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Column by Gabelli Funds

The Months of Historically Low Volatility Are Unlikely to Return Any Time Soon

Photo: Spiff / Wikimedia Commons
By Michael Gabelli

The U.S. equity market closed slightly higher for April as corporate earnings continued to post strong first-quarter gains but in aggregate have so far been unrewarded with higher prices. The U.S economy is keeping the job market tight and both wages and inflation are starting to rise. Merger and acquisition activity spiked sharply higher on ‘Merger Monday’ on the last day of the month as well.

Volatility has receded from the early February high, though the months of historically low volatility that preceded it are unlikely to return any time soon. President Trump’s zigzag decision-making style has added a new variable of day-to-day investment uncertainty with agenda items ahead including the Iran nuclear weapons deal, NAFTA, highly complex tariffs, and North Korea. The U.S. Federal Reserve’s gradual liquidity reduction and rising rate policy have weighed on stock prices. The main drivers for rising stock prices, we believe, continue to be lower corporate taxes, reduced regulation, and U.S. economic growth.

There are many moving pieces for the market to digest in real-time, and thus many unanswered questions – whether the $150 billion-plus trade tariffs are simply negotiating tactics, how aggressive Congress will be on data privacy and business models, how quickly inflation will come back, and how aggressively the Federal Reserve will raise rates to stay ahead of it.  The most demanding question to be answered is how much trouble the markets can withstand at once?  In isolation, current headwinds seem manageable as long as fundamentals remain the priority.  Rising uncertainties may keep the stock market on edge, but corporate profit growth, aggressive corporate stock buybacks, and deals should provide a cushion for any selloffs.

Merger and acquisition activity in both the utility and energy sectors are standouts so far this year.  In the staid and highly regulated sub-sector niche of water utilities, an unusual four-way bidding war deal dynamic is developing as California Water Service Group (CWT) made an unsolicited takeover bid for water utility SJW Group. SJW had previously agreed to acquire Connecticut Water Service Inc. (CTWS). On April 19, in order to participate in this water-industry consolidation, Eversource Energy (ES) announced an unsolicited bid for Connecticut Water Service. Stay tuned for more intriguing investment opportunities as the Water War unpredictably unfolds in the weeks ahead.

More specifically in terms of merger arbitrage opportunities, deal activity remained strong. Below is an update on two deals that have been in the global news recently.

Sky agreed to be acquired by Twenty-First Century Fox or Comcast

Sky plc received a formalized acquisition proposal from Comcast at £12.50 cash per share, or about £30 billion. Twenty-First Century Fox has said it remains committed to buying Sky, and Sky’s share price reflects the expectation that Fox and Disney (who is in the process of acquiring most of Fox’s assets) will increase Fox’s bid for Sky, currently at £10.75. As a refresher, Sky received an initial offer of £10.75 cash per share in December of 2016 from Twenty-First Century Fox. Fox, which already owns about 40% of Sky, has been unable to close the acquisition due to British political scrutiny of the transaction, though regulatory approval could come in June 2018. The extended regulatory review left an opening for Comcast to make a bid for Sky, which Comcast has long viewed as having a premier position in European media. Twenty-First Century Fox is currently in the process of being acquired by Disney, which also believes Sky is a crown-jewel asset.

Monsanto agreed to be acquired by Bayer 

Going back, Monsanto agreed to be acquired by Bayer in May 2016 for $128 cash per share, or about $65 billion. In March, shares slumped after reports suggested that the Department of Justice was “months away” from completing its review and that Bayer may be required to sell additional assets. Bayer had already agreed to sell seed and agrochemical assets (with the recent addition of vegetable seeds) to BASF for $9 billion. In April, shares of Monsanto reacted positively as the company made progress towards gaining antitrust approval in the U.S., and Bayer reported they are having very good and constructive discussions with the DOJ. The last important remaining condition is receiving antitrust approval from the DoJ in the U.S., which could be granted in June, as the companies have offered significant concessions, including the divestment of Bayer’s digital agricultural business, which had been an area of focus. In addition, Bayer reiterated its expectation the deal will close in the second quarter of 2018. The companies have effectively created a fourth large competitor in the space through their divestments to BASF. BASF should be able to now compete against the other large agricultural companies, including Bayer/Monsanto, ChemChina/Syngenta, and DowDupont.

Column by Gabelli Funds, written by Michael Gabelli
 

To access our proprietary value investment methodology, and dedicated merger arbitrage portfolio we offer the following UCITS Funds in each discipline:

GAMCO MERGER ARBITRAGE

GAMCO Merger Arbitrage UCITS Fund, launched in October 2011, is an open-end fund incorporated in Luxembourg and compliant with UCITS regulation. The team, dedicated strategy, and record dates back to 1985. The objective of the GAMCO Merger Arbitrage Fund is to achieve long-term capital growth by investing primarily in announced equity merger and acquisition transactions while maintaining a diversified portfolio. The Fund utilizes a highly specialized investment approach designed principally to profit from the successful completion of proposed mergers, takeovers, tender offers, leveraged buyouts and other types of corporate reorganizations. Analyzes and continuously monitors each pending transaction for potential risk, including: regulatory, terms, financing, and shareholder approval.

Merger investments are a highly liquid, non-market correlated, proven and consistent alternative to traditional fixed income and equity securities. Merger returns are dependent on deal spreads. Deal spreads are a function of time, deal risk premium, and interest rates. Returns are thus correlated to interest rate changes over the medium term and not the broader equity market. The prospect of rising rates would imply higher returns on mergers as spreads widen to compensate arbitrageurs. As bond markets decline (interest rates rise), merger returns should improve as capital allocation decisions adjust to the changes in the costs of capital.

Broad Market volatility can lead to widening of spreads in merger positions, coupled with our well-researched merger portfolios, offer the potential for enhanced IRRs through dynamic position sizing. Daily price volatility fluctuations coupled with less proprietary capital (the Volcker rule) in the U.S. have contributed to improving merger spreads and thus, overall returns. Thus our fund is well positioned as a cash substitute or fixed income alternative.

Our objectives are to compound and preserve wealth over time, while remaining non-correlated to the broad global markets. We created our first dedicated merger fund 32 years ago. Since then, our merger performance has grown client assets at an annualized rate of  approximately 10.7% gross and 7.6% net since 1985. Today, we manage assets on behalf of institutional and high net worth clients globally in a variety of fund structures and mandates.

Class I USD - LU0687944552
Class I EUR - LU0687944396
Class A USD - LU0687943745
Class A EUR - LU0687943661
Class R USD - LU1453360825
Class R EUR - LU1453361476

GAMCO ALL CAP VALUE

The GAMCO All Cap Value UCITS Fund launched in May, 2015 utilizes Gabelli’s its proprietary PMV with a Catalyst™ investment methodology, which has been in place since 1977. The Fund seeks absolute returns through event driven value investing. Our methodology centers around fundamental, research-driven, value based investing with a focus on asset values, cash flows and identifiable catalysts to maximize returns independent of market direction. The fund draws on the experience of its global portfolio team and 35+ value research analysts.

GAMCO is an active, bottom-up, value investor, and seeks to achieve real capital appreciation (relative to inflation) over the long term regardless of market cycles. Our value-oriented stock selection process is based on the fundamental investment principles first articulated in 1934 by Graham and Dodd, the founders of modern security analysis, and further augmented by Mario Gabelli in 1977 with his introduction of the concepts of Private Market Value (PMV) with a Catalyst™ into equity analysis. PMV with a Catalyst™ is our unique research methodology that focuses on individual stock selection by identifying firms selling below intrinsic value with a reasonable probability of realizing their PMV’s which we define as the price a strategic or financial acquirer would be willing to pay for the entire enterprise.  The fundamental valuation factors utilized to evaluate securities prior to inclusion/exclusion into the portfolio, our research driven approach views fundamental analysis as a three pronged approach:  free cash flow (earnings before, interest, taxes, depreciation and amortization, or EBITDA, minus the capital expenditures necessary to grow/maintain the business); earnings per share trends; and private market value (PMV), which encompasses on and off balance sheet assets and liabilities. Our team arrives at a PMV valuation by a rigorous assessment of fundamentals from publicly available information and judgement gained from meeting management, covering all size companies globally and our comprehensive, accumulated knowledge of a variety of sectors. We then identify businesses for the portfolio possessing the proper margin of safety and research variables from our deep research universe.

Class I USD - LU1216601648
Class I EUR - LU1216601564
Class A USD - LU1216600913
Class A EUR - LU1216600673
Class R USD - LU1453359900
Class R EUR - LU1453360155

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