Vilas Fund letter to investors for the fourth quarter ended December 31, 2016.
To Our Partners,
The Vilas Fund, LP returned 27.02% net of fees during 2016, which was ahead of the 11.96% return of the S&P 500 Index, including dividends. Looking at the Fund’s 5 year return of 23.36% annualized, there are only 20 unique mutual funds that have a better 5 year performance record than the Vilas Fund (Morningstar, 12/31/2016). This is out of roughly 8,500 mutual funds in the industry, at the end of 2010, and ignores the survivor bias created when poorly performing funds close. Also, the Fund’s five year annualized return of 23.36% compares favorably to the 14.66% annual gain for the S&P 500 Index. As a general rule, equity mutual funds have done far better than the average hedge fund over the last 5 years as the vast majority of hedge funds had materially less exposure to the rising stock market.
To be frank, while these long term returns are decent, they aren’t good enough. Value strategies, such as ours, have been swimming upstream over the last decade as value has under-performed glamour by a significant margin, though we sense the tides are turning lately. We can do better.As a firm with deep ties to the State of Wisconsin, including the area in Northern Wisconsin, Vilas County, that is the location of our family summer lake home and is the source of the firm’s name, we thought that the following quote from Green Bay Packers Head Coach Mike McCarthy, after a four game losing streak this past November, was pertinent.
“Let’s just state the facts: I’m a highly successful NFL head coach,” McCarthy said Monday as part of an answer that lasted 2½ minutes. “With that, I’ve never looked at the ride to this point as smooth or whatever the words you used. To me, it’s always bumpy, and to me that’s the joy of it. That’s this game. That’s how hard it is in the NFL.”
The Packers went on to win seven games in a row and defeated the NY Giants, convincingly I might add, to enter the playoffs.
In the past, I simultaneously ran two mutual funds, one equity and one fixed income, for nearly 16 years. Both of these funds, at various points in their lives, were top performers in their categories over long periods of time and, due to this historical outperformance, grew into multi-billion dollar funds. This performance also led to feature stories in many media outlets, including Barron’s, Wall Street Week with Louis Rukeyser, The New York Times, and the Wall Street Journal. Thus, I could argue in a similar way that I’m a successful investment manager. While we, at Vilas Capital Management, would like to generate returns that exceed the S&P 500 Index with smooth, monthly regularity, the reality is that some years are far better than others and we won’t win every game.
“The Golden Era of Hedge Funds Draws to a Close With Clients in Revolt” – Bloomberg, December 28, 2016
The Investment Management Industry, including many of the professionals at allocating institutions, investment consulting firms, portfolio managers, brokerage firms, and the end customers, at times tends to ignore one of the most powerful concepts in finance: buy low, sell high works better than the other way around. If we look at the flow of funds data from the Investment Company Institute, there were massive inflows into equities in the second half of the 1990’s, mild inflows in the mid 2000’s and large outflows from the financial crisis until just recently. As bond yields fell, there were massive inflows into bond funds. In a very big picture analysis of the flow data, the investment community at large bought stocks when they were expensive and ignored bonds when yields were high. Then, when stocks fell twice, they sold stocks en masse and bought bonds when yields were low.
One form of selling stocks and buying bonds was the mass flow of money out of public equity strategies and into hedge funds post the tech bubble bursting in 2000 and the 2008 financial crisis. Hedge funds touted that they would keep correlations to the equity market at a low level post these two large downdrafts. Investors wanted the diversification benefits for when the next big market correction occurred. The only way to accomplish this was for the hedge fund industry to have very little exposure, on a net basis, to equities, the best performing asset class over long periods of time. Post the Financial Crisis, nobody seemed to bother to ask two fundamental questions: Are stocks cheap? and When should we expect the next market crash to occur? The answer to the first was a screaming “Yes.” And then, by corollary, the answer to the second would be “A long, long time from now.”
To make matters worse for the hedge fund industry, it is clear that investors would have been far better off using a 40% equity, 60% government bond blend over the last 10 years if volatility reduction was the true goal. This portfolio, constructed using Vanguard Funds (VBLTX and VFIAX), would have produced a 6.83% weighted average compound annual return. In one of the worst years in the last 80 years, 2008, this portfolio lost 9.75%. The HFRI Fund Weighted Composite Index, a great proxy for hedge funds as a group, produced a return of 3.37% annually over the last 10 years but fell 19.03% in 2008. Thus, investors would have been far better off using a simple 40% equity, 60% bond strategy in both returns, which were almost exactly twice as high, and losses in 2008 which were roughly half the level of losses in the average hedge fund. It is our sense that due to the lower long term net returns and larger risk profile of the average hedge fund when compared to a simple blended portfolio, the industry will contract significantly over the next few years.
What makes the Vilas Fund different?
First, the Vilas Fund is a value fund that makes concentrated investments into underpriced equity securities and sells short overpriced securities. Ever since the financial crisis, most managers of hedge funds shunned equities, as described above. Over the last seven years, it was our belief that equities were extremely cheap, especially in the financial sector, at a time when financing costs were near 100 year lows. It turns out that financials were cheap partially because financing costs were near 100 year lows. Thus, an investor could borrow very cheap money and buy cheap equities. If this was real estate we were discussing, in which individual properties trade seldomly and are generally marked via appraisals, the investment industry would cheer the purchase of a nice apartment or office building at a high cap rate (cash on cash rate of return) with inexpensive money. In fact, they would, and did, shovel tons of money in that direction. Why would the same not be true, then, when buying equities? Because nobody wanted them or their lousy, stinking volatility. Volatility reduction of portfolios became the driver, not trying to make money with a buy low, sell high mentality. Thus, the hedge fund industry invested in bonds, commodities, and other “uncorrelated” investments that would deliver “uncorrelated” returns. The problems and risks were simple: what if stocks were cheap and performed really well? Second, what if bond yields were artificially low due to the huge demand for volatility reduction? The industry was not positioned for these outcomes and it clearly shows from the performance data since the financial crisis. Given their high fees and investment strategies, it is no wonder that hedge funds, as a group, have performed poorly. It was our belief that equities were great investments that partially led to our success.
Second, our fees are less than half of the typical hedge fund. Charging a 1% management fee and a 10% performance fee once we exceed an 8% compounded annual return hurdle rate (for clients that hire us before the Fund reaches $100 million) is a far lower fee than the typical 2% and 20% model.
Third, we trade very little when compared to other managers. Trading tends to enrich Wall Street, not our Fund partners, leading to lower net returns.
Fourth, the Vilas Fund has been extremely tax efficient when compared to the industry. Our capital gains, in years in which we took them, were relatively small and were largely long term in nature. In 2016, we project issuing large realized losses, which are roughly 75% short term and 25% long term, despite returning over 27% last year. Even though taxes do not show up in published performance numbers, they are an extremely important consideration for taxable investors.
The Vilas Fund needs to rise roughly 37% to get back to the “high water mark” of July 31, 2015. With that said, we think that there is a massive amount of upside remaining in the holdings and positioning of the Fund. As an example, our third largest holding, Citigroup, traded at an average price-to-book value of 1.93 since January 1, 1990. Today, Citigroup is trading at 0.81 times book value. See the chart below.
The average value of 1.93 times means that a good portion of the time, Citigroup traded at a price-to-book value ratio higher than 1.93. Thus, it could rise 140% and simply be back to long term average valuation levels, ignoring the likelihood that it will spend some time above the long term average. In our experience, securities tend to become overvalued, crash to being significantly undervalued, stay there a while, and then become overvalued again. Because of this, we do believe that at some point in the future, the stock of Citigroup will become overvalued once more, making our “return to average valuation levels” a conservative assumption. With the changed regulatory environment that should result from the new Administration, we think that reaching these valuation levels in the next three to five years is quite probable. Adding in the financial leverage that we are inexpensively employing in the Fund, along with the expected growth in book value per share of the companies we own (we estimate 6% per year to be conservative), it is quite easy to see how large returns from the 12/31/2016 level are possible.Barron’s wrote in the January 9, 2017 issue that “Value stocks still look like a good deal now, says Bob Schmidt, manager of the Brandes Institute, which researches market behavior on behalf of Brandes Investment Partners, a San Diego value manager overseeing $28 billion. Schmidt divides the world’s stocks into 10 equal groups, ranked by the ratio of share prices to tangible book value. On average, he found that over the past two decades, the cheapest decile was about 40% as expensive as the costliest. By last year, that figure had fallen to 15%. The only period close to that was during the dot-com bubble, at 25%. “During the tech-stock bubble, many active managers had a hard time keeping up with Dell, Cisco, and AOL,” says Schmidt. “Until recently, it was the same thing with Facebook, Amazon, and Netflix.”
In another analysis, if one takes our main holdings today, including financials and automobile manufacturers, and charts their performance relative to the S&P 500 Index since the inception of the Fund on August 9, 2010, it is clear that these holdings have lagged the broader market by a considerable margin. In fact, some of these holdings, including the major US banks, returned roughly 50% over the last 6 years and 5 months while the S&P 500 Index doubled. Other holdings, such as foreign banks and our Japanese automobile manufacturer, are actually down significantly over this holding period. If our holdings were to “catch up” to the market over the next few years, large relative gains would result. Said another way, if an investor is looking to participate in the equity market with new capital, our holdings are clearly not extended.
Volatility does not equal risk. Period. Risk equals risk and volatility equals volatility. Risk, in our framework, is the probability of losing money over a long (multi-year) holding period, not how much a stock jumps around over a few weeks or months. Do human beings tend to act poorly during and after periods of declining or advancing prices? Clearly, the answer is yes. But the reward for those who view the world as many value investors do is significant. A lumpy series of returns that compound at 15% over 30 years results in $1 turning into $66.21. A smooth series of returns at 5% over 30 years turns $1 into $4.30. For very long term investors, such as retirement assets in pension funds and IRA’s, family wealth, insurance company assets and endowment money, the preference should be for higher, yet more volatile, returns. Thus, the massive industry concern about short term volatility seems misplaced.
Short positions and Pari Mutuel betting
On a final note, with a relatively small amount of capital, the Fund is short three high flyers: Amazon, Netflix and Tesla. In a nutshell, these companies are either barely profitable, in relation to their market values, or are producing losses, yet trade with massively large valuations when compared to competitors and market averages. Investors have concluded that these three will all be long term “winners”, economically speaking. This may very well be true on a fundamental basis. Investing, however, is similar to Pari Mutuel betting at a horse race. If a horse is the favorite, it draws many bets for it to win, show, etc. Due to this, the horse track automatically changes the odds so that the prize for winning gets smaller the more bets are made on the favorite horse. Taken to an extreme, if all spectators bet on the same horse to win, the odds get adjusted so that even if that horse wins, they would all lose money. Mathematically, it is clear to us that the valuations of these companies are so high that even if these three companies “win” in their respective fields, losses are the likely result for investors at today’s prices.
The Vilas Fund, LP is positioned, both long and short, to capitalize on the reversion to the mean of the differential between the most expensive and least expensive market deciles. Today, that differential is near record high levels. We know of no other commingled investment fund that is positioned to benefit from the rebound of value vs. glamour more so than The Vilas Fund, LP.
John C. Thompson, CFA
Vilas Capital Management, LLC.
The Aon Center, Suite 5100
200 East Randolph Street
Chicago, IL 60601
Performance data referenced represents past performance and does not guarantee future results. Performance includes the reinvestment of dividends and other earnings. Net performance is net of all fees and is based upon the current investors’ fee structure. Future performance will vary depending upon each investor’s capital account and fee structure. The current performance may be higher or lower than the performance data provided herein. .
The Vilas Fund, LP is a private fund and the securities are offered in reliance on an exemption from the registration requirements of the Securities Act and are not subject to the protections of the Investment Company Act. The Securities and Exchange Commission has not reviewed the securities or the offering materials. The Vilas Fund, LP securities are subject to legal restrictions on transfer and resale and investors should not assume they would be able to resell them. All information contained herein is subject to revision and completion. Should there be a discrepancy between the offering materials and this document, the offering materials will control. This document is not intended to be a complete description of the business engaged in by Vilas Capital Management, LLC, nor is it an offering or solicitation to invest. Any such offer or solicitation may be made only by means of a confidential private offering memorandum. No subscriptions will be received or accepted until subscription documents are completed and Vilas Capital Management, LLC has approved the subscription agreement and an investor’s eligibility to invest. Prospective investors must be accredited investors and meet certain minimum annual income or net worth thresholds in order to be eligible to invest.
Investment in the fund involves a high degree of risk. An investor could lose all or a substantial portion of his or her investment. The Vilas Fund, LP’s results were obtained by using a highly concentrated value strategy which includes short positions. The Fund may also use leverage.
This presentation contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of Vilas Capital Management, LLC and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. Factors that could cause The Vilas Fund, LLP actual results to differ materially from those described in the forward-looking statements can be found in The Vilas Fund Confidential Private Offering Memorandum and Subscription Agreement. Vilas Capital Management, LLC does not undertake to update the forward-looking statements to reflect the impact of circumstances or events that may arise after the date of the forward-looking statements.