Vilas Fund 2Q15: Is It Because Value Stocks Are Riskier?

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Vilas Fund investment commentary for the second quarter ended June 30, 2015.

Performance Highlights:

The Vilas Fund, LP, has substantially outperformed the S&P 500 Index and the HFR Fundamental Value Index since its inception in August, 2010:

The Vilas Fund, LP, has compounded at the following rates for the period ending June 30, 2015:

Vilas Fund

Further, the Vilas Fund has produced extraordinarily tax-efficient historical returns:

Vilas Fund

Assuming the highest Federal Tax Rate and a state effective tax rate of 5%, an investor in the Vilas Fund since inception would have lost, on average, only 0.68% per year to taxes.

Strategy Overview:

Given the large number of new partners in the Fund and the increase in interested parties, we thought it would be helpful to summarize our investment strategy and the academic foundation of our approach. I developed the Vilas Fund’s strategy over the last 22 years through analyzing past mistakes, learning from great investors, and combing through academic data. Mistakes usually occurred when I paid too much for a company’s stock that didn’t live up to expectations. Also, when I tried to be too cheap by investing in companies with major problems, our results suffered. To learn further, I studied those individuals who were extremely successful in the field of money management. It became clear that most of them were value investors, especially over longer periods of time. I studied the great ones, including Benjamin Graham, Joel Greenblatt, Mason Hawkins, Sam Zell, Warren Buffett, and David Dreman, among others. It is no secret these famous investors attribute much of their long-term success to the value philosophy of buying equities of low-priced, out-of-favor companies. While working on my business degree at the U of C, I was extremely fortunate to take a course in Corporate Finance from Robert Vishny. Professor Vishny, along with Josef Lakonishok and Andrei Shleifer, coauthored a seminal value investing paper titled “Contrarian Investment, Extrapolation and Risk” in 1994. These three professors used their paper as the basis for LSV Asset Management, a firm with a top industry track record and over $90 billion of assets under management today.

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The basic foundation of the Vilas Fund’s strategy is that cheap, undervalued stocks, defined as those stocks with low price-to-book, low price-to-earnings, and/or low price-to-cash flow ratios, outperform expensive companies over time. Further, those companies with low barriers to exit, low supplier power, low buyer power, strong brand names, little threat of substitutes or new entrants, and higher switching costs have better economic returns than those companies without these attributes. Lastly, when we identify materially overvalued equities with less than ideal economic and financial characteristics, we initiate and hold short positions with the goals of reducing portfolio risk and increasing expected return. We point to key excerpts from the “Contrarian Investment, Extrapolation and Risk” paper by Lakonishok, Shleifer, and Vishny (1994) that form the academic underpinning of our strategy:

Vilas Fund - Value Stocks Outperform Growth Stocks:

“While there is some agreement that value strategies have produced superior returns, the interpretation of why they have done so is more controversial. Value strategies might produce higher returns because they are contrarian to ‘naive' strategies followed by other investors. These naive strategies might range from extrapolating past earnings growth too far into the future, to assuming a trend in stock prices, to overreacting to good or bad news, or to simply equating a good investment with a well-run company irrespective of price. Regardless of the reason, some investors tend to get overly excited about stocks that have done very well in the past and buy them up, so that these ‘glamour’ stocks become overpriced. Similarly, they overreact to stocks that have done very badly, oversell them, and these out-of-favor ‘value’ stocks become underpriced. Contrarian investors bet against such naive investors. Because contrarian strategies invest disproportionately in stocks that are underpriced and underinvest in stocks that are overpriced, they outperform the market (see De Bondt and Thaler (1985) and Haugen (1994)).”

“On average over the postformation years, the low B/M (high P/B) (glamour) stocks have an average annual return of 9.3 percent and the high B/M (low P/B) (value) stocks have an average annual return of 19.8 percent, for a difference of 10.5 percent per year. If portfolios are held with the limited rebalancing described above, then cumulatively value stocks outperform glamour stocks by 90 percent over Years 1 through 5.”

“The results in this article establish (in varying degrees of detail) three propositions. First, a variety of investment strategies that involve buying out-of-favor (value) stocks have outperformed glamour strategies over the April 1968 to April 1990 period. Second, a likely reason that these value strategies have worked so well relative to the glamour strategies is the fact that the actual future growth rates of earnings, cash flow, etc. of glamour stocks relative to value stocks turned out to be much lower than they were in the past, or as the multiples on those stocks indicate the market expected them to be. That is, market participants appear to have consistently overestimated future growth rates of glamour stocks relative to value stocks. Third, using conventional approaches to fundamental risk, value strategies appear to be no riskier than glamour strategies. Reward for bearing fundamental risk does not seem to explain higher average returns on value stocks than on glamour stocks.”

Vilas Fund - Is It Because Value Stocks Are Riskier?:

“Two alternative theories have been proposed to explain why value strategies have produced higher returns in the past. The first theory says that they have done so because they exploit the mistakes of naive investors. The previous section showed that investors appear to be extrapolating the past too far into the future, even though the future does not warrant such extrapolation. The second explanation of the superior returns to value strategies is that they expose investors to greater systematic risk. In this section, we examine this explanation directly.”

“Value stocks would be fundamentally riskier than glamour stocks if, first, they underperform glamour stocks in some states of the world, and second, those are on average ‘bad’ states, in which the marginal utility of wealth is high, making value stocks unattractive to risk-averse investors. This simple theory motivates our empirical approach. The results show that value strategies have consistently outperformed glamour strategies. Using a 1-year horizon, value outperformed glamour in 17 out of 22 years using C/P (Cash Flow/Price) to classify stocks, in 19 out of 22 years using C/P and GS (Growth Rate of Sales), and in 17 out of 22 years using the B/M (P/B) ratio. As we move to longer horizons, the consistency of performance of the value strategy relative to the glamour strategy increases. For all three classification schemes, the value portfolio outperforms the glamour portfolio over every 5-year horizon in the sample period.”

“A second approach is to compare the performance of value and glamour portfolios in the worst months for the stock market as a whole. Table VII, Panel 1 presents the performance of our portfolios in each of 4 states of the world; the 25 worst stock return months in the sample based on the equally weighted index, the remaining 88 negative months other than the 25 worst, the 122 positive months other than the 25 best, and the 25 best months in the sample. The average difference in returns between value and glamour portfolios for each state is also reported along with t-statistics for the test that the difference of returns is equal to zero. The results in this table are fairly clear. Using both the B/M and (C/P, GS) classification schemes, the value portfolio outperformed the glamour portfolio in the market's worst 25 months.”

“...the betas of value portfolios with respect to the value-weighted index tend to be about 0.1 higher than the betas of the glamour portfolios. As we have seen earlier, the high betas probably come from value stocks having higher ‘up-market’ betas, and that, if anything, the superior performance of the value strategy occurs disproportionately during ‘bad’ realizations of the stock market. Even if one takes a very strong pro-beta position, the difference in betas of 0.1 can explain a difference in returns of only up to 1 percent per year (assuming a market risk premium of 8 percent per year) and surely not the 10 to 11 percent difference in returns that we find.”

Conclusion and the Behavioral Tendencies the Vilas Fund Exploits:

“This conclusion raises the obvious question: how can the 10 to 11 percent per year in extra returns on value stocks over glamour stocks have persisted for so long? One possible explanation is that investors simply did not know about them. This explanation has some plausibility in that quantitative portfolio selection and evaluation are relatively recent activities. Most investors might not have been able, until recently, to perform the analysis done in this article. Of course, advocacy of value strategies is decades old, going back at least to Graham and Dodd (1934). But such advocacy is usually not accompanied by defensible statistical work and hence might not be entirely persuasive, especially since many other strategies are advocated as well.”

“We conjecture that the results in this article can best be explained by the preference of both individual and institutional investors for glamour strategies and by their avoidance of value strategies. Below we suggest some reasons for this preference that might potentially explain the observed returns anomaly. Individual investors might focus on glamour strategies for a variety of reasons. First, they may make judgment errors and extrapolate past growth rates of glamour stocks, such as Wal-Mart or Microsoft, even when such growth rates are highly unlikely to persist in the future. Putting excessive weight on recent past history, as opposed to a rational prior, is a common judgment error in psychological experiments and not just in the stock market. Alternatively, individuals might just equate well-run firms with good investments, regardless of price. After all, how can you lose money on Microsoft or Wal-Mart? Indeed, brokers typically recommend ‘good companies’ with ‘steady' earnings and dividend growth.”

“Presumably, institutional investors should be somewhat more free from judgment biases and excitement about ‘good companies’ than individuals, and so should flock to value strategies. But institutional investors may have reasons of their own for gravitating toward glamour stocks. Lakonishok, Shleifer, and Vishny (1992b) focus on the agency context of institutional money management. Institutions might prefer glamour stocks because they appear to be ‘prudent’ investments, and hence are easy to justify to sponsors. Glamour stocks have done well in the past and are unlikely to become financially distressed in the near future, as opposed to value stocks, which have previously done poorly and are more likely to run into financial problems.

Many institutions actually screen out stocks of financially distressed firms, many of which are value stocks, from the universe of stocks they pick. Indeed, sponsors may mistakenly believe1 glamour stocks to be safer than value stocks, even though, as we have seen, a portfolio of value stocks is no more risky. The strategy of investing in glamour stocks, while appearing ‘prudent,’ is not prudent at all in that it earns a lower expected return and is not fundamentally less risky. Nonetheless, the career concerns of money managers and employees of their institutional clients may cause money managers to tilt towards ‘glamour’ stocks.”

“Another important factor is that most investors have shorter time horizons than are required for value strategies to consistently pay off (De Long et al. (1990) and Shleifer and Vishny (1990)). Many individuals look for stocks that will earn them high abnormal returns within a few months, rather than 4 percent per year over the next 5 years. Institutional money managers often have even shorter time horizons. They often cannot afford to underperform the index or their peers for any nontrivial period of time, for if they do, their sponsors will withdraw the funds. A value strategy that takes 3 to 5 years to pay off but may underperform the market in the meantime (i.e., have a large tracking error) might simply be too risky for money managers from the viewpoint of career concerns, especially if the strategy itself is more difficult to justify to sponsors. If a money manager fears getting fired before a value strategy pays off, he will avoid using such a strategy. Importantly, while tracking error can explain why a money manager would not want too strong a tilt toward either value or growth, it does not explain why he would not tilt slightly toward value given its apparently superior risk/return profile. Hence, these horizon and tracking error issues can explain why money managers do not more aggressively ‘arbitrage' the differences in returns across value and glamour stocks, but they cannot explain why such differences are there in the first place. In our view, such return differences are ultimately explained by the tendency of investors to make judgmental errors and perhaps also by a tendency for institutional investors to actively tilt toward glamour to make their lives easier.”

It is clear from the above academic analysis and data, which have been expanded through recent periods and shown to work equally well around the world by firms such as Brandes and others, that The Vilas Fund’s strategy is based upon solid footing. We are thankful to have learned from some of the best investors in the world, listed above, and to have met and studied under Professor Rob Vishny. The 4 trips to Omaha were also some of the greatest learning experiences an investment professional could hope for, especially regarding security selection, portfolio construction, and tax efficiency. While we know that no strategy works every month, quarter, year, or even, occasionally, multi-year periods, empirical data show cheap stocks outperform expensive ones over longer time horizons.

Vilas Fund - Investment Commentary:

The Vilas Fund, LP, commenced operations on August 9, 2010. In a few short weeks, the Fund will be five years old. Our performance continues to exceed the market and our competition by healthy margins over longer time frames. However, in the summer of three particular years, 2011, 2012, and now 2015, the exact same external force has caused significant selloffs and market angst: Greece.

After being up ~6% in the middle of the quarter, we finished the quarter slightly in the red. How a country of 11 million people and $240 billion of GDP (which is smaller than the economy of Wisconsin), in a world with over 6 billion inhabitants and $87 Trillion in GDP, could cause so much trouble in three years out of the last five is remarkable. Greece is entirely irrelevant and any selloffs due to the media circus surrounding its issues were, and will continue to be, wonderful times to buy value stocks.

Currently, we see attractive opportunities in large financial services companies around the world, select major integrated oil firms, a Japanese auto manufacturer, and a few consumer staples providers. In a world of new market highs occurring almost daily, we continue to find companies trading extremely inexpensively relative to the market, their own histories, and other investment options including cash, bonds, and real estate.

For example, Deutsche Bank, one of our holdings, is ridiculously cheap. It is trading around $33 today, down from over $70 five years ago. It would be hard to argue that this stock is “extended”. In fact, it is only a few dollars above its five year low and isn’t too far above its nadir during the worst of the 2008 – 2009 Financial Crisis. Its long-term owners are rightfully asking “what bull market?”

Deutsche Bank has a tangible book value per share of $46. Hypothetically, this means that if DB shut its doors, sold off all its assets and paid off all its debts, shareholders should receive $46, a gain of ~40% from here. Additionally, DB has a large asset management business, with $1.2 trillion in client funds, that does not consume much, if any, capital. Thus, in our hypothetical “shutdown” scenario, this business unit would remain open because its returns on equity are very, very high. We figure the asset management business is worth roughly $15 per share as a standalone entity. Further, if the investment banking and traditional banking businesses were put into run-off instead of liquidation, they would create massive earnings during the wind-down, creating additional value for shareholders. However, ignoring this fact and continuing with the thought experiment of shuttering most of the bank’s activities, this strategy would create a $15 stock representing the ongoing asset management business and payout a $46 dividend to shareholders. Our math says that equals $61 in total value per share, nearly double DB’s current stock price today.

We believe the new CEO of Deutsche Bank will create an entity that is worth far more alive than dead. This value will take time to unfold, however. In five years, we project DB’s tangible book value per share could grow to roughly $60. While this company has sold at well over 2 times book value in the last 10-15 years, we think that as the industry rationalizes, the price-to-tangible book multiple on a good day could hit 1.5. Thus, five years out, this stock should trade at $90, inclusive of dividends, indicating it could compound at over 25% per year on average for the next 5 years. Does this seem far-fetched? Cigna, one of the largest health insurers, recently turned down an offer to be acquired by Anthem for 4 times book value and roughly 20 times tangible book value. The health insurance business, has, at times, been a tough industry and is heavily regulated, not unlike today’s global banking industry. Further, with the stroke of a government pen, the healthcare industry could be rendered nearly obsolete if the U.S. eventually allows all citizens into Medicare, the path chosen by every other industrialized country. Banks do not have the risk of obsolescence by government fiat. They have other risks, clearly. But, the need for banks can never be supplanted by government programs. Because banks are the most critical part of any capitalistic economy (witness the effects of the Lehman bankruptcy and bank closures in Greece), we believe that they will experience material increases in their operating metrics as the industry rationalizes. Improved returns will drive significant multiple expansion.

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