Value Investing

Vilas Fund 4Q15 Quarterly Letter: Arbitraging the value vs. growth phenomena

Vilas Fund letter for the fourth quarter ended December 31, 2015.

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Overview:

The core premise of the Vilas Fund, LP is that value stocks, representing those slower growing companies that sell at low multiples of book value, cash flow or earnings, outperform glamour stocks, including faster growing companies that are selling at very high multiples of book value, cash flow and earnings. The data is crystal clear, from Fama and French to Lakonishok, Shleifer and Vishny, that, over time, value outperforms growth. Further, the data show that slower growing companies at low prices tend to experience both revenue acceleration and multiple expansion while faster growing companies tend to decelerate and experience multiple contraction. It is this “double whammy” that produces the long term outperformance of value over glamour.

In this sense, the Vilas Fund is arbitraging the value vs. growth phenomena. As Joel Greenblatt stated in his book “The Little Book that Beats the Market”, the data is extremely clear that value is the superior strategy over long time horizons. Then why, he asks, don’t all investors adopt value investing?  Because value does not always beat growth in every time period and can go for extended periods of time lagging their fancier counterparts. The time periods where growth outperforms value, especially if extended, tend to shake the confidence of many investors and causes them to switch to growth strategies, exacerbating the money flow into the highly valued equities and out of the inexpensive securities. We are in such a period of time.

The second form of arbitrage that the Vilas Fund has employed from time to time is the fact that high expected returns are embedded in a few sectors of the market while the cost of funding additional purchases is near 50 year lows. For example, our MetLife position is currently trading at 7.2 times 2016 earnings estimates. This company has grown its earnings per share at a rate of roughly 8% per year over the last decade, through the worst financial crisis in 80 years. We see no reason that the company cannot continue to grow its earnings at a respectable rate indefinitely. MetLife’s earnings yield is 13.9% (1 divided by 7.2) and the long term rate of growth should range between 5-8%. Thus, we would expect that the company could produce a total return of 15-20% per year over the next decade or more. Due to extremely low interest rates, the Vilas Fund can access additional funds at a cost of less than 1.5% per year. We believe that this arbitrage of prospectively high equity returns from quality companies with extraordinarily cheap funds is an opportunity that does not come around often.

Over the last 5 years, stocks trading at low price-to-book multiples have meaningfully lagged growth stocks, as shown by the following graph. At the same time, our aggressive posture surrounding the allocation of capital to equities funded, in part, with cheap debt offset the fact that our equity positions were not keeping up with their growth brethren. Because of this offset, the Fund was largely able to significantly exceed market returns from inception through July 31, 2015. However, the last 5 months of 2015 were very difficult as value equities declined while select growth equities advanced rapidly.

Vilas Fund
Chart via Patrick O’Shaughnessy, Investor Field Guide 

Vilas Fund - Performance Discussion:

Both arbitrages that the Vilas Fund currently employs hurt our results in 2015 as the Fund declined 34.6%. Since the inception of the Fund, the Fund has compounded at 12.6% (net of all fees and expenses) vs. 14.1% for the S&P 500 Index through 12/31/2015. Clearly, we are in a period of time where our strategy is out of favor in the financial markets. While our strategy of purchasing companies at low multiples of earnings and book value and selling short extraordinarily expensive companies should work extremely well in the long run, we know that periods of market euphoria, where valuation is ignored, creates unfavorable short term performance periods.

The Vilas Fund is invested significantly in Europe and Japan, anticipating that quantitative easing in those regions will created stronger returns for equity securities in those markets coupled with the fact that equities outside the US are materially cheaper than domestic companies. Unfortunately, our investments in Europe, in particular, declined significantly in value despite the quantitative easing undertaken by the ECB. This is opposite of the experience in the US where many financial firms doubled and tripled as the Fed printed money. We think that this is a delayed response and a major recovery will occur.

Vilas Fund - Portfolio Overview:

The portfolio is heavily invested in financial services companies, comprising roughly 77% of assets at the current time. An additional holding in the Auto sector is roughly 7% of assets, major oil producers are roughly 0.5% of assets. The short positions, including shares sold short, short positions in calls, and purchases of out of the money puts, are roughly 15% of assets. Thus, the fund has roughly $5 long for every $1 short. We expect to see the large, growth equities that dominated performance last year return to saner valuations and expect that when this happens, the Fund will benefit. The Vilas Fund is also heavily invested outside of the US market as holdings in Europe, the UK, and Japan are materially more attractive than their US counterparts. At the current time, 72% of our net exposure is outside the US and 28% remains in the US. We do not hedge our currency exposure, however, and this has detracted from our results due to the strong dollar. As of the time of this writing, the Fund’s long positions are trading at 0.61 times book value and 7.0 times 2016 GAAP earnings estimates. The short positions are trading at 33 times book value and 117 times 2016 Non-GAAP earnings estimates. The Vilas Fund holdings, listed from largest to smallest, follow:

Vilas Fund

After a tremendous market advance from January 1, 1995 through December 31, 1999, as the manager of an equity mutual fund, we were faced with a similar dilemma:  some stocks were very inexpensive while many others were trading at valuations never seen before. We decided to fully invest in the cheap stocks and hope for a teeter totter type of market response where the cheap stocks would go up while the expensive stocks decline. This is, in fact, what happened. That Fund rose 25% in 2000 and 19% in 2001, far exceeding the 9% and 12% market losses those years, respectively.

We see a similar, though significantly cheaper and not as pervasively overvalued, market environment today. Thus, we are somewhat fully invested, believing a similar market response will occur. Our financials either have not appreciated in many years or are trading near 10 year lows. Honda is trading near its 10-year low, as are our oil positions. Amazon and Tesla, our current short positions, are trading near all-time highs. Thus, if the market acts similarly to 2000-2001, the Vilas Fund is very well positioned to take full advantage of the opportunity.

Vilas Fund - Market and Economic Overview:

Value has now underperformed growth strategies for nearly every year the last 9 years and by nearly 5% annually. This is an extremely unusual occurrence as the data shows that value equities outperform growth equities by roughly 1% per year over very long time periods. The year ended 12/31/2006 was the last year that value strategies exceeded growth by a significant margin. The cumulative lag is enormous; in fact, it is expanding and accelerating.

Periods like these tend to end with a sharp, quick reversal, usually surrounding an impending recession. While we were confident that the US could avoid a recession, the bond market is sending clear recessionary signals via a flattening yield curve, rapidly increasing credit spreads and equity markets which are dramatically favoring growth companies over value, another sign that usually precedes recessions. Also, the Chicago PMI fell dramatically to 42.9, indicating a material contraction of activity may occur. In fact, as you can see on the graph below, every time the Chicago PMI has fallen to this level, it has surrounded a recession:

Vilas Fund

Contrary to many media reports and the comments from the Fed itself, the Fed began tightening monetary policy 24 months ago (December 2013) when they began tapering the amount of money printing. The latest increase in the Fed Funds rate is merely a continuation of this tightening cycle, not the start of one. Recessions usually follow Fed tightening cycles by 24 months +/-. The growth drivers of the worldwide economy, which until lately had been the emerging markets, have become a drag due to their overcapacity and indebtedness. Thus, while the US housing market should stay strong and should increase employment, the rest of the world and commodity industries are either limping along or flashing recession signals.

If a recession were to transpire, we believe that the valuations of the most extended growth sectors of the market will get exposed as ridiculous while the financial sector will dramatically outperform due to massively increased levels of capital and underwriting standards, on a net basis, over the last 6 years. While leveraged buyout and commercial real estate lending standards have retreated significantly, the size of these markets pale in comparison to the residential mortgage market where conditions remain relatively tight. Further, the financial system is overcapitalized and has significant margins of safety. Because of their depressed valuations, we continue to favor global financial institutions due to their long term growth potential from increased levels of earning assets (loans, insurance policies, etc.), increased long term activity in mergers and acquisitions, and increases in assets under management. Further, restructurings, cost reductions, exiting businesses with low returns on equity and reduced government fines should all result in significant increases in profits and increased returns on shareholder capital. If asked for a catalyst for the reversal we envision, a recession would top our list.

Vilas Fund - Arbitrage:

The key, however, in any arbitrage is to be able to withstand the periods where the markets trade opposite to the long term trend. Unfortunately, the second half of 2015 was such a time period. Expensive, large glamour stocks appreciated rapidly while the cheapest companies depreciated. Sort of the worst of all worlds given our long term strategy. Cliff Asness, founder of AQR (former Goldman Sachs partner and a University of Chicago PhD), wrote about this phenomena in a paper he wrote in 2000 titled “Bubble Logic, Or, How to Learn to Stop Worrying and Love the Bull”. I spoke to Cliff about his paper in mid 2000 as we were both lamenting the irrationality of some of the prices in the stock market at the time, particularly Cisco Systems. It is our understanding that AQR was funded with $1 billion of capital from Goldman Sachs and they utilized a similar “growth vs value” arbitrage that our firm is currently employing. On our call in 2000, Cliff indicated that AQR had turned this $1 billion into $400 million before it turned around. And turn around it did. They outperformed the markets massively and AQR has grown to $135 billion in assets under management today, fifteen years after the last bubble burst.

Some useful recent comments:

"I used to think being great at investing long-term was about genius," Asness said. "Genius is still good, but more and more I think it's about doing something reasonable, that makes sense, and then sticking to it with incredible fortitude through the tough times." 

(Bloomberg, November 2015)

Vilas Fund - Historical Performance Analysis:

After periods where my management has lagged the market by a significant amount, the following has been the relative performance of the mutual fund (1998-1999), the mutual fund (2007-2008) followed by the private account at UBS that was the basis of the Vilas Fund (2009-2010), and the Vilas Fund (2011) over the next two years:

Vilas Fund
1 During the period of formation of the Vilas Fund (from 12/31/2008 to 8/8/2010), an account at UBS was basis of the Fund, managed identically to the Fund post creation, and was the only account managed by John C. Thompson during this period of time. The performance listed for 2009-2010 is pre-management and incentive fees but net of operating expenses (commissions, interest, etc).

Because the intrinsic value of the securities that we hold has not changed materially, our long positions have retreated and our short positions have appreciated, the expected return of our strategy has increased over the last 24 months, particularly since our July 31 “high water mark”. Our goal is to quickly recover lost ground and exceed the July 31 high water market in short order.

Conclusion:

The equity markets are reasonable today. The price-to-book multiple (2.5) of the S&P 500 is roughly at its long term average while interest rates are far below their long term averages. The S&P 500 traded at 1285.5 on January 6, 2006. On January 19, 2016 it is trading at 1887. This increase compounds to a 3.9% return annualized over 10 years. Adding in dividends of roughly 2-2.5% yields a decade long return of 6% for the market. This is not extended and does not appear to be a level where a “bear market” will begin. Further, the British index, the FTSE 100, traded at 5977.8 on January 7, 2016, which compares to its level of 5731.8 on January 6, 2006. Thus, British equities have compounded at 0.4% annually over the last decade (without dividends). Further, with price-to-earnings multiples at a more reasonable 16 times 2016 estimates, it is hard to argue that the equity markets are heading significantly lower given today’s low interest rate environment. Thus, we believe that our net long position will pay significant dividends over coming years.

The Vilas Fund owns quality companies that are selling at extremely depressed valuations. This is an unstable situation, in a positive way. Further, the Fund is short extremely expensive companies that should struggle to earn their cost of capital over time. It is this arbitrage that should also pay significant dividends once rationality returns.

We believe that if one agrees that value investing outperforms other options over long periods of time, thinks we are competent, and agrees that we generally have the right idea buying companies at 0.6 times growing book values and 7 times 2016 GAAP earnings estimates while selling short stocks at 33 times book value and 117 times 2016 Non-GAAP earnings estimates, the time to invest in the Vilas strategy is now. Our history shows that periods where we are out of favor, which tend to coincide with the onset of recessions, tend to be followed by excellent relative results.

Thank you for your confidence in our firm and in The Vilas Fund.

Sincerely,

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