The Vilas Fund letter to partners for the month ended October 31, 2015.
Vilas Fund – Performance Update
The past few months, and years, have been extremely trying for value investors. While we had escaped much of the downdraft in the nearly 5 years through July 31, 2015, August and September were terrible months for our strategy. The Fund has rebounded 8.6% in October and another 1.9% so far in November (through Friday, 11/6/15). Our long term results, however, are significantly better than the S&P 500 and the average result of hedge fund managers.
While we dislike adverse market moves as much or more than our Partners, they are part of the structure of our fund and are to be expected. In fact, in many ways our fund is operating in a somewhat similar manner as a private equity fund but with very conservative public equities. With obvious gross generalization, it is our opinion that today public equities are materially cheaper than private companies. Thus, while many private equity deals are transpiring at 8-12 times EBITDA, our Fund is trading at 8.1 times net income. Big difference. Further, we are using far less leverage than private equity firms usually employ in their deals but we are using leverage nonetheless. Paying 8 times earnings for a growing company and financing additional purchases with a cost of funds of 1% today as we are, is, in our opinion, a better approach than paying 8 times EBITDA and financing 2/3 of the purchase with debt costing 7-8% all in. Further, our Fund does not have to pay a “control premium” or receive an “IPO discount” upon sale. And finally, our Fund is able to invest all of our Partners’ capital immediately, as opposed to drawing the capital as transactions are sourced and closed. Private equity fund returns conveniently ignore cash held on the sidelines to fund future capital calls in return calculations. All in, we believe that the return on the Vilas Fund will exceed those of the aggregate private equity fund industry, both on an IRR and cash-on-cash return basis over the coming years, due to these factors.
The problem, however, is that we must mark our portfolio to market every day, every month, and every year. Private equity uses appraisals based upon a variety of factors, including the estimated value at the end of their holding period discounted back to the present. For private equity partners, low volatility is the result but, in our opinion, it is a mirage. As an example, Hilton Hotels was purchased in 2007 with roughly 22% equity and 78% debt. Starwood and Marriott, the best public comparisons, fell roughly 60% in 2008, due to the Financial Crisis. Rather than realizing a decline in the equity value in-line with public market comparables, the new owners of Hilton simply marked the equity down 10%. The reality is that the Hilton equity was lost two or three times over. Big difference.
The prices of our investments are readily discoverable in public markets. While the intrinsic value of our investments is actually quite stable, market prices gyrate all over the place. It is the “true worth” number that keeps us sailing in the right direction, even through storms, as we estimate value based upon conservative assumptions. For example, very attractive returns would result if the investments in our portfolio simply returned to book value. The old adage was to buy banks and brokers at book value and sell them at twice book. Book value would be a home run for our Partners today.
Vilas Fund – Market Overview and History
I recently recalled a story from my past that may be applicable to today’s market action. As you may recall, I started managing an equity mutual fund in the early 1990’s when that fund had less than $5 million in capital. By the mid-2000’s the fund had grown to $1.5 billion.
In the late 1990’s, the market was obviously extremely frothy for technology shares. In 1998, I began selling our technology positions. Clearly, this was far too early. However, after buying these names at 10-15 times earnings in the mid 1990’s, it was extremely difficult to see value at 30-40 times earnings that had increased very rapidly over the preceding 7 years. Boy were we early (wrong).
After over two years of significant market underperformance in 1998, 1999 and early 2000, our clients and internal investment team became extremely frustrated with my portfolio management. I became a bit (exactly) like the boy who cried wolf. The more I pointed to the high valuations in the sector, the more our clients and team pointed to the charts going straight up and to the right over the last decade or longer. Further, when I reinvested into Wells Fargo, CIT, Concord EFS and other “old economy” value stocks, they proceeded to go down and to the right. Clearly, I was “detracting value,” I was told. Massive value.
Now, near the end of this period, every trade I made became a public spectacle inside the office. When I sold a technology stock (or GE or Johnson and Johnson at 50-60 times earnings, for that matter) and purchased a value stock, it was as if there was some new gossip on the Kardashians or J Lo. To say that these moves were not popular would be an understatement. I was selling our “best stocks”, I was told. In fact, by February of 2000, I was repeatedly warned that my time at the helm was near an end. I was also told that if I sold one more share of a technology name, I was fired. Thankfully, I had already whittled the technology weighting in the fund down to basically Microsoft, figuring that it would lose less than the rest in the eventual correction that I foresaw, and Compaq, which was later acquired by HP for a big premium.
Leading up to this warning was a discussion with my former firm’s Director of Research. One of our long time holdings, Intel, was going parabolic. At the time, it was trading at roughly 70 times earnings, up from 10 times earnings in the early 1990’s. These earnings in 1999, however, were roughly 2/3 from selling microprocessors and 1/3 from “harvesting gains” in their venture capital portfolio. When I argued that these venture capital gains were likely not going to be able to be repeated into the future, the response was probably somewhat like what Galileo encountered from the Church when he postulated that the Earth revolved around the Sun, not the other way around. It became very lonely. My only ally was a young analyst at our firm named Clint Oppermann. He is a brilliant person who was also a student of history, a rare combination in the investment field.
The “final straw” occurred when I sold our remaining stake in Intel and purchased shares in US Bank, which was one of the cheapest banks in the market at the time, selling at roughly 12 times earnings. Believing that all earnings are the same and all cash is green, I felt that paying 12 times earnings was far better than paying roughly 100 times Intel’s operating earnings. The Director of Research at our firm disagreed. He came to me, almost shaking with anger, and asked if I just sold the remaining small Intel position and bought US Bank stock. I said, sheepishly, “yes”. He then said “how can you be so arrogant?” I looked at him, puzzled. He said “how can you be so arrogant to sell another technology name when the Fund is so underweight technology and buy US Bank when the Fund is so overweight financials already?” I explained that it would take Intel 20 years of rapid growth to catch up to the P/E multiple that US Bank currently traded at because US Bank would grow, too, after all. He said “you are not hearing me. We are so overweight financials already and so underweight technology, how can you be so arrogant to think that all of these 30-40 analysts that cover Intel and portfolio managers that own it are wrong and you are right?” I again tried with the math and argued that all assets are worth the present value of their future free cash flow and how we shouldn’t assume that “trees grow to the sky”. He left the room in disgust.
Over the next couple years, the Fund outperformed the market by a very significant amount due to these, and similar, moves. Because of this outperformance, the assets in the Fund increased from roughly $40 million in early 2000 to $1.5 billion a couple of years later. It sure made for interesting internal politics the next few years.
I was convinced that I would never see this type of stock market again. Given the fact that the market is selling at 16-17 times earnings today instead of 30 times in 1999, this is basically still true. However, the tails of the market today are at least as wide, if not wider, than they were in 1999. Cisco Systems, EMC, Qualcomm, Intel, Microsoft, Yahoo and AOL basically did have solid earnings and, by and large, were decent companies, AOL excluded. Today’s crop of darlings, including Amazon, Netflix, Salesforce.com, LinkedIn, Tesla and Palo Alto Networks, are a far cry from Cisco Systems and Microsoft. Some are losing lots of money or have not made much money in 20 years. Most of these companies only have material earnings if investors exclude compensation paid in stock. As an aside, if we are to exclude these compensation expenses, does it not follow that the stock that these employees are paid in is nearly worthless? If the stocks of these companies sold at 12 times earnings like US Bank did, there is no way they would, or could, pay employees with massive amounts of stock. It would be too dilutive. Because of this, it is our assertion that this crop of large tech, bio-tech and social media companies is more expensive today than their forefathers were in the late 1990’s.
The timing of bursting of bubbles is impossible to predict, as is the size the bubble reaches before it pops. Further, the money that flows into these names has to come from somewhere: the discredited value investors. Due to accelerating withdrawals from the funds managed by those backward looking fools, the cheapest names actually fell dramatically in 1999 and early 2000. The same thing is happening today.
While nobody likes to lag the market or lose money, and we are no exception, the reality remains that the long positions in The Vilas Fund, LP (the Fund) currently trade at 8.1 times 2016 GAAP estimates while our short positions currently trade at 119 times 2016 non-GAAP estimates. This is far wider than the spread was in 1999. The mutual fund I used to manage rose ~19% from 2000-2002 when the market fell ~38%. This meant that the S&P 500 had to appreciate over 90% to “catch up” to the Fund I managed. Due to our positioning today, if a similar end to the bubble valuations occurred, we are of the belief that the Vilas Fund would trounce these results both on an absolute and relative basis.
Some will argue that it is different this time. Bank regulations, fines, capital charges, low interest rates, etc will make earnings at the banks permanently below par. I will argue that it is not different. Banks have the ability, and responsibility, to exit business lines that are not earning adequate returns on capital. They are doing this every day. It is this lack of barrier to exit that will improve returns and, eventually, return bank earnings to levels that significantly exceed their cost of capital. When competition leaves an industry, the returns to the remaining players increase. Period.
There is another analogous situation: tobacco. Back in the mid 1990’s, the tobacco companies were struggling with massive lawsuits and fines. They were being sued because the executives knew that smoking was bad for our health. The companies paid massive fines and all had to increase the price of a pack of cigarettes by 50-100% (my memory is a little fuzzy but it was a lot). What happened since? In 1998, the year of the Master Settlement Agreement, the price of Philip Morris’ stock was roughly $10. Today it is $58. It paid a massive dividend over those years as well (my recollection is that Philip Morris was yielding 6 or 7% around that time period). The banks, brokers and insurers will pass along the added costs of regulation, capital increases and compliance to consumers. People can quit smoking. We cannot quit using banks. The financial sector could do as well over the next 15 years, or possibly even better, than tobacco did over that period.
Investors are also arguing, in a “it is different this time” sort of way, that Amazon is really earning $9 billion in “cash flow” not the ~$900 million in GAAP earnings estimated for 2015. We think GAAP is the right number. To be unbashful, I will take my CFA, accounting and finance training at a top business school (the University of Chicago), my ~3 years of calculus and advanced math training (where I earned straight A’s and usually was close to, or at, the top of the class), the extremely complex math associated with fluid mechanics, heat transfer, and other engineering classes and 23 years of managing money over young analysts, momentum oriented portfolio managers, journalists with degrees in english or journalism, or investment bank research reports that are glowingly positive while knowing that these companies need to raise debt and equity capital over time. GAAP earnings exist for a reason. Using alternate metrics for a one-off problem, such as fines for the Financial Crisis, does make some sense, though fines lower retained earnings and our estimates of value are based upon this lower level of book value. However, using non-GAAP metrics such as adding back increases in payables and massive stock based compensation to earnings while ignoring massive capital expenditures hidden by lease accounting is reckless. Someday, the market will see Amazon for what it is: a nearly profitless company.
Another way to look at this: if you had a really big bank account, you could buy Amazon today for about $316 billion and get roughly $2.3 billion in Wall Street estimated GAAP earnings paid to you in 2016 (though Amazon has yet to earn $2.3 billion, cumulatively, since it was founded 20 years ago). Or, you could buy all of Target, Deutsche Bank, FedEx, MetLife, Honda, Genworth, and Morgan Stanley for about the same amount but which are collectively expected to earn $29.5 billion in 2016. We like $29.5 billion more than $2.3 billion. Maybe we are weird. By the way, in 2000 at our annual investor meeting, I presented the same argument about Sun Microsystems. At the time, Sun, which was “the dot in dot com”, was worth more than Gillette, Pepsi, CIT Group, Concord EFS, US Bank, Office Depot and a few others combined. Sun is in the “where are they now” file. Gillette was bought by P&G for a big premium, CIT was bought by Tyco, Pepsi has done extremely well, Concord EFS was bought by First Data for a big premium, US Bank has done very well, but Office Depot has struggled at bit. In all, they did well and crushed the performance of Sun Microsystems, which fell on hard times. We owned all of the stocks in the latter half of this list and own most of those in the Amazon comparison list as well. We really like our chances.
In the past, I should have shorted Intel and bought more US Bank even though it would have gone against us for a while. It would have worked far better, eventually. Today, due to the partnership structure of the Vilas Fund, we can and are taking advantage of this silly season to the greatest extent possible. While it may be a bumpy airplane ride, we would rather wind up in the Caribbean than take a smooth ride to Peoria.
As interest rates increase and the valuations of low P/E and low P/B stocks rise, our aggressive posture will be significantly pared back. In essence, we are being greedy today when others are fearful but plan to be fearful when others become greedy. The current opportunity to buy solid, profitable, growing companies at 8 times earnings, partially financed with 1% debt, and sell short shares of bubble-like stocks at extreme valuations, will not be around forever.
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
Office: (312) 702-1976
Cell: (608) 576-3938