To Our Shareholders, For the quarter ended December 31, 2013, the net asset value (“NAV”) per Class A Share of The Gabelli Value 25 Fund Inc. increased 8.4% compared with increases of 10.5% and 10.2% for the Standard & Poor’s (“S&P”) 500 Index and the Dow Jones Industrial Average, respectively. See page 2 for additional performance information.
Name Change – 2013
The Board of Directors approved a change to the name of the Fund, effective December 9, 2013, to The Gabelli Value 25 Fund Inc. The name change highlights the Fund’s overweighting of its core 25 equity positions and underscores the upcoming 25th anniversary of the Fund’s inception.
Annual (P)review
The fourth quarter provided a fitting end to a remarkable year. Despite recurring drama in Washington, recession in Europe, and turmoil in emerging markets, the U.S. equity market ended the year 170% above its March 2009 low, representing a compounded annual return of over 22%. Unfortunately, the past is little help in divining the future: stocks do not go up because they went up, and they do not go down because they went up. Stocks ultimately move because of changes in their fundamentals. Our job is to understand those fundamentals and balance the risk and reward of each stock selection. At any given moment, the market presents stocks that are cheap and those that are dear. Finding cheap stocks may be more difficult than it was five years ago, but this just means we need to dig a little deeper.
We are optimistic, as it appears for the first time in many years that the world is poised for a synchronized recovery. Indeed, the U.S. is entering its fourth consecutive year of expansion. The housing market is rebounding, job growth is slowly improving, and government policy, which heretofore probably has not added to growth, is unlikely to hinder the rebound as pre-election gridlock sets in. Even the geopolitical stage seems free of major conflict, though flashpoints throughout the Middle East, between China and Japan, and between Russia and its neighbors remain concerning.
The actions of the world’s central banks are also key to the nominal value of stocks. After Ben Bernanke’s eight-year run at the helm of the Federal Reserve, there is a new person – Janet Yellen – behind the curtain. By most accounts, Chairman Yellen is likely to continue the Fed’s current policy of monetary accommodation, even with the announced $10 billion reduction in its monthly bond purchases to $75 billion (i.e., the so-called “taper”). Whether in anticipation of the taper or due to other factors, rates did rise in 2013, with the yield on the benchmark 10 Year U.S. Treasury increasing from 1.76% to 3.03%.
As we have written here in the past, all else equal, increasing rates should reduce the price of risk assets, like stocks. The problems with this equation are that: (a) all else is never equal, i.e., an increase in economic growth should be able to outweigh any deleterious effect of rising rates and (b) the magnitude of a rate rise is likely to be small. Rates remain low compared with the 1960 – 2011 average on the 10 Year U.S. Treasury yield of 6.7%. Current rates still leave mortgages eminently affordable and stocks as a better alternative than cash or bonds. This also means that the hurdle rate for corporate activity, whether in the form of internal investment, share repurchases, or mergers and acquisitions, is relatively modest. Combining this with low organic growth but improving confidence, we think is a formula for robust M&A – an environment for which our style is particularly well-suited.
People + Process + Philosophy = Performance
We are often asked what makes us different, so at year end, we hold up a mirror to ourselves much as we might evaluate a prospective investment. Our success boils down to three factors:
People. We take great care in hiring, training and motivating (Y)our research team. These 30+ analysts hail from around the world but share a passion for stocks. We look for inquisitive and critical thinkers who can formulate and express an independent long-term view of their industry and its participants. Importantly, (Y)our team also includes a group of top-notch traders, client service and operational professionals.
Process. Over the 36 years our firm has been in business, we have institutionalized a repeatable methodology for gathering, arraying, projecting, analyzing, and communicating data about potential investments. We believe in old-fashioned hands-on research that includes company visits, plant tours, trade show attendance, etc. (Y)our analysts generate a lot of frequent flier miles. Along the way, they construct proprietary cash flow models and document their work in written reports that enhance accountability.
Philosophy. Our stock selection is based upon the principles first articulated in 1934 by the fathers of security analysis, Benjamin Graham and David Dodd. We contributed to the canon of value investing by introducing the concept of Private Market Value (PMV) with a Catalyst™. We define PMV as the price an informed buyer would pay to own 100% of an enterprise. The discount in the public price of a security versus its PMV provides us with “margin of safety,” as coined by Graham & Dodd in their seminal work, Security Analysis. We seek one or more catalysts – events or circumstances such as M&A, financial engineering, change in management, and change in regulation – that could drive the public price of a security closer to its PMV. Taken together, these elements, along with a patient and long-term bias, have allowed us to deliver superior performance. We may not outperform the market in every year, but we believe we can do so over an entire investment cycle.
Deals, Deals and More Deals
Worldwide M&A volume totaled $2.4 trillion in 2013, a decline of 6% from 2012. Fourth quarter worldwide volume was particularly disappointing, down approximately 30%. Despite this pause in deal making, the Fund benefited from a number of transactions in 2013, including Joh. A. Benckiser’s acquisition of D.E Master Blenders, Conagra’s purchase of Ralcorp, Media General’s (0.7% of net assets as of December 31, 2013)
merger with New Young Broadcasting, and Verizon’s announcement that it would purchase the 45% of Verizon Wireless owned by Vodafone (0.4%).
Financial engineering activity, on the other hand, was very strong, with 27 spin-offs completed in the U.S. and over 20 already announced for 2014. Among the 2013 spin-offs held by the Fund are News Corp. (0.4%) and CST Brands (0.4%). A key attraction of financial engineering, in our view, is that it facilitates future tax- efficient M&A. This dynamic adds to our conviction that 2014 will be a busier year for deals.
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 stated in U.S. dollars or U.S. dollar equivalent terms are presented as of December 31, 2013.
The Bank of New York Mellon Corp. (0.5% of net assets as of December 31, 2013) (BK)($34.94 – NYSE) is a global leader in providing financial services to institutions and individuals. The company operates in over one hundred markets worldwide and strives to be the global provider of choice for investment management and investment services. As of September 30, 2013, the firm had $27.4 trillion in assets under custody and $1.5 trillion of assets under management. Going forward, we expect BNY Mellon to benefit from rising global incomes and the cross border movement of financial transactions.
Cablevision Systems Corp. (1.8%) (CVC – $17.93 – NYSE) provides broadband, TV, and phone service to over three million subscribers in the New York metropolitan area. An industry pioneer, CVC has developed the most advanced plant in the country and converted over 70% of its subscribers into triple play (video, phone, and broadband) customers. In the process, Cablevision achieved industry-leading average monthly subscription revenues and margins. This peak performance led the company to become a victim of its own success; combined with competition from Verizon FiOS (%) in approximately half its footprint, Cablevision saw reduced growth and a sagging share price in 2012/2013. The company’s efforts to address these declines appear to be paying off. Management has also been active on the financial front, spinning off Madison Square Garden (%) in February 2010 and AMC Networks (%) in June 2011 and repurchasing over 10% of shares outstanding. Early in 2013, Cablevision agreed to sell its Optimum West (formerly Bresnan) systems to Charter Communications (%), capturing an attractive equity return. Cablevision is now a single-market, pure-play cable operator, which could facilitate an eventual consolidation of the company in our view.
CBS Corp. (4.5%) (CBS)($63.64 – NYSE) operates the CBS television network and the premium cable network Showtime, owns 29 local television stations and 130 radio stations, and is the third largest international outdoor advertising network. We believe CBS has a number of opportunities to generate incremental non-advertising revenue from the sale of existing content to online video distributors (OVDs) and the retransmission of consent agreements with traditional distributors. In addition, we expect a continued recovery in advertising, especially that of radio and outdoor, to contribute to earnings growth. Finally, we believe financial engineering, including the announced $3 billion share buyback and the planned spinoff and REIT conversion of CBS Outdoor, could act as a catalyst for shares.
CST Brands Inc. (0.4%) (CST)($36.72 – NYSE) , headquartered in San Antonio, TX, is one of the largest independent convenience store operators in North America, with 1,900 stores located in nine U.S. Midwest states and Canada. The company was spun-off by Valero on May 1, 2013. CST’s store-base is concentrated in markets with above average population growth; 849 of the 1,034 total U.S. stores are located in three states with projected cumulative population growth of over 15% over the next decade: Texas (628), Colorado (158) and Arizona (63). CST owns the majority of its real estate, which mitigates lease risk and should provide downside protection; we estimate the real estate to be worth in the range of $1.5 billion to $2 billion or ~$20 to $26 per CST share. CST has generated $13 billion in revenue and $387 million of pro forma EBITDA over the trailing twelve month period.
Honeywell International Inc. (2.6%) (HON)($91.37 – NYSE) is a leading producer of avionics, power, and electronic systems for the aerospace market, as well as process automation and security products for the industrial, residential, and commercial building markets. The company also makes turbochargers for the automotive industry and provides technologies to the energy market. HON offers excellent products, has a strong balance sheet, and generates substantial free cash flow that could be used for internal growth, acquisitions, and stock repurchases. In addition, the company is executing on its long term strategy to expand in less costly regions of the world, while reducing costs in more costly countries by closing plants, consolidating facilities, and implementing six sigma and lean manufacturing. HON is on track to achieve its five-year targets, outlined in 2009, of growing revenues at a 6% – 8% compounded annual growth rate to a range of $41 to $45 billion and expanding the segment margin by 300 – 500 basis points to 16% – 18%. Achieving these goals should position HON for greater profitability gains in the future.
Investment AB Kinnevik (less than 0.1%; 0.5%) (KINV’A – SEK 299.30 – Stockholm Stock Exchange; KINV’B – SEK 297.90 – Stockholm Stock Exchange) , headquartered in Stockholm, Sweden, was established in 1936 as an investment company. Kinnevik manages a portfolio of listed holdings, primarily in the telecommunications and media sectors, including publicly traded Millicom, Tele2, Modern Times Group, CDON Group, Black Earth Farming, and Transcom Worldwide. In addition, typically through its New Ventures subsidiary, Kinnevik invests in small and mid-size companies with significant growth potential, focusing primarily on online, microfinance, and agriculture businesses. Kinnevik’s largest unlisted holding is its 36% interest in Zalando, a leading European online footwear and fashion retailer. On December 9, 2013, Kinnevik announced that it had sold its 25.1% interest in BillerudKorsnäs, a manufacturer of fiber-based packaging, to a group of Swedish institutions for approximately SEK 3.7 billion in cash. After the transaction, Kinnevik will have net cash of around SEK 3 billion. Management noted that the company’s strong financial position should support continued development of the company’s current holdings and enable Kinnevik to continue to make new investments within telecom and financial services, as well as online and media companies.
National Fuel Gas Co. (2.1%) (NFG)($71.40 – NYSE) is a diversified natural gas company. NFG owns a regulated gas utility serving the region around Buffalo, NY; gas pipelines that move gas between the Midwest and Canada and from the Marcellus to the Northeast; and an oil and gas exploration and production business. NFG’s regulated utility and pipeline businesses, as well as its California oil production business, provide stable earnings and cash flows to support the dividend, while the natural gas production business offers significant upside potential. NFG’s ownership of 800,000 acres in the Marcellus shale, including 745,000 acres in the shale fairway of Pennsylvania, holds enormous natural gas reserve potential, and we believe the position could be worth $3.4 billion, based on recent comparable transactions. Despite the decline in natural gas prices leading to lower production levels, we continue to expect significant long-term earnings and cash flow growth from gas production, and we remain excited about the expansion or financial engineering potential of the strategically located pipeline network. The company has increased its dividend for over forty consecutive years.
Rolls-Royce Holdings plc (2.4%) (LSE:RR)(1,275.00 – 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 for 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. In 2012, RR closed on the previously announced arrangement to exit the IAE International Aero Engines AG joint venture, which was a collaboration of four companies to produce the V2500 engine, primarily for a narrow body Airbus A320 program. In return for its equity in the joint venture, RR received $1.5 billion and an unspecified amount for each hour flown by the currently installed fleet of V2500 powered aircraft for fifteen years following the completion of the transaction, which we continue to view positively.
Twenty-First Century Fox Inc. (1.2%; 0.5%) (FOXA)($35.18 – NASDAQ; FOX – $34.60 – 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.
Vivendi SA (1.0%) (VIV)(€ 19.16 – EPA) is a French media and telecommunications holding company in the late stages of a decade long transition. Most recently, the company sold most of its 62% stake in Activision Blizzard and reached an agreement to sell its entire 53% stake in Maroc Telecom SA. Early in 2014, Vivendi expects to separate into two entities: a telecom firm consisting of SFR, the second largest French wireless provider, and a media firm consisting of Canal+ (a Francophone focused pay TV 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 TV provider). We expect SFR and 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 Activision and Maroc disposals.
Xylem Inc. (0.8%) (XYL)($34.60 – 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
The top contributor to performance for the fourth quarter was CBS (+15%), which has benefited from solid execution and a thoughtful capital allocation strategy, as highlighted by a significant ongoing share repurchase program and the planned REIT conversion and spin-off of its outdoor advertising segment. Satellite firms DIRECTV (2.3% of net ass ets as of December 31, 2013) (+16%) and DISH Network (1.1%) (+16%) reported strong third quarter results, including positive subscriber additions; speculation about a combination of those firms continues. Finally, global aerospace sales remain robust benefiting firms such as Rolls-Royce (+18%), CIRCOR (1.4%) (+30%), and Honeywell (2.6%) (+11%).
Detractors to performance included Swedish Match (2.5%) (–9%), which faced increasing competitive pressures in its cigar business on top of existing price pressure in its Swedish snus business, and Remy Cointreau (0.1%) (–21%), which experienced significant volume declines in the Chinese spirits market. Gold miners Newmont Mining (1.1%) (–17%) and Barrick Gold (0.3%) (–5%) ended the year down, in sympathy with the price of gold.
Conclusion
While we think economic conditions will continue to slowly improve, double-digit equity market returns cannot continue indefinitely. Volatility is likely to return as the push and pull between rising rates and accelerating growth plays out. Our focus remains on generating superior tax-efficient, inflation-adjusted returns by relying upon our time tested people, process and Private Market Value (PMV) with a Catalyst™ philosophy.
