Mario Gabelli- “Think Like an Owner”

Fall 2011

Mario Gabelli ’67, CFA, started his career as an automotive and farm equipment analyst at Loeb Rhodes & Co. In 1977 he founded GAMCO Investors (NYSE: GBL), where he is currently Chairman and CEO, as well as a portfolio manager and the company’s largest shareholder. GAMCO now manages roughly $36 billion dollars across open and closed-end mutual funds, institutional and private wealth management, and investment partnerships. Mr. Gabelli earned his B.S. from Fordham Univerity.

G&D: How did you become interested in investing?

MG: I used to hitch hike from the Bronx and caddy at a country club in Westchester. Later in the afternoon after the market closed the specialists would arrive and talk stocks. The other caddies would go home at 4pm but I would stay and listen to what the specialists were talking about. This was maybe when I was in the 7th grade. I still remember my first stocks, Coca Cola, AT&T, and Beech Aircraft.

G&D: Can you bridge us from those days to business school?

MG: I was always passionately involved in the market and would go into high school and read the The Wall Street Journal and Business Week religiously. When I went to college at Fordham I had some great professors teaching finance but it wasn‘t until I had Professor Roger Murray at Columbia that I saw the sun, the moon and the stars align themselves and knew this was what I wanted to do. Reading Graham and Dodd helped me to learn the mechanics for how to evaluate stocks. Their approach to stock analysis and valuation made a lot of sense.

G&D: How would you describe your approach to investing and how it has evolved over the years?

MG: I left Columbia on a Friday and joined Loeb, Rhoades & Co. next Monday not taking the 3 months off like a lot of people do now. I inherited the industries followed by Michael Steinhardt who had left that day. Steinhardt went on to start one of the most successful hedge funds. So I covered farm equipment, conglomerates, auto parts and automotive.

Sometime around 1969, one of the analysts who covered the broadcast and entertainment industries left to start his own firm and I walked into my boss‘s office and said ―I quit. He said,―Why, you‘re doing well? And I said, ―I want to cover the broadcast industry. And he said, ―Fine, you got it.‖ Why did I do that? I knew if I followed ABC, NBC, and CBS, which were in New York, I could convince everyone that I should follow the movie industry. I knew this because they were the program suppliers which would get me to LA. Growing up in the Bronx you don‘t get a lot of opportunities to go to LA. I later left Loeb, Rhoades and went to William D. Witter which merged with Drexel and 90 days later I started an institutional re- search firm. This was in 1977, and at that time the market had been at 1,000 and started recovering but then quickly declined. The key question was how was I going to convince individuals and corporations and pension plans that they could make money in the stock market?

At the time, there was a lot of inflation. If you had property, plant and equipment, the replacement cost was significantly higher than what you paid for it. Interest expense was 12% to 15%, and taxes were not predictable. So we came up with the idea: what is the value of the business if someone is trying to take it private? We figured out what was the value of the business today, what it would likely be worth five years hence and how would one finance it. So we came up with the notion of private market value and we did this because we were trying to convince individuals and institutions that this was a great time to buy stocks. We wrote a re- port on a company called Houdaille, and if I recall correctly, the stock was around $26 or $28 and Henry Kravis came around and bought the stock at about $39 or something like that and I took out an ad in the Wall Street Journal. I said, ―to my friends at Houdaille and KKR, thanks for surfacing the values in the market. So that was in 1979 and that‘s how I got to meet Henry.

G&D: Can you talk a bit about how your approach differs from the Graham or Buffett methodology?

MG: It‘s the same thing. The analysts are trained to gather the data and read it carefully. These days you can get the data faster. We array the data in our format. Project the data and then interpret it. Interpret it in a way that assigns a value and then build in a margin of safety. So everything Graham and Dodd taught in the 1930s is still applicable today.

G&D: Would you say that your methodology works better for some industries than others?

MG: Of course. How do you value Facebook or how do you buy Apple with an almost $400 billion market cap? We had a rigorous discussion today with the analyst covering Apple. I love Apple‘s products, and the company sells at about $400 per share and they've had great numbers but it‘s hard for me to see how financial engineering or a takeover with a catalyst helps to surface increased value for them, and that‘s how we look at companies.

G&D: What do you say to people who argue that catalysts are usually already priced into companies?

MG: Nonsense. Let‘s say there is a company selling at $10 and you predict it‘s worth $20 based on your analysis. Will the discount narrow between the $10 and $20 so that you can earn your return? Will the company‘s value grow to over $30? Will someone come in and buy it? At the time in the 1970s if there was that sort of gap we would wonder if someone would come in and fire a ―thunderbolt (a tender offer). So the difference between the current stock value and the intrinsic value would lead to an event to unlock the value. Look at what‘s happened in the last year. Fortune Brands announced that they were breaking up.

G&D: We remember you recommending it on CNBC about two years ago when the stock was trading at about $20.

MG: Well the reason for that was not complicated. We are a touchy feely organization so I drink bourbon. It‘s a business we've been tracking for a long time and the value was there. Nowadays, Sara Lee is splitting into two parts, Kraft is splitting into two parts, and there are so many other examples. Why are all of these companies splitting up? They do so because it is a more tax efficient way to let the value surface and allow someone to buy pieces. But the key is seeing that value ahead of time and knowing the pieces ahead of time so that you can take advantage of it. For example, would Pepsi split the company in two parts so that its snack business and its beverages business can reach a higher publicly traded value? Would CVS do it? There are a lot of candidates that you could identify.

A catalyst could be as simple as a new product introduction. We have been following coffee for 40 years and coffee wasn't growing. And then all of a sudden it was November 1989, the Berlin Wall came down and it really helped open the global marketplace. A lot of the western companies flocked to the Eastern European and CIS countries to sell their products, including coffee. And more recently you had single serve coffee introduced in a number of countries. Another example is oil and gas and shale drilling. So a catalyst can take many forms.

G&D: Conversely, if you have an investment thesis about a company and you've held the company for a long time and the catalyst isn't coming to pass, how long do you wait?

MG: One of our oldest funds, the asset fund, was incepted in 1985. The turn- over is 7%, so that‘s what, a 15 year holding period? As in the movie Waterboy, if the CEO heads for the wrong goal line, we will try to stop him and if they continue to do it, we will sell. Or, if the stock goes above intrinsic value, we will find better options out there.

G&D: Could you give an example of a company you like and how you valued it?

MG: If you look at the human population there are about seven billion people. One and a half billion people are too young to drink or don‘t do so for philosophical reasons. My first visit to China was in 1981. Two things were clear: the cul- ture loves to gamble and loves to drink. The important thing to think about is which companies had pricing power. What companies had businesses that required the least amount of capital expenditures to maintain the brand. Could the Japanese and Chinese create a vodka and then sell it at a lower price? Would consumers still be willing to spend a certain amount of their income on a particular product? The ideal thing is to find businesses people are loyal to, like alcoholic beverages and coffee. You have to look at who the customers are and how postponable is the purchase. So if you look at a business like Cable TV, you have subscription revenues that are predictable (albeit with some churn rate) and then you look at what customers are likely to want in the next 10 years, which is probably speed, mobility, video, voice. Then we try to understand who packages it up best and what can go wrong with the pricing power of that service. And how does this business compare to a company that sells widgets that are hot but who knows how sus- tainable it is, and based on relative and fundamental analysis, try to come up with an approximate value to put on that business.

G&D: Was it through similar analysis that you found Fortune Brands?

MG: We look at the pricing power of an industry, such as distilled spirits. The global distilled spirits business is about $250 billion. We know the growth rate for distilled spirits in each sector (vodka, scotch, tequila, etc.). Then we look at the companies consolidating, such as Pernod in Paris, Diageo, Anheuser Busch, etc. We follow the industry globally, and we have an analyst in New York who‘s a Columbia Business School alum as well as one in Shanghai who is following industries in which we have a core competency, such as beverages. So we were following Fortune Brands and we watched what the company was doing and the changes in management. We could see the potential for Bourbon. It wasn't be- cause we liked Jessica Simpson and Dukes of Hazard. We were seeing what all of the other businesses in For- tune Brands were doing, how management was allocating cash, what the under- lying value was and what all the catalysts were. We were buying the stock. Then Bill Ackman came along and purchased 11% of the company, and we knew he was going to push them over the goal line. They then announced the split. So now the underlying value of the individual businesses has surfaced.

We look at what will hap- pen on a reasonably predict- able basis over the next five years, we look at the cash flows, we look at the multi- ple we are paying today based on enterprise value and EBITDA, and try to evaluate the person that will run the business. We meet with the management and we look at various competi- tors and we believe five years from now the distilled business of Fortune Brands, now traded under the BEAM ticker, is probably between $80-$85. Kevin Dreyer, Associate Portfolio Manager of Gabelli Asset Fund, has done the work on this and we think the company is going to be taken over. There are lots of entities that could do it and Bourbon is a $6 billion category. The only thing that bothers me is when I watch Boardwalk Empire and―prohibition. The other concern is sin taxes.

G&D: What do you think of Fortune‘s other business, the Fortune Brands Home & Security business, that is so tied to the housing industry? How do you approach and value that business?

MG: There are 90 million single family houses in the United States. Starting in 2001 and 2002, Alan Green- span really wanted to get the economy going and lowered interest rates. Every- one was being sold on the idea they should own a home, and so we built about 1.6 to 1.8 million homes per year and everyone benefit- ted from that and in 2007 that bubble collapsed. Now we are building about 500,000 homes per year. Eventually we will go back to the normalized amount of 1 million per year or so. So back to Fortune Brands– they have the Moen brand of bathroom and kitchen products. With Moen you go into Home Depot and pay maybe $200 for a faucet. They also have cabinets, which can be very expensive and postponable in terms of remodeling and also things like windows, which you probably don‘t replace unless they break. So we look at these businesses and believe you really need housing to pick up in order for them to do well because most people can put off upgrading their existing home needs. We look at what the earnings power of the company is at 500,000 new homes per year. What about 1,000,000? Then we look at another of their businesses: Master Lock.

What is the earnings power for each business, what will the earnings power be in five years under a good environment or a bad environment and whether there is a margin of safety. Can these businesses survive in another economic contraction?

The stock started trading the other day at $11.10 on 155 million shares so it‘s about a $1.7 billion market cap with about $500 million in debt so you‘re paying around $2 billion and you've got about $285 million of base EBITDA. The earnings would nearly triple if we get back to 1,000,000 homes. EBITDA could reach $500 million.

G&D: Could you talk about a few other stocks you like?

MG: When we went public in 1999, the hot groups were AOL, Yahoo, and other dot-coms. We started a utility fund. As we looked around at the utility world, it was somewhat in shambles. Enron went out and said to the utility world, ―You are all dumb: you've got to go global, you've got to diversify, and you've got to do acquisitions. Bottom line, if you went back and looked at utilities, they were rate-of-return regulated. If inflation was going to stay at 2% or 3%, they were going to do well. A company in Buffalo called National Fuel Gas, which we like today, was a business that sold home heating gas. They have 750,000 customers. It gets cold in Buffalo, so it‘s a reason to stay in business. About 80 years ago, they had the McKinsey of their time recommend that they go out and buy land. So they bought a million acres in land mostly from West Virginia to New York. And periodically they would go and drill down and put a gathering system in and get gas. Then when the well was depleted they would use it to store gas. It was a nice little company, paying a growing dividend, etc. Fast forward to now, it is trading around $55, with 83 million shares and $4.6 billion market cap with about $900 million debt. Some of the questions we ask to understand and evaluate the business are the following: What is the utility worth and what would someone pay to buy it? What is the pipeline worth? What is their midstream business worth? What are some of their oil holdings in California worth? And their raw land? New technology comes along and instead of drilling vertically down in the Marcellus area 10,000 feet below the surface, you have other options. If you put a well down, it costs about $3 million. If instead you went down and then drill laterally it costs about $5 million. And then hydraulic fracking is in the mix. And fracking unlocks huge amounts of oil and gas. Now, over the next ten years, who knows what happens with the price of oil and gas? But the company has land in an area of the world that everyone wants because of shale. They've got a midstream business that they can transform into an MLP and monetize. They also have an oil business they could sell. So we try to find the value of the business over the next ten years. If gas ever goes to $6 over that time we make a ton of money, and if your IRR is 25% to 35% and you own the mineral rights as opposed to leasing, you do very well.

G&D: Is there another company that you would like to tell us about?

MG: Another company is right here in New York City. Cablevision spun off Madi- son Square Garden. There are 75 million shares of MSG and it‘s trading in the low $20s and there is no debt and they have $300 million in cash. They are putting their cash towards refurbishing the MSG arena. So when I look at the Cable Network associated with the company, we put a value on it, and when we do that, we see we are getting two sports teams for free: The Knicks and The Rangers. There are always super rich people who want to buy sports teams. I think you could buy those teams for $20 per share, and so the question is should we own this company to participate in that upside? Now, the questions are: is there going to be an NBA season this year? We don‘t know.

G&D: Isn't there also an issue with the controlling family?

MG: They are owned by the Dolans. I am friends with the Dolans. We voted against Chuck Dolan‘s company going private four years ago at $36 a share because we thought there were hidden assets and that the deal was leaving too much on the table for our clients. They ended up spinning off Cablevision and Madison Square Garden and AMC Cable. Chuck Dolan‘s son Jimmy is doing a better job running MSG and is becoming more shareholder friendly and he won‘t sell. This is a keeper for him.

G&D: So do you in general like those companies that tend to have high insider ownership?

MG: Well, GAMCO Investors did go public, and I have 98% of the vote. So we can‘t preach against A/B shares. We‘re owners and we know how to think like owners. If you have 80% of the vote and 3% of the economics that bothers us unless it‘s something like the 14th generation of a family. But it‘s hard to paint with one broad brush — it depends on the shareholder.

G&D: You have had a long interest in American Express? What do you think of the competitors Visa and MasterCard? Do you see long term threats to those companies?

MG: Of course. There‘s always a threat. When I started in the broadcast industry, there was very little spent on capital expenditures. You could focus on some high growth cyclical company with great cash generation and to buy a TV station in a major market you paid 12 or 13 times cash flow. Today a trade just took place at 7 or 8 times cash flow. To buy a major market newspaper you were paying 25 times back in the day, and that‘s if you could even get one. Now they are trading at five times cash flow due to technological change. Sony Walkman had the only game in town and they stopped creating. Now if you go back to ten years ago, the only card company we could follow was American Express. We owned it and still own it. More recently MasterCard and Visa went public and Discover spun out. So now we have four companies we can look at and we are certainly interested in the digital wallet. Can AXP adapt quickly? Time will tell.

G&D: You have a history of waging proxy battles with some management teams. What are you looking for in a management teams and what makes you advocate for change?

MG: If you entrust money to us, we want to make a return and also act like surrogate owners. Sometimes management teams will go in the wrong direction. Starting in about 1987, we issued a Magna Carta of shareholder rights and what we would vote for and against for our share- holders. We said, if you try to put in a poison pill, we would vote against it. If it‘s already in there, we can live with it.

G&D: In the case of a company like Myers Indus- tries, where you've tried to advocate for change for many years, what do you do?

MG: In the case of Myers, I started as an auto analyst and I would go to Ohio religiously to visit with them, so we knew the company. They tried to go private with Goldman Sachs a few years ago. So we looked at them and told them not to make any more deals and they sort of pushed back. They pushed the owner‘s son off the board. So we said, ―Our clients own 10%, we should get some board seats.‖ And then during that period, Bear Stearns went bust and Lehman col- lapsed, and the money markets shut down. We ran out of juice in that instance. Are we going to go back?

We haven‘t made a decision yet. Our clients now own 15% and there are two or three other institutions that have been patient and may get involved. Why not add another director who can add some value?

G&D: To what do you credit your success?

MG: I do credit a lot to Columbia and to Roger Murray, my value investing professor.

G&D: What is it that you've done so well that others can‘t replicate?

MG: A lot of people have replicated what I've done. Chuck Royce has done a terrific job. Henry Kravis has done better than I have in the private world, albeit with some leverage. There‘s clearly a bias to- wards success by following value investing. I feel like I‘m not working for a living and have the right northern star.

G&D: What are some of the most common errors that you see young analysts make?

MG: Young analysts –what about me? I still make plenty of errors. We bought Netflix at $40 and sold it at $80. It went to $300.

G&D: What about in terms of assessing the fundamentals of the business?

MG: Sometimes the younger analysts get concerned about Mr. Market and the events of today, the volatility in stocks, especially due to all the new ETFs and high frequency trading and the like. Mr. Market is now more volatile than ever. There were reasons the uptick rule was eliminated. One of the reasons was because it made it easier for electronic trading. And so, there was a group of highly focused organizations and individuals that wanted to dismember regulatory elements that had reduced volatility to a degree. So what happened last year with the flash crash was partially the result of that lobbying group having success at changing the rules of the game. So analysts need to look at intrinsic value and realize that the antics of Mr. Market to the fourth power are creating more volatility than they might have other-wise become accustomed to.

G&D: Do you have any advice for novice analysts who tend to get lost in the weeds with the wealth of information surrounding each company?

MG: Yes, and that is that you cannot study a company without feedback mechanisms and benchmarks. So the key is to start by getting to know an industry extremely well. That gives you a great perspective. For example, we have a conference on the autoparts industry. Start off by reading everything that‘s happened in the last 20 years in an industry. So you read all the trade info and then you cross check. Then understand how that industry relates to other industries. And then you need to understand the stock. First understand the business and then understand the stock. Those two things don‘t always go in lockstep.

G&D: When you came to Columbia last year, you provided handouts of Sara Lee. What do you think of their businesses now?

MG: Sara Lee is a company with many products. The CEO, Brenda Barnes parachuted in a few years ago and started looking at the company and trimming it down and selling various businesses such as Hanes- brands. We knew the food business because we have a team that does health and wellness and then we also follow consumer products companies so we knew well the businesses they were involved with. And as we are closely following the company, they came up with the single serve coffee, which really took off in Europe. Then I tried some personally, and it was so easy. Just look at the categories they are in. We watched the company and slowly but surely we‘re adding to it at times where we could get the appropriate margin of safety. Now we see the company being split up in two parts and then once they split, the question is will one company be sold, or will both be sold? So at $16.70, I‘m still in the camp that I can make 30% on the upside and I think that‘s OK.

G&D: Is there anything you wished you knew when you were getting started in the asset management business?

MG: Even though I could make money for my clients in 1976, I probably structured my business in the wrong way. I should have been in the hedge fund world. You can‘t be in the business of ignoring over priced securities; you need to be able to short them. I also don‘t think I‘d ever have gone public. The burdens of regulation are too great.

G&D: What books or publications should aspiring investors be reading?

MG: I read annual reports and reading them constantly is simply the best way to learn about businesses. For example, I got an annual report of a company in Racine, Wisconsin. The company is Twin Disc. I hadn't seen the company in a long time but was just curious about them. And then all of a sudden I noticed they are producing a transmission dedicated to fracking. Meanwhile, I had been sensitized to the dynamics of shale because of National Fuel Gas, and here I see a company producing a critical component. The stock was at $11. They have approximately 12 million shares, and at the time a $130 million market cap. Because we run a micro cap fund we can own it there and also in separate ac- counts for our private wealth management clients. So we start buying the stock. It went from $11 to $40 in a year. It then dropped back to $28, and now we own about 7% of the company for our clients. We have an analyst who graduated from Columbia Business School within the last few years following the company. Now, for the last 40 years I‘ve been reading Variety and Billboard and Automotive News and Farm Income Journal and all sorts of other things that give you an idea of what‘s going on around the world. The hard part is to connect all the dots. In World War II, how did the allies find out where the German V-1 bomb base was? An intelligence analyst was reading the social papers and he was wondering why all these German generals were going to this location in the middle of no- where? And he figured out that‘s where they were making the bombs and sending them to England. So gather the data, array the data, and then figure out the valuation techniques.

G&D: Is there anything you‘d like to leave our readers with?

MG: Everyone should go shark fishing. When you go shark fishing, you leave a chum line. The sharks smell the chum line and follow it. So if anything breaks the chum line, you don‘t have nearly as much success. So the notion of understanding the first rule of life is important: don‘t lose money. The best way to learn not to lose money is to lose money. Going through a market like this is a great learning experience, because people realize no matter how smart they are, things change very quickly.

G&D: Thank you for speaking with us, Mr. Gabelli.