The Gabelli Blue Chip Value Fund: Finding Value in the US Stock Market
It is hard to be pessimistic about the future of the US economy. We have been in an extraordinary period of growth combined with declining inflation and interest rates. Even the international economic shocks of 1998 failed to knock the US economy off its growth track.

Recently, the news on the global economy has been more positive than negative. All the pieces are in place for synchronized global growth in the year ahead, with Japan on the mend, Europe regaining momentum and Asian, Eastern European and Latin American economies recovering.

The Two Tiered Stock Market
These good times are reflected in the stock market, with most leading indices trading at or near record valuations. Investors have increased the multiple of earnings at which they are willing to buy a company. Since 1990 corporate earnings have grown about 8% a year, while the market has returned 18% a year. The difference has come from an expansion in the P/E ratio from 8 to 27. In other words, since 1990 the earnings gains account for only 20% of the price appreciation of the S&P 500. Falling interest rates, declining inflation, muted business cycles and a tremendous confidence in the Federal Reserve have greatly expanded the price investors are willing to pay for stocks.

Another characteristic of the stock market's expansion has been that the high returns have been concentrated in a narrow number of stocks. The winner's circle of stocks has been characterized by large capitalization companies that deliver consistent profits. These stocks are best represented in the S&P 500 which has provided much more generous returns than the broad market mirrored by indices such as the Wilshire 500 or the Value Line Composite. As an example of this two tiered stock market, in 1998 the S&P 500/Barra Value Index, which consists of all the value stocks in the S&P 500, returned 15% versus 42% for the S&P 500/Barra Growth Index, which contains the other half of the S&P 500, the growth stocks. This difference between value and growth stocks was the widest ever since these indices were calculated starting in 1975. Although value has closed the performance gap in 1999, growth stocks are still leading by a significant margin, with the growth index returning 9% versus 7.5% for the value index.

Valuations
Investors have fallen head over heels for large companies with consistent earnings growth and have shunned cyclical companies with less predictable earnings patterns as well as any company that has suffered temporary operating difficulties and fallen short of earnings expectations. To a degree, this is rational investor behavior. It makes sense for investors to want businesses with good current growth and to avoid those demonstrating less certain prospects. But in the last several years that strategy has produced spectacular returns. Investors are now paying a multiple of earnings that is two to three times the longer term earnings growth rates for market favorites such as General Electric, Cisco or Walmart, while blue chip value stocks are trading at price earnings ratios that are half of their long term growth rates.

Taking Advantage of the Market's Split Personality
While the market leading growth stocks are great companies, based on historical valuation barometers, they are no longer great investment bargains. In fact, one could argue convincingly that current valuations defy logic. At the same time, there are terrific investment opportunities in quality companies that have had temporary difficulties but that could experience dramatic upward revisions in their market value when conditions improve. How do we identify such opportunities? Just as bargain shoppers look for brand names as a guide to quality on the discount racks, we search for brand and franchise values that are trading at deeply discounted valuations. These "blue chip value" companies possess the financial strength to rejuvenate growth and broadly distribute their products. At the same time, we look for a catalyst or sequence of events that will revive the company's reputation and cause investors to revalue it upwards.

There are numerous such opportunities in today's market. Here are a few examples:

Technology at a Value Price
Hughes Electronics has transformed itself from a defense/aerospace contractor into a satellite and consumer media distribution company. With its DirecTV business it is the largest provider of satellite television service. The company's heavy upfront investment in this business has restrained earnings, disguising its exceptional growth. In the year 2000, GM Hughes could trip its cash flow and start to show earnings improvement. Long term growth would increase if proposed changes in regulation that would allow satellite television providers to offer local broadcasts is passed. Consumers' inability to watch local news broadcasts has been the single biggest reason DirecTV has not grown even faster. Finally, there is pressure on General Motors, the majority owner of Hughes, to spin off the rest of the company to the public. If this happens, we think the stock will receive a much better valuation. Presently, Hughes is trading at a 30% discount to the sum of its parts valuation. We view that as a great bargain.

Brand Names at a Discount
Mattel, one of America's leading toy companies, is down to $12 ¾ from a high of $42 due to slowing Barbie sales and a wrenching inventory adjustment by the U.S.'s largest toy retailer ToysRUS. Barbie is responsible for almost one third of the company's sales, but Mattel has numerous other strong brand name lines including Fisher Price and Hot Wheels. In addition, it owns the Learning Company/Broderbund, one of the leading interactive educational toy companies. The opportunities for cross product development are tremendous, as Mattel's popular toy and game lines can now be made into interactive learning products. The company is increasing its margins by offering its products directly to consumers via the internet and catalogues. CEO Jill Baraud is under heavy pressure from shareholders to get Mattel back on track. We think she is doing a good job and that Mattel's earnings will regain momentum.

Mattel can earn $2.00 a share by 2001 and we believe that once growth is re-established that investors will give the company a 20 price earnings multiple. That is nearly triple from today's price. Cendant is a leading franchisor of well known hotels, real estate and auto rentals such as Ramada Inn, Howard Johnson, Days Inn, Avis, Caldwell Banker and Century 21. The company was hit by an accounting scandal that took it down from $40 in mid-1998 to $18 today. The company needs to put the accounting problems behind it, and to continue to post good earnings and cash flow growth in order to return to a multiple of 18 times earnings in two years and 11 times cash flow to get a value of $32 per share.

Insurance Stocks - A Reversal in Fortune
America's best insurance companies are now trading at rock bottom prices. There is a good reason for that. Prior to 1999, declining claims losses and a healthy bond market resulted in excess capital and cutthroat pricing competition for the property casualty companies. Margins have shrunk and earnings have stalled. However, pricing seems to be bottoming out, possibly indicating the bottom of the cycle and better earnings growth going forward. For the life insurers, concern about the future growth of their popular annuity products has cut their stock prices. Looking forward, leading insurers have very valuable customer bases. Proposed deregulation of the financial services industry should pass within a year, making these cheap insurers attractive takeover targets for other diversified financial service companies to acquire.

As noted value investor Benjamin Graham said, "In the short run the stock market is a voting machine. In the long run, it is a weighing machine." Now is an opportune time to distinguish between what is popular and what weighs in with a lot of value.

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