Vice Fund

Jeff Middleswart is portfolio manager of the Vice Fund (VICEX)and Director of Research for Behind the Numbers.  The Vice Fund is a mutual fund primarily focused on the alcohol, tobacco, gaming and defense industries.  Founded in 1988, Behind the Numbers (BTN) is an independent research provider to institutional money managers. Given that BTN research is focused on stocks to avoid or sell short, Jeff has an extensive background in ferreting out potential problems from companies’ financial statements. Prior to his work on the short side, Mr. Middleswart served as Senior Analyst at Barre and Co (now Southwest Securities) where he focused on high yield bond analysis. Jeff manages the Vice Fund (VICEX) with a value bias and focus on dividends and dividend growth.

Jeff began managing VICEX in Feb. 2010.

As of June 30, 2010 YTD 1?Year 3?Year 5?Year Since Inception
Vice Fund(inception date 8/30/2002) ?3.12% 35.06% ?6.92% 1.83% 7.23%
S&P 500 -6.65% 49.77% -4.15% 1.92% 5.34%

I would like to start out a little bit with your background; can you tell us about your experience with short selling?

With so many companies paying their executives with stock these days – the predictable outcome of government attempts to limit pay in the 1990s; there are incentives to both search for short-term items that will fuel even greater growth and to cheerlead the stock.  What we have seen is that many of these gimmicks may last 6-24 months, but in the end they cannot be sustained indefinitely.  Companies cannot simply restructure their way to higher profits unless there is sales growth, and they cannot expand sales growth in the future when they cut advertising and R&D spending to make current earnings.  Looking at the results of the stock market indices over the years, which tend to be dominated by a handful of companies, many investors would be surprised to see that in any given year 25%-40% of the companies in the index decline.  Thus, short-selling is a sizable asset class and one that remains viable in the majority of years.  I’ve been looking for short selling ideas for 17 years now by finding fundamental issues with companies.  We have had a number of successes where we were the only ones raising the red flags as problems for a company until they explode and the stock is pummeled.  Some of the favorites in the past were Paging Network, Sunbeam, AES, Providian Financial, Weight Watchers, and Constellation Brands.

What factors do you look for when short selling a stock?

There are dozens of items to look for.  We like to find businesses in decay where pricing is falling, new technology is superseding the current offerings, and there is less need to buy something a second or third time as rapidly.  Tires, batteries, computers, modems were all examples of this.  Companies where the income statement looks great, but somehow they never produce any cash flow and the balance sheet continues to pile up debt and receivables are other areas to look for.  A business that is not self-financing can be something easy to trip up when the cost of capital rises or it cannot roll-over debt – these are often companies that have little real growth and seek to be a growth company by acquiring other ones but they are addicted to the next deal and start to overpay.  Constant restructurings are another thing to look for.  Often you will see a company that has realigned its business, changed employees, sold business lines, bought others, announce that it is writing down assets every year for a decade – then you look closer and see that even after these accounting charges, profitability is lower now than when all the restructuring began.

What factors do you look for when short selling a stock?

There are dozens of items to look for.  We like to find businesses in decay where pricing is falling, new technology is superseding the current offerings, there is less need to buy something a second or third time as rapidly.  Tires, batteries, computers, modems were all examples of this.  Companies where the income statement looks great, but somehow they never produce any cash flow and the balance sheet continues to pile up debt and receivables are other areas to look for.  A business that is not self-financing can be something easy to trip up when the cost of capital rises or it cannot roll-over debt – these are often companies that have little real growth and seek to be a growth company by acquiring other ones but they are addicted to the next deal and start to overpay.  Constant restructurings are another thing to look for.  Often you will see a company that has realigned its business, changed employees, sold business lines, bought others, announce that it is writing down assets every year for a decade – then you look closer and see that even after these accounting charges, profitability is lower now than when all the restructuring began.

I just reviewed a book titled The Art of Short Selling , do you agree with most of the author’s philosophy or do you have a different methodology?

I think you’re talking about Kathryn Staley’s book.  I would agree with areas that she focuses upon as well.  The key word is “Art” as there is not a set of rules that work in every situation.  Some companies can have great financials but their number one customer is going bankrupt.  That company may be a great short, and there won’t be an accounting red flag that trips.  Red flags have to be viewed in context too – cutting R&D will inflate current earnings, but every cut is not necessarily bad.  A company may spend 10% of sales on R&D for 10 years in a row, then work on a large project that drives the R&D spending to 14% of sales one year and it returns to 10% the next.  That’s a cut in R&D but may be easily explained.  She does a good job of pointing out that the more accounting items that are unsustainable; the stronger a company may be as a short-sale candidate.  I would always emphasize cash flow over income though.  A company that generates strong cash flow can normally finance itself, pay for growth and generally avoid the massive pitfalls with some of the accounting gimmicks that may still hit their results.  A company with weak and declining cash flow makes a stronger short sale when the income statement items work against them.

How can one use lessons from short sellers to invest long only?

Short selling provides a frame-work of essentially negative selection.  You are looking for reasons NOT to own something.  By knowing what unsustainable results look like and what bad companies look like, “longs” can be evaluated to determine if those problems are present.

Jim chanos has made big headlines with his announcement of his “short of China”; do you have any opinion on this matter?

I will say that this not a situation I’ve studied at any level as much as

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