of Private Market Value, and we believe it is appropriate for a high quality asset such as BEAM, with great brands, margins, growth prospects, pricing power, and distribution. The transaction is expected to close in the second quarter. Two media holdings were also the subject of M&A during the first quarter. After being pursued through most of 2013 by Charter Communications (less than 0.05%), Time Warner Cable (0.3%) agreed to be acquired by Comcast (0.4%) in an all stock transaction. The combined company would serve over 30% of all U.S. pay- television households and thus has drawn close regulatory scrutiny. We believe the odds favor a Comcast closing on current terms early in 2015. Another bidding war took place across the Atlantic, as French media and telecom conglomerate Vivendi (0.5%) auctioned its wireless subsidiary, SFR. Cable entity Numericable and wireless competitor Bouygues submitted competing proposals; in April, Vivendi chose to move forward with Numericable, allowing Vivendi to continue its transition to a pure content company and providing it with significant excess capital, which we expect will be returned to shareholders. With extremely attractive financing available to acquirers, we expect deal activity to continue to increase over time, albeit not in a linear fashion.
Let's Talk Stocks The following are stock specifics on selected holdings of the 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 are presented as of March 31, 2014.
AMETEK Inc. (1.7% of net assets as of March 31, 2014) (AME, Financial)(AME - $51.49 - 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 significant 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 the Electronic Instruments Group, 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 $30-$100 million. Differentiated businesses compete on the basis of product capability, have higher growth rates, and offer superior returns. In the Electromechanical Group, AMETEK's key strategy is to reduce costs by increasing efficiency and moving noncore operations to low cost countries such as Mexico, the Czech Republic, and China.
Beam Inc. (0.9%) (BEAM, Financial)(BEAM - $83.30 – NYSE), headquartered in Deerfield, Illinois, is a leading producer of distilled spirits with brands including Jim Beam, Sauza, Maker's Mark, Courvoisier, Pinnacle, Cruzan, Knob Creek, Skinnygirl, and Effen. Beam competes in the ~$500 billion global spirits industry and is the leader in the $7 billion bourbon whiskey category, which is currently the fastest growing market segment in the U.S. Beam has strong brands, pricing power, top and bottom line momentum, and is one of the only companies in the industry without a family that owns a controlling stake in the business. As such, we have long considered Beam a compelling acquisition candidate for strategic acquirers. On January 13, 2014, Beam announced that it agreed to be acquired by privately held beverage producer Suntory Holdings of Japan for $83.50 per share in cash. The acquisition is expected to close in the second quarter of 2014.
Chemtura Corp. (0.1%) (CHMT, Financial)(CHMT - $25.29 - NYSE) is a global developer, manufacturer, and marketer of engineered specialty chemicals. Its products are used as additives, ingredients, or intermediates, serving major industries such as agriculture, building & construction, energy, electrical & electronics, transportation, and general industrial. Since its emergence from Chapter 11 in November 2010, under the leadership of Craig Rogerson, the management team has focused on actively managing its portfolio via investments in three vertical markets (transportation, electronics & energy, and agriculture), while monetizing businesses with below target long term potential. The recent sale of Consumer Products generated $250M of net proceeds; the potential sale of AgroSolution (presently undervalued) should generate another $900M of net proceeds. We expect this cash to be used for debt reduction, share repurchases, investments in the remaining operations, and potential bolt-on acquisitions. As management aims to build a more focused business portfolio, the remaining operations, Industrial Performance Products (petroleum additives and urethanes) and Industrial Engineered Products (bromine & flame retardants and organometallics), are expected to grow revenues via innovations, share gain, and geographic expansion, while bottom line will benefit from internal actions. In addition, market demand for flame retardants used in electronics and insulation foam applications should improve. We estimate that the "New Chemtura" (exclusive of Consumer and Ag) will generate EPS of $1.50 and $1.80 in 2015 and 2016, respectively. The EPS calculation is based on a declining number of shares: it assumes that proceeds from the sale of Consumer Products and estimated proceeds from the potential sale of AgroSolution will be mostly used for share repurchases. Management should announce its decision regarding whether it will sell or keep AgroSolution by the end of the second quarter; the decision will depend on the valuation given to the operations by the interested party/ies.
Dana Holding Corp. (DAN, Financial)(0.3%) (DAN - $23.27 - NYSE) is a Maumee, Ohio based supplier of axles, drivelines and thermal products for the automotive and trucking industries. Dana's new CEO, Roger Wood, has begun to emphasize the company's strong technological expertise in thermal management technology, including advanced battery cooling products for next generation vehicles. Additionally, the company is beginning to reap the benefits of efforts to improve customer pricing as well as internal manufacturing efficiencies, both of which are expected to improve margins amid robust demand in the company's core auto and trucking markets.
Davide Campari-Milano SpA (0.2%) (MIL:CPR, Financial)(CPR - €5.95 - Borsa Italiana Milan Stock Exchange) is a leading beverage company headquartered in Sesto San Giovanni, Italy. The Company was founded in 1860 and is today the sixth largest player worldwide in the premium spirits industry. The Company's portfolio consists of over 50 brands and spans spirits (the core business), wines, and soft drinks. The company owns many niche brands including Aperol, Appleton, Campari, Cinzano, SKYY Vodka, and Wild Turkey. Campari's growth strategy aims to combine organic growth through strong brand building with shareholder value enhancing acquisitions, focusing on strong, niche brands that will enhance the company's critical mass in key markets. In March, the company agreed to acquire Forty Creek Distillery, a leading producer of Canadian whisky.
Diebold Inc. (0.3%) (DBD, Financial)(DBD - $39.89 - NYSE) is a global leader in the manufacture and servicing of ATM machines. It also provides security systems and services, primarily to the financial, commercial, government, and retail markets worldwide. In June 2013, Diebold appointed former Hewlett-Packard and Siemens executive Andy Mattes as its new CEO to lead a restructuring and turnaround of its operations. Andy, along with newly recruited leaders, has shown early signs of success, reducing the size of the workforce, freeing up working capital, and moving to standardize business practices globally to drive efficient operations. Returning margins to historical and peer levels should enable substantial upside for Diebold. At the same time, Diebold is positioning itself to benefit from a wave of global bank branch automation, whereby high-tech ATMs capable of handling advanced transactions replace tellers. Diebold is also focused on higher margin growth opportunities including the servicing of ATMs, a broader commercial security presence across verticals, and software as a service (SAAS). Altogether, we see Diebold as capable of doubling earnings over the next four years, while continuing to support a strong dividend.
Genuine Parts Co. (1.3%) (GPC, Financial)(GPC - $86.85 - 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.
Mandarin Oriental International Ltd. (0.2%) (SGX:M04, Financial)(M04 - $1.74 - Singapore Exchange) is the holding company for Hong Kong based Mandarin Oriental Hotel Group (MOHG), which operates twenty-six deluxe hotels and resorts containing 7,466 rooms located in twenty countries. Mandarin Oriental International Ltd. is incorporated in Bermuda and listed on the Singapore exchange. Mandarin Oriental currently has eighteen hotels in its development pipeline, all of which are management contracts that allow the company to grow without significant growth capital experience related to real estate development. The management and incentive fees stream from management contracts is a high-margin, high multiple business that augments the company's growth profile. MOHG continues to be 74% owned by Hong Kong based conglomerate Jardine Strategic Ltd.
Rolls-Royce Holding plc (1.1%) (LSE:RR, Financial)(RR – GBX 1,074.00 - London Stock Exchange) provides jet engines, power and propulsion systems, and services to commercial aviation, defense, marine, oil and gas, and other industries. RR has leading engine positions as one of two suppliers on the Boeing 787 Dreamliner and the Airbus A350, two new wide body programs that will provide the company with significant long term growth opportunities. The delivery of new jet engines also provides recurring, higher margin parts and service revenues which will benefit the company. During year-end 2013 results, Rolls-Royce surprised investors with 2014 guidance that called for a marked falloff in defense revenues due to program completions and what it described as well publicized cuts by two of its major customers. Civil aerospace margins will also be slower to improve than most had expected. Notwithstanding near term headwinds, we believe RR over the next decade will see substantial growth in its civil aerospace operations, accompanied by improved margins approaching the levels of its peers. The company's modest debt levels provide balance sheet optionality for acquisitions or other investments. Currently RR is set to acquire Daimler's 50% interest in Rolls-Royce Power Systems at a contractually set price, which could be quite accretive to earnings.
Time Warner Cable (0.3%) (TWC)(TWC - $137.18 - NYSE) is the second largest cable operator in the U.S., with 11 million subscribers located primarily in New York City, Los Angeles, the Carolinas and Midwest. The company was spun-off from Time Warner in March 2009. After several strong years of growth and shareholder returns, the company encountered customer service and competitive challenges in late 2012 which left it vulnerable to takeover. Indeed, Charter Communications (less than 0.05%), backed by Liberty Media (0.7%), attempted on several occasions to acquire the company in 2013. Finally in February 2014, Comcast (0.4%), the largest cable operator in the U.S., agreed to acquire TWC in an all stock transaction. While the proposed deal has been criticized in the press, we expect it to close with minimal conditions early in 2015.
Twenty-First Century Fox Inc. (1.9%; 0.2%) (FOXA)(FOXA - $31.97 - NASDAQ; FOX - $31.12 - 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.
UnitedHealth Group Inc. (0.2%) (UNH)(UNH - $81.99 - NYSE) is the largest and most diverse health insurance company in the United States. UnitedHealth is actually much more than just an insurance company, with its Optum division providing $40 billion worth of technology, pharmacy benefits management, and other care services to its customers annually. The company has successfully navigated the changes required by the Affordable Care Act and is cautiously participating in the new insurance exchanges. UnitedHealth is also finding new growth internationally, especially in Brazil where the company serves almost 5 million people.
Vivendi SA (0.5%) (XPAR:VIV)(VIV - €20.22 - EPA) is a French media and telecommunications holding company in the late stages of a decade long transition. In April 2014, the company announced it had reached an agreement to sell its French wireless operation, SFR, to French cable operator Numericable. Over the last year the company also sold most of its 62% stake in ActivisionBlizzard and reached an agreement to sell its entire 53% stake in Maroc Telecom SA. After closing the SFR sale in early 2015, Vivendi will be a more focused media firm consisting of Canal+ (a Francophone focused pay television network owner and distributor), Universal Music Group (UMG) (the number one recording music company and number two music publishing entity in the world) and GVT (a fast growing Brazilian broadband and pay television provider). We expect GVT to eventually be sold and would not dismiss the possibility of a breakup of Canal+ and UMG. While operating conditions have been challenging in most of Vivendi's businesses, it appears their trajectory is finally turning more positive and should be supported by a healthier balance sheet after the SFR, Activision and Maroc disposals.
Xylem Inc. (0.7%) (XYL)(XYL - $36.42 - NYSE) is a global leader in the design, manufacturing, and application of highly engineered technologies for the transportation, treatment, 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. Xylem's attractive business mix also generates strong cash flow, which is expected to support acquisitions, debt service, and dividend growth. Concerns regarding weakness in Europe and municipal spending levels in the U.S. remain, although we believe the long term fundamentals outweigh these concerns. Investment Scorecard
Top contributors to performance included Brown-Forman (0.3% of net assets as of March 31, 2014) (+21%), which rose in sympathy with the Beam acquisition announcement, as well as continued strong growth for American whiskey; Beam, Inc. (0.9%) (+23%), due to the deal mentioned above; DIRECTV (1.7%) (+11%), which was speculated to be in merger discussions with DISH (0.5%); GATX (0.6%) (+31%), which is experiencing strong supply/demand dynamics for its tank cars; and Actavis (0.5%) (+23%), which announced the acquisition of Forest Labs in a transaction that would combine two of the world's fastest growing specialty pharmaceutical companies and be immediately and significantly accretive to earnings. Detractors to performance included Media General (0.2%) (–19%), which declined along with other pure- play television broadcasters due to potential new FCC regulations, which may negatively impact earnings; Diageo (1.0%) (–5%), which is the leading spirits company in many Latin American markets whose exchange rates have declined; Scripps Networks (0.5%) (–12%), which declined after merger discussions with Discovery Communications (0.8%) reportedly ceased; and Navistar (0.6%) (–11%), which experienced a slower than anticipated recovery in U.S. Medium and Heavy Duty Truck market share.
Conclusion
As we hope you expect, in the face of these external developments and uncertainties, our process remains unchanged. We conduct bottoms-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 Catalystâ„¢ stock selection process identifies potential acquisition targets and likely candidates for financial engineering. Should volatility return and "Mr. Market" provide us with an opportunity, we remain prepared to increase our ownership of businesses that fit these characteristics, as well as invest in new opportunities as they come available.
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.
