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.
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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 20 year average of 1.3 million, however, and is still inadequate given the pent up demand from the aftermath of the Financial Crisis. We believe that housing starts will once again recover to 1.5 million+ and will be the main driver of the US economy over the next few years.
As for the industrial sector of the global economy, it is our belief that it will be soft for some time to come. The world has plenty of capacity to manufacture goods. In fact, we may have too much capacity in a number of sectors, especially those that furnish commodities and capital goods to consuming regions. China was consuming 50% of the world’s raw materials, including steel, aluminum, copper, etc. while only contributing 8-10% of world GDP. They were spending too much and it had to end. The Vilas Fund has little exposure to these sectors, other than our ~4% position in global energy firms.
We don’t think that the industrial parts of the US economy are large enough to overcome the positives with the consumer and the reality of Government consumption. The consumer is 68% of GDP, Government is 18% and fixed investment is 13%. Housing investment is another 3-4% (though much larger when looking at related industries). A strong consumer and housing sector should propel the US economy through this current rough patch. Thus, we are bullish on the US economy.
And finally, the “bubble” parts of the markets are becoming narrower. While we could have done a better job predicting which sectors would fall first, it is clear that these sectors are losing steam. Biotechs, which we shorted 3 times in the last few years and made small amounts of money on each time, have lost ~25%, Fitbit and GoPro have fallen a lot, Green Mountain Coffee Roasters has fallen, casinos have lost 60%+, the 3D printing space has crumbled, and even Tesla is beginning to fall. Three brokerage firms, including Morgan Stanley, Barclays and Baird, have cut their ratings or estimates for Tesla in recent days. Tesla has fallen roughly 15% in recent weeks. It appears that it is hard to make cars, profitably, and that not many people can afford $100,000 to $130,000 for a car. Thus, of all of the overpriced areas, most are beginning to correct. Only a handful of extended stocks remain, and one of them is Amazon. Amazon will eventually succumb to the same forces that have hit the other parts of the “bubble” market. Earnings matter and Amazon has little history of earning money. Their largest cost, shipping, is rising rapidly (see recent price increases by FedEx and UPS). This isn’t good for a company with almost no profit margin.
We have been here before. In 1998 and 1999, cheap stocks went down and expensive stocks went up. We all know how that ended. Until very recently, this market is very reminiscent, though not as pervasive, of that 1999 period. In fact, if we look at value vs growth stocks, the value index has underperformed the growth index for the last 1, 3, 5 and 10 years. Over the last 10 years, value has underperformed growth by roughly 2% per year. This is a highly unusual occurrence. From 2000 to 2003, value stocks trounced growth stocks, by perhaps the largest margin in 100 years. We believe that another major reversal should occur in coming years and cheap stocks should begin to outperform expensive stocks by a significant margin.
If we look at our holdings, our long portfolio is selling at roughly 0.7 times book value and 8.6 times 2016 earnings estimates. These are remarkably low levels. In fact, in the history of this fund and during my 23 years running pooled investment vehicles, I don’t remember our overall portfolio being this cheap, at least not for long. Also, these companies should grow their earnings roughly 11% in 2016. We do realize that growing earnings are better than static earnings, after all. On the short side, our portfolio trades at 30+ times tangible book value and 100+ times non-GAAP earnings, which is close to its highest level since the Fund’s inception. It is as if some investors do not like earnings anymore. Rather, they like stories. We like earnings and prefer to tell stories to the kids at bedtime.
As an illustration, one of our holdings, MetLife, is currently selling at 7.8 times 2016 earnings estimates. The company is about as conservative as they come and is the top seller of life insurance worldwide. At this low valuation level, if MetLife never grew again, though also didn’t go into decline, the owners of the company would earn 13.0% per year into perpetuity (1 divided by 7.8). The reality is that the company has grown earnings at roughly 8% per year over the last decade. Thus, assuming earnings grow similarly into the future, we would expect that this position could produce roughly 20% returns, annually and nearly into perpetuity, from this extraordinarily low current valuation. Further, MetLife grew these earnings in an incredibly difficult declining interest rate environment and through the Financial Crisis. As interest rates rise, growth of earnings could accelerate. The stock is priced to perform very well regardless of interest rates, as are all the financial holdings we own today.
Given that many of our holdings are selling near their 52 week lows and are far below their 52 week highs, we ran an analysis to see what the effect would be if all of them, both long and short, simultaneously sold at their 52 week highs again. While this is a highly unlikely event in the short run, it is a non-heroic scenario for the overall portfolio as, eventually, we expect our long portfolio to reach new highs in coming years. The bottom line is that the equity in the Fund would grow roughly 70% from its closing level on October 9th, 2015 if every holding simultaneously sold at its 52 week high. While obviously not a forecast, it does show how depressed many of our positions are currently.
In conclusion, as value investors we have been swimming upstream in a growth dominated market. Over the last few quarters, value has underperformed growth at an accelerating rate. We see signs of this dynamic ending but, as with everything, we are unsure of the timing. We do know that value stocks outperform growth stocks over very long time periods. The data is crystal clear going back hundreds of years to the inception of financial markets. Ben Graham and his protégés didn’t become great investors randomly. In the end, Wall Street becomes a weighing machine and stocks that are too cheap rise and those that are too expensive fall.
John C. Thompson, CFA
CEO and Chief Investment Officer
Vilas Capital Management, LLC.
The Aon Center, Suite 5100
200 East Randolph Street
Chicago, IL 60601
Vilas Capital Management, LLC is a value manager that seeks to outperform market averages, net of all fees and expenses, by investing in a concentrated portfolio of undervalued securities. When available, the firm may also sell short extremely expensive securities that we believe have very little chance of living up to market euphoria. The firm evaluates investments utilizing quantitative measures such as price-to-book value, price-to-earnings, and returns on capital over a market cycle as well as qualitative factors based on our more than 20 years of investment management experience. The firm also uses “time frame arbitrage” by looking at investments with 5-10 year horizons instead of the shorter term time frames used by the vast majority of market participants.