Vilas Fund investment commentary for the third quarter ended September 30, 2016.
The Vilas Fund, LP rebounded significantly in the third quarter of 2016, increasing 42.2% from its level on June 30, 2016. On a year to date basis, however, the Fund remained down 17.2%. Its three year performance also remained negative as it returned -12.0% annually. Over the last 5 years, the Fund produced a positive return of 18.6% per year and since the Fund was formed on August 9, 2010, it has returned 7.6% per year. While the longer term numbers, which include the high returning periods of 2012 and 2013, are somewhat favorable, our shorter term performance is lacking, to say the least. Again, our primary goal is to recover the lost ground from 2015 and 2016. Second, we aim to produce significant positive returns from our former high water mark.
In a world where most investment funds are being managed to limit volatility, both downward and upward, the Vilas Fund is being managed with a goal of maximizing long term returns. While this has created periods of both strong and weak results, and we are currently living through the latter, over long periods of time it is economically better to earn higher rates of return. Compounding capital at higher rates of return over long periods of time creates significantly more wealth than compounding at lower rates of return. Thus, our goal remains to maximize returns. However, we fully understand the emotional roller coaster that all have gone through and will strive to keep future drawdowns less pronounced.
Vilas Fund – Portfolio Review
Our top industry holding, financial services, remains, for lack of a better description, under attack. Regulators, including the Federal Reserve and the Department of Justice, continue to raise capital requirements and institute large fines for past activities. While these may make the politicians and the majority of the public happy, the effect has been to lower the profitability, risk appetite and capability of the world’s financial sector. This, in turn, has lowered growth around the world. If the goal is to accelerate global growth, it is our assertion that the climate for financial services firms must change from antagonistic to supportive. This means that governmental actions should change from lowering returns on shareholder equity to increasing returns on equity, as unpopular as that may sound. Without a solidly profitable financial sector, global growth will remain far below potential. Despite their tendency toward counterproductive behavior, it is a matter of time for the politicians around the world to discover that if their actions, or lack thereof, produce better economic results, more votes will be the result. Everyone responds to incentives, even those in Washington, Tokyo, Berlin and London.
Our second largest industry concentration is the automotive sector. Our main holding is Honda, with a new purchase of Ford as the other position. Both are trading at low multiples of book value and at very low price-to-earnings multiples. Further, both stocks have been quite out of favor over the last year and a half. Like the financial space, the auto sector has performed poorly due to fears of another recession looming on the horizon. While we may indeed experience a recession at some point in the intermediate future, these holdings seem to reflect the majority of the negative repercussions of that outcome in their current share prices. In the great recession of 2008, Honda, for example, bottomed at the same price-to-book multiple that it is currently trading at. This was during the worst auto market in many decades, a market that produced the bankruptcies of GM and Chrysler. Thus, it is our assertion that much of the negative economic views is priced into the shares.
The Fund’s short position is highly concentrated in Tesla Motors, where we are short the stock, own out of the money puts, and have written calls. We continue to believe that the company is massively overvalued, will never produce material profits, and is being overhyped by a less than forthright management (to be kind). The company is using the fact that nearly all humans would like to reduce global warming, thereby saving the polar bears, etc., to raise massive amounts of capital for projects that make little economic sense. Unfortunately, the company also appears to be stretching the boundaries of accounting and disclosure rules to survive. In the end, all companies must create profits and adhere to the rules of the land. Attempting to save the polar bears, while extremely noble, does not justify non-adherence to the rules and standards of conduct propagated by the SEC and common decency.
The Fund has repurchased small stakes in BP and Viacom and has created a position in Carlyle Group to complement the Blackstone Group holding. BP is trading at book value and has a 7% dividend yield. Oil prices should rebound over time. Viacom, purchased late in the quarter, is “in play” as CBS will likely reacquire it to increase their combined negotiation power with the satellite and cable providers. Viacom has been a Fund holding in the past and was one of our holdings for many, many years predating the creation of the Vilas Fund. Les Moonves will do a great job with Viacom assets. If, for some reason, the companies do not recombine, Viacom will be a solid performer as it is trading at 7 times trailing earnings.
Carlyle and Blackstone are benefiting from asset flows into private equity funds. While we may disagree with the accounting of these funds as they tend to use high levels of leverage but use appraisals to value holdings, thereby dramatically lowering volatility, the reality is that there is little likelihood of this changing. Because returns are high, mainly due to leverage, and volatility is low, due to infrequent and often times “model based” appraisals, pension funds and other large investors will continue to increase allocations to this sector. Blackstone and Carlyle are the two leading firms in this space. Both trade with very high dividend yields, 7% and 17% respectively, and very low valuations of normalized earnings.
And finally, as stated earlier, the Fund’s main industry allocation remains the financial services sector. Our largest holdings currently include Citigroup, NMI Holdings, Barclays, MGIC, HSBC, Morgan Stanley and Metlife, in descending order of size. We continue to believe that this group is severely undervalued and will appreciate at a rapid rate, recovering lost ground. On average, we estimate that our banks and insurers are trading at 0.75 times book value and 8.9 times 2017 earnings estimates, which are depressed due to onerous regulations and very low interest rates. We believe that they will, over time, return to their “normal” valuations of roughly 1.5 times book value and low teens price-to-earnings multiples. Why? Fines will end, interest rates will rise, returns on capital will increase, and the growth of the sector will shine through.
As the adage goes, buy low, sell high is the best way to profit from the stock market. From time to time, however, when you buy low, those securities subsequently trade at far lower prices than most would think possible. We are in one of those times. In the long run, undervalued companies tend to outperform and overvalued companies tend to underperform. As value investors, we continue to await that eventuality.
John C. Thompson, CFA
CEO and Chief Investment Officer
Vilas Capital Management, LLC