Vilas Capital Q3 Letter
The third quarter of 2015 was one of the most challenging since we started the Vilas Fund. In a nutshell, the US market fell over 7% overall (foreign markets sold off more) but the global financials, major oil producers and autos fell significantly faster than the market. Our short positions, which are intended to protect principal in a downturn, actually rose during the quarter, and our concentration and leverage exacerbated the results. In essence, if it could go wrong, it did. From June 30, 2015 to September 30, 2015, the Fund lost 27.5%. However, since the end of the quarter, the Fund has recovered a material portion of that loss, rising 17% from September 30, 2015 through the close of business on October 9, 2015.
Between my personal investment, Firm capital and other family investments, roughly 20% of the Fund is “our money”. We like losses less than most. If we look at other periods where our Fund fell, the down periods proved to be temporary and of short duration. For example, after the Fund fell materially in the summer and fall of 2011, within six months it had risen just over 100%. In 2012 the Fund fell again and within six months it rose about 61%. While we will only know if this downdraft is over with the passage of time, we are extremely confident that our positions will recover quickly and forcefully and believe that a similar rebound is in store. Again, only time will tell.
Our optimism is based upon the reasonable valuation of the overall market, the low level of interest rates around the world, quantitative easing in Europe and Japan, global equity securities that are extremely attractive, a US economy that shows no signs of recession, and a narrowing of the “bubble” parts of the market.
First, the US equity market is very reasonable from an overall valuation standpoint. At the end of the third quarter, US stocks were selling at 15.1 times forward earnings estimates. This compares to the 25 year average of 15.8 times earnings. Further, on a price-to-book value basis, which is a far better metric than the Shiller CAPE ratio or other cyclically adjusted statistics, the S&P 500 is trading at 2.4 times book value, vs its 25 year average of 2.9 times. It is hard to argue that the overall market is expensive. In fact, given the 2% yield on the 10 year US Treasury, 0.6% 10 year German bonds and 0.3% Japanese 10 year bonds, these equity valuations are downright cheap.
Equity markets are not priced in a vacuum. Investors must consider the opportunity cost of equity investments versus the risk free rate. US Treasuries are the risk free rate. Short term Treasuries are yielding almost nothing while 10 Year bonds are yielding about 2%. Also, Treasuries are taxable at ordinary income tax rates. The 100 year average return on a 10 Year Treasury is roughly 5%, thus the current environment is far below the long term average. Because of this, stocks should be selling at valuations that are higher than their long term averages as the opportunity cost is so depressed. The bottom line is that the dividends and earnings we are receiving on our holdings are more valuable today versus the risk free opportunities to invest capital.
Second, central banks around the world are still printing money. Japan and the EU are aggressively expanding their monetary base. This is also very bullish for equities. It actually does not matter which central banks are printing, just that one or more are. Given that capital can flow somewhat freely around the developed world, money printed in far off lands eventually winds up in the risk assets that are the most attractive, regardless of location. We saw European debt markets recover when the US was printing and the EU was not, as an example. The flow of capital from central banks to the markets is keeping the economy and worldwide credit markets functioning, which is a good thing. Without global printing, we believe deflation would result. Given the cheap equities around the world, extremely low interest rates and falling commodity prices, it is clear that deflation is the big, underlying fear in the markets. If inflation was a potential problem, Treasury, Bund, and Japanese yields would be far higher. Thus, printing is needed and, thankfully, is being executed at a decent pace.
Third, we have found that global equities are significantly cheaper than some similar firms in the US. Thus, we have roughly 56% of our net assets invested outside the US. These regions include Germany, the UK and Japan. In essence, the equities of Barclays, Deutsche Bank and Honda are roughly 20% cheaper than their US counterparts. We believe that this discount will close, to some degree, over the next few years. Honda, which is one of our top 5 holdings, should benefit from its high-quality cars, its non-unionized workforce, and its competitive position vs Volkswagen. Honda is experiencing 50% sales growth in China as of late and should pick up a bit of market share from the fallout from VW’s recent scandal. In essence, while we also like our US holdings, the overseas holdings are cheap enough to warrant the extra capital we have allocated to them.
Fourth, we do not see a recession brewing. The main areas of concern are commodities and industrial firms that have supplied the Chinese expansion. While a large and important slice of the US economy, it is our belief that these areas are not large enough to overcome the positive momentum in the rest of the economy. GDP is comprised of Government spending, including Social Security, Medicare and Defense, consumer spending and business investment. We do not see Government spending falling anytime soon as transfer payments to the elderly are actually accelerating. Defense spending is growing as well.
Consumer spending is expanding at a decent pace and should continue. Jobs are growing, the consumer has paid off a tremendous amount of debt, the net worth of the consumer continues to grow, and housing formation is accelerating. The unemployment rate has fallen from 10% in 2009 to 5% today. Many will argue about the labor participation rate, etc. Overall, however, it is clear that the job market is getting better. The debt service ratio, which measures debt payments as a percentage of personal income, has fallen from 13.2% in the 3rd quarter of 2007 to 9.8% today. While this may not seem like much, 9.8% is the lowest reading going back to at least 1980. This means that consumers have dry powder. Further, the net worth of households in the US is now $84 Trillion, up from $68 Trillion in the third quarter of 2007. House prices are up, as are stocks and bonds, and people have finally saved. This is good. And housing, one of the largest parts of the economy, has been below trend for many years but is finally improving. Housing starts, which peaked at over 2.3 million in 2006 and fell to roughly 500,000 in 2009, have recovered to a 1.1 million run rate currently. This compares to the