Vilas Fund investment commentary for the second quarter ended June 30, 2015.

Performance Highlights:

The Vilas Fund, LP, has substantially outperformed the S&P 500 Index and the HFR Fundamental Value Index since its inception in August, 2010:

Vilas Fund

The Vilas Fund, LP, has compounded at the following rates for the period ending June 30, 2015:

Vilas Fund

Further, the Vilas Fund has produced extraordinarily tax-efficient historical returns:

Vilas Fund

Assuming the highest Federal Tax Rate and a state effective tax rate of 5%, an investor in the Vilas Fund since inception would have lost, on average, only 0.68% per year to taxes.

Strategy Overview:

Given the large number of new partners in the Fund and the increase in interested parties, we thought it would be helpful to summarize our investment strategy and the academic foundation of our approach. I developed the Vilas Fund’s strategy over the last 22 years through analyzing past mistakes, learning from great investors, and combing through academic data. Mistakes usually occurred when I paid too much for a company’s stock that didn’t live up to expectations. Also, when I tried to be too cheap by investing in companies with major problems, our results suffered. To learn further, I studied those individuals who were extremely successful in the field of money management. It became clear that most of them were value investors, especially over longer periods of time. I studied the great ones, including Benjamin Graham, Joel Greenblatt, Mason Hawkins, Sam Zell, Warren Buffett, and David Dreman, among others. It is no secret these famous investors attribute much of their long-term success to the value philosophy of buying equities of low-priced, out-of-favor companies. While working on my business degree at the U of C, I was extremely fortunate to take a course in Corporate Finance from Robert Vishny. Professor Vishny, along with Josef Lakonishok and Andrei Shleifer, coauthored a seminal value investing paper titled “Contrarian Investment, Extrapolation and Risk” in 1994. These three professors used their paper as the basis for LSV Asset Management, a firm with a top industry track record and over $90 billion of assets under management today.

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The basic foundation of the Vilas Fund’s strategy is that cheap, undervalued stocks, defined as those stocks with low price-to-book, low price-to-earnings, and/or low price-to-cash flow ratios, outperform expensive companies over time. Further, those companies with low barriers to exit, low supplier power, low buyer power, strong brand names, little threat of substitutes or new entrants, and higher switching costs have better economic returns than those companies without these attributes. Lastly, when we identify materially overvalued equities with less than ideal economic and financial characteristics, we initiate and hold short positions with the goals of reducing portfolio risk and increasing expected return. We point to key excerpts from the “Contrarian Investment, Extrapolation and Risk” paper by Lakonishok, Shleifer, and Vishny (1994) that form the academic underpinning of our strategy:

Vilas Fund - Value Stocks Outperform Growth Stocks:

“While there is some agreement that value strategies have produced superior returns, the interpretation of why they have done so is more controversial. Value strategies might produce higher returns because they are contrarian to ‘naive' strategies followed by other investors. These naive strategies might range from extrapolating past earnings growth too far into the future, to assuming a trend in stock prices, to overreacting to good or bad news, or to simply equating a good investment with a well-run company irrespective of price. Regardless of the reason, some investors tend to get overly excited about stocks that have done very well in the past and buy them up, so that these ‘glamour’ stocks become overpriced. Similarly, they overreact to stocks that have done very badly, oversell them, and these out-of-favor ‘value’ stocks become underpriced. Contrarian investors bet against such naive investors. Because contrarian strategies invest disproportionately in stocks that are underpriced and underinvest in stocks that are overpriced, they outperform the market (see De Bondt and Thaler (1985) and Haugen (1994)).”

“On average over the postformation years, the low B/M (high P/B) (glamour) stocks have an average annual return of 9.3 percent and the high B/M (low P/B) (value) stocks have an average annual return of 19.8 percent, for a difference of 10.5 percent per year. If portfolios are held with the limited rebalancing described above, then cumulatively value stocks outperform glamour stocks by 90 percent over Years 1 through 5.”

“The results in this article establish (in varying degrees of detail) three propositions. First, a variety of investment strategies that involve buying out-of-favor (value) stocks have outperformed glamour strategies over the April 1968 to April 1990 period. Second, a likely reason that these value strategies have worked so well relative to the glamour strategies is the fact that the actual future growth rates of earnings, cash flow, etc. of glamour stocks relative to value stocks turned out to be much lower than they were in the past, or as the multiples on those stocks indicate the market expected them to be. That is, market participants appear to have consistently overestimated future growth rates of glamour stocks relative to value stocks. Third, using conventional approaches to fundamental risk, value strategies appear to be no riskier than glamour strategies. Reward for bearing fundamental risk does not seem to explain higher average returns on value stocks than on glamour stocks.”

Vilas Fund - Is It Because Value Stocks Are Riskier?:

“Two alternative theories have been proposed to explain why value strategies have produced higher returns in the past. The first theory says that they have done so because they exploit the mistakes of naive investors. The previous section showed that investors appear to be extrapolating the past too far into the future, even though the future does not warrant such extrapolation. The second explanation of the superior returns to value strategies is that they expose investors to greater systematic risk. In this section, we examine this explanation directly.”

“Value stocks would be fundamentally riskier than glamour stocks if, first, they underperform glamour stocks in some states of the world, and second, those are on average ‘bad’ states, in which the marginal utility of wealth is high, making value stocks unattractive to risk-averse investors. This simple theory motivates our empirical approach. The results show that value strategies have consistently outperformed glamour strategies. Using a 1-year horizon, value outperformed glamour in 17 out of 22 years using C/P (Cash Flow/Price) to classify stocks, in 19 out of 22 years using C/P and GS (Growth Rate of Sales), and in 17 out of 22 years using the B/M (P/B) ratio. As we move to longer horizons, the consistency of performance of the value strategy relative to the glamour strategy increases. For all three classification schemes, the value portfolio outperforms the glamour portfolio over every 5-year horizon in the sample period.”

“A second approach is to compare the performance of value and glamour portfolios in the worst months for the stock market as a whole. Table VII, Panel 1 presents the performance of our portfolios in each of 4 states of the world; the 25 worst stock return months in the sample based on

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