An Interview With Jeff Middleswart- Portfolio Manager of the Vice Fund

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 Jim Chanos has and I’m not much of a macro player.  I believe China has some growing pains and likely some problems in the near-term.  Real estate prices in key areas are out of reach for many citizens, their export markets in the US and Europe are still down – so I agree with the current view that China could see more selling pressure.  Longer term, the country is still industrializing, its domestic market is growing (thus it may not always be dependent on export markets) thus it should still have some good long-term growth characteristics.

Do you short sell at all in the Vice Fund? No. While there has been some short selling in this fund in the past, we believe it is our mission to stick with the “Vice” concept because we believe it works.  In addition, we want to leave it up to investors to address the level of hedging or short exposure that makes them comfortable.

Can you explain to the readers the philosophy of the Vice Fund? In the basic terms, our view is that “vice stocks” outperform over the long term.  To go a bit deeper, I’d say there are two parts to this philosophy. The first is that we believe that companies in these four industry groups typically have characteristics that we find attractive. These include strong cash flow, the ability to pay and increase dividends, pricing power, and barriers to entry. The second aspect is that these companies often sell at modest valuations, in part because they are shunned by investors. Good fundamentals and low valuations are a nice combination in our view.  So while a few of these vice companies are likely to appear in your portfolio anyway, we simply focus on these areas, and consider these groups of companies a core holding.

Why did you choose these specific industries and not other ones that people might find distasteful like oil companies, or chemical companies etc? One reason is that we like companies with stable cash flows and low cap-ex requirements, and many of the vice companies fit that bill. Oil and chemical companies can see large swings in results solely due to changes in commodity prices that are beyond their control and vital to their business.  That can also force up their cost of doing business – drilling an oil well costs more when everyone else has contracted with the bulk of the rigs for example.  Another key idea is that the vice industries are not easy to get into. To start up a brewery able to compete with dominant player like SAB Miller is difficult. Yes, there are microbreweries that have taken market share from the big guys, but if they are truly successful, they become acquisition candidates.

That’s not to say that we don’t find companies outside the primary four that we like. You mentioned chemicals, and we do own Monsanto, which are certainly a dominant player and cash flow generator. Also, I should point out, it’s not that we simply like to invest in companies that some investors find distasteful.  It’s that the valuation of certain companies can be compelling because of investor behavior. There have been several studies of late concluding that “sin stocks” have outperformed for this very reason.  Plus, for us to be interested, these companies must have the cash flow characteristics and barriers to entry we’ve mentioned.  After all, there are plenty of stocks in distasteful industries that aren’t compelling investments. And we’re not even talking about Coke and YUM Brands!

According to the fund rules are you allowed to buy and stocks outside of these four industries? Yes, and we have in moderation.  But we expect most of our investments to remain more or less equally distributed amongst alcohol, tobacco, gaming and defense, with a few special situations from other industries mixed in.

If the main emphasis of the fund is high barriers to entry, high dividend yields and cash flows, why limit yourself to only four industries; there are many companies outside these industries that possess these characteristics? As alluded to above, we will invest outside the four primary vice industries when we find a company with similar characteristics especially pricing power. However, we believe the vice industries should serve as a core holding in most stock portfolios given how shareholder friendly they are, so we want to ensure this niche is available to investors with our fund.

You seem to like contrarian industries; one might say this is a value approach, yet your average stock has a P/B of over 3.3. Would you consider yourselves value investors?

Many of the stocks we buy have large share repurchase programs in place.  Repurchasing shares reduces shareholder equity.  Also dividends reduce shareholder equity and our companies pay above average dividends too.  Those are the primary reasons why price to book value is over 3x.  We do consider ourselves value investors because many companies we own trade at low multiples of cash flow. The value of most assets is dependent upon the cash flow it can return to the investor. We think we own a group of companies that will provide investors with high cash flow in relation to purchase price. We do, however, understand that there are some assets that have great value even though they aren’t producing much cash flow at the moment. These can include raw land or manufacturing assets that are difficult to reproduce due to technical challenges, market conditions or regulation. We like investing in these types of assets, but that’s not our focus with the Vice Fund.

Do you place more emphasis on company specifics, or overall industry characteristics? While we can talk generally about vice industries, there is wide variability among the companies in regards to operating attributes, market share, competitive structure and valuation. We are far more focused on company specifics.

Your largest holding is Philip Morris Intl; can you tell us what you find attractive in the company?

Emerging markets are still seeing growth in number of smokers and people trading up to name brand cigarettes so Philip Morris has growth potential.  It has large market shares that it continues to work on building overseas.  Plus the lawsuit and regulation issues that impact tobacco in the US are not nearly the same overseas.  A $12 billion share repurchase program and a dividend of over 4.5% generate great shareholder returns too along with the growth.

Your second and third largest holdings are tobacco companies also. Can you explain why you are so bullish on this industry?

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