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Column by Gabelli Funds

When Spreads Widen One Can Add to Existing Positions at Lower Prices to Earn Greater Returns

Photo: Khantipol / CC-BY-2.0, via Wikimedia Commons
By Michael Gabelli

M&A performance was crimped in October as market volatility caused most spreads to widen. This presented an opportunity to put cash to work by adding to existing positions at lower prices to earn greater returns. Since our first investment product dedicated to merger arbitrage in 1985, we have invested through periods of heightened market volatility. Our conservative investment discipline consisting of no leverage, position size limits and a preference for strategic, fully-financed transactions allows us to add to high-conviction positions at times of market stress to earn higher risk-adjusted returns. 

More specifically, in October:

  • The spread on the Rockwell Collins (COL-NYSE) deal with United Technologies widened from about $5 to $12, despite winning approval from U.S. antitrust regulators. “Arbs” expected Chinese antitrust (SAMR) approval to come quickly after the DOJ, but the approval has not yet been received and the delay has resulted in a wider spread. On his October 23 earnings call, United Technologies CEO Greg Hayes said that SAMR approval had been delayed because the Chinese were waiting for U.S. clearance, which itself was delayed until early October.
  • NXP Semiconductors (NXPI-NASDAQ) traded lower given the market volatility and a decline in semiconductor stocks broadly. Although we made progress in reducing our position prior to the market selloff, our remaining position clipped performance in October. After reporting results after market hours on October 31, the stock rallied more than 10% to $83.

In October, we also realized gains on transactions that closed including Boeing’s $4 billion acquisition of aerospace supplier KLX Inc. and Conagra’s $11 billion acquisition of Pinnacle Foods. On October 30, WestRock received DOJ antitrust approval for its $5 billion acquisition of KapStone Paper and Packaging, and the deal subsequently closed on November 2. We are building our pipeline of deals with notable new transactions announced in October including:

  • Red Hat, Inc. (RHT-NYSE), a developer of software and services used to manage IT infrastructure, agreed to be acquired by IBM for $190 cash per share, or about $32 billion.
  • Endocyte, Inc. (ECYT-NASDAQ), a biopharmaceutical company developing therapies for the treatment of cancer and inflammatory diseases, agreed to be acquired by Swiss drugmaker Novartis for $24 cash per share, or about $2 billion.
  • Imperva, Inc. (IMPV-NASDAQ), which develops data center security software, agreed to be acquired by technology investor Thoma Bravo for $55.75 cash per share, or about $2 billion.

We continue to find attractive opportunities investing in announced mergers and expect future deal activity will provide further prospects to generate returns uncorrelated to the market.

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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