Vilas Capital Management commentary for the third quarter ended 31, 2017.
Dear Vilas Fund Partner,
The Vilas Fund, LP rose 15.0% in the three-month period ended 9/30/2017. On a year-to-date basis, the Fund has increased 19.7%. Since the Fund began a little over 7 years ago (August 9, 2010), it has appreciated at 16.0% per year, net of fees, compared to the 14.3% return of the S&P 500 Index. This performance has compounded an initial investment of $1 at inception into $2.88 as of quarter end. If we are fortunate enough to have this rate of return (16%) continue through our ten-year anniversary, the Fund will have grown $1 into $4.40, net of fees. Importantly, the Fund has also been very tax efficient and has produced a net negative amount of realized capital gains from inception through year end 2016. Thus, the returns we show were not partially “taxed away”.
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The power of compounding capital at somewhat higher rates is compelling, especially for those investors with longer term time horizons. This is the entire premise of the Vilas Fund: attempting to generate a high return on investment by using the capital markets to their fullest. To accomplish this, we utilize a value strategy, buying stocks well below what we believe they are worth, usually at low multiples of book value and earnings, and selling short glamour stocks, or those with extremely rosy outlooks and massive valuations, at levels far above their worth. Academic research has found that, over time, deep value stocks tend to outperform glamour stocks by roughly 9.5% per year over rolling 5-year periods1.
The markets have not cooperated with this data recently: growth stocks have produced significantly higher returns than value stocks since 2005. We believe that this trend will reverse in the intermediate future, and with a vengeance. We would not be surprised to see a similar downdraft in the glamour segments of the market as we witnessed in the 2000-2002 period for technology stocks and the early 1990’s for biotech stocks. Ironically, the reason I was able to begin managing an equity fund in the mid 1990’s was due to the fact that the former manager concentrated on glamorous, but unprofitable, biotech and healthcare stocks that crashed. An early lesson that wasn't lost on me. Following this, the 2000-2002 period was undoubtedly the best in my equity management career as the Fund I managed increased 19% from 12/31/99 to 12/31/2002 while the stock market fell 38%. We believe that a similar set of circumstances, though not as widespread, will occur in the not too distant future. If the future environment is very similar to the past bursting of the tech bubble, the Vilas Fund, LP should perform markedly better in relation to the market than the other equity fund I managed.
Why are we so optimistic? Because we have seen this movie before and are positioned to benefit greatly. Cisco Systems, Intel, EMC, Linear Technology, Oracle, Microsoft, Dell, Nortel, and Sun Microsystems were far better companies, from an earnings, cash flow and balance sheet perspective, when compared to today’s crop of glamour stocks. They still fell ~90% on average. Tesla, Amazon and Netflix, to name a few, are trading at higher valuations than the “four horsemen” stocks did in 1999 yet have comparatively poor balance sheets, lousy earnings quality, and dubious business models. This is a recipe for disaster and will eventually end very poorly.
On the other hand, our portfolio of financials, healthcare stocks, retailers, and automobile manufacturers are selling at roughly 11 times 2018 earnings estimates, on a weighted average basis. In addition, the financials we own in the US and Europe are selling, on average, at roughly tangible book value per share, which implies that there is no value for their ongoing operations. These valuations are very attractive and should provide for compelling future returns.
Thus, the Vilas Fund is short a smattering of companies with massive market capitalizations, poor balance sheets, and virtually no earnings while it is long companies with low valuations, strong balance sheets and decent long-term growth outlooks. Our long positions, to be clear, may seem to some to be as exciting as watching paint dry. However, we will trade a low valuation with a decent long-term outlook for certain fast growing high fliers with poor financial characteristics every time. There is a reason Aesop wrote the “Tortoise and the Hare” fable: slow and steady wins the race.
Portfolio Structure and Commentary
The Vilas Fund currently has roughly $3.60 of long positions for every $1 of short positions. This ratio has fallen in the last quarter as we have increased the quantity of our short positions in order to attempt to protect principal in an inevitable market correction. The main positions in the short portfolio include Tesla, Netflix, Amazon and Ferrari. We added the position in Ferrari as we believe that it is considerably overvalued after its nearly 100% increase in 2017. This is a shorter-term position designed to provide higher “beta”, or market sensitivity, protection in a correction. We believe that Ferrari is a great brand and company in many respects but we need to protect principal and this was a good vehicle to do so, no pun intended. The other short positions are glamour stocks that will never be able to produce profits that will yield a good return for shareholders. Thus, they are bubbles destined to pop.
Amazon has been successful because they employ a predatory pricing strategy whereby they price their merchandise below cost, especially after wasteful packaging and delivery expenses, in order to gain market share and to “delight customers”. We know what Amazon's net income is, they disclose their profit in AWS, they disclose their volume in third party sales, which we can then estimate the profitability by looking at eBay and Alibaba, so we can then solve for their first party merchandise profit or loss. It appears that Amazon is losing many billions per year in their main general merchandise business. Consistently losing money in a business line to gain market share and force others out of business is the definition of predatory pricing.
To continue growing at the rate they are growing, Amazon needs to “consume” a company the size of Macy’s and Gap, combined, every year. Unfortunately, predatory pricing is illegal and is the reason the antitrust laws are on the books from the Rockefeller/Standard Oil years, including the Sherman Act of 1890, the Clayton Act of 1914, and the FTC act of 1914. These laws were enacted to prevent a “winner take all” strategy, arising from predatory pricing, that concentrates wealth and power. Eventually, the predatory company will raise prices once there is no competition, hurting society.
We believe that it is a matter of time for one of the many hundreds of retailers who has been decimated by this unlawful activity to sue Amazon for antitrust violations, gain class action status, and win. Or, it is possible that the Justice Department brings a case on its own. Regardless, the easy going for Amazon is likely over, as it was after FTC action against Microsoft in the late 1990’s or IBM before that. Thus, we are short Amazon as they will likely never gain the monopoly pricing power that would be necessary to recoup their losses in the general merchandise business.
Tesla, our largest short position by a considerable margin, is destined to be a terrible stock and will likely enter the protection of the bankruptcy court at some point in the future. Why? A business cannot perpetually lose money in a highly, highly capital intensive industry and finance itself with lots of debt and little equity. When Tesla fails, it is our opinion that members of the current management team will likely reside in very close proximity to Jeff Skilling, Bernie Ebbers and John Rigas. The end (less pollution, potentially) does not justify the means (untrue statements by management, puffery via Twitter and improper accounting). It didn’t for Enron, it didn’t for Worldcom, and it didn’t for Adelphia. Unfortunately, these issues only come to light after the fact when the SEC and Justice Department have a disaster on their hands.
Our long portfolio has many companies selling far below what they are worth. Over the last 5 years, Honda, our largest position, is down 9%, and Barclays, our second largest holding, is down 30%. Both companies should be trading at least 50% higher than their current share prices. In addition to our concentration in very large US financial companies (C, MS, GS, MET, BAC, BX, AIG), which have been performing very well, and positions in GM, Ford and Daimler that have recently outperformed the market, we have a smattering of newer or increased holdings, such as Transocean, General Mills, Target, Walgreens, CVS, Medtronic, Kroger, Express Scripts and Viacom, that are all trading at very attractive levels compared to what they are worth. We see plenty of upside in the long portfolio, in aggregate, and therefore have increased our short positions to protect principal instead of selling our long positions.
When asked our opinion about the stock market, we generally respond “what part?” There is a huge divergence between the have and have not’s. It is sort of like asking what we think of house prices? The answer is quite different if we are discussing the Bay Area, East Hampton, Palm Beach or Aspen vs. Detroit, Chicago, Wisconsin, Iowa or Indiana. We could make an argument that houses in the former areas have recently appreciated so rapidly that they are somewhat “overpriced” while houses in the Midwest are somewhat “underpriced”.
It is similar in the stock market. On one hand, we have Amazon with a nearly $500 billion enterprise value that has, according to the New York Times, only produced $5.7 billion in profit since inception. Therefore, it is trading at nearly 100 times trailing, twenty-year cumulative earnings. In contrast, General Motors, with almost $10 billion in trailing annual net income, is trading with a $59 billion market capitalization, or roughly six times trailing twelve-month earnings. Due to the financial “gravity” of valuations reverting to the mean, we forecast a massive rotation, out of growth and into value, instead of an overall bear market.
We appreciate your investment with our firm and look forward to the next few years with great optimism.
John C. Thompson, CFA
CEO and Chief Investment Officer
Vilas Capital Management, LLC.
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