Vilas Capital Management commentary for the third quarter ended September 30, 2019.
Dear Vilas Fund Partner,
The Vilas Fund, LP rose 4% in the third quarter of 2019, bringing the year-to-date performance to +50.5%. Strong returns from a number of positions, such as NMI Holdings, Lincoln National and Citigroup, and a nice rebound in CVS added materially to the Fund equity. However, a continued and unexpected downdraft in Viacom hurt the results somewhat.
Since the Fund was started on August 9, 2010, it has compounded partner capital at 11.7% annually, which is somewhat below the 13.6% return of the S&P 500 Index but well ahead of the 5.7% return of the HFR Fundamental Value Index. An initial $1 million investment at the inception of the Fund has grown to $2.75 million over the last 9 years.
On Friday, October 11th, two major developments occurred. First, the President changed direction and, in essence, began the process of striking a compromise deal with China to avoid further tariffs and the resulting economic damage those tariffs are causing globally. It is our belief that the rest of the trade issues will be resolved - not in a perfect way but potentially in a “good enough” manner - such that most or all current tariffs will also be removed.
The second, and we might add massive, development is that the Federal Reserve is now expanding its balance sheet again, at a rate of $60 billion per month, as opposed to contracting it as recently as July of this year. Expanding their balance sheet is the way a central bank “dilutes” a fiat currency, regardless of how it is implemented (i.e. purchasing T-Bills, Mortgages, 10 Year Treasuries, Corporate Bonds, Stocks, and any other financial instrument). Why is this important? It is clear that the economy is slowing and that the Fed needs to help. By removing riskless assets from the system, it forces investors to take additional risk, including interest rate risk, credit risk or equity risk. Further, it creates additional inflation, on the margin, as there is now more money chasing the same amount of goods, such as houses, cars, food, and healthcare. In a place, worldwide, where inflation has been too low, this is a good thing as it reduces potential credit losses for investors, banks and insurers, and adds to economic growth, though it tends to transfer wealth from savers in riskless assets to those who take risk.
The bottom line regarding these two moves is that they are extremely bullish for economic activity a few quarters from now. The stock market will begin to anticipate this reality and bid equities higher. CNBC recently wrote an article that indicated that the flows into money market funds have been running at a pace of $322 billion over the last six months, the fastest flight to safety since late 2008. In addition, investors have poured over $8 trillion into bank deposits, money markets and bond funds since the financial crisis and have been net sellers of stocks since those dark days. As a result, the pain trade is up, meaning that if the stock market rises, fewer folks than normal are positioned to benefit from it. This potentially could lead to an explosion higher as fear of missing out (FOMO) sets in and people strive to get back into a market that has already risen. Also, interest rates should rise materially due to these factors.
The Vilas Fund, LP is positioned to benefit greatly from an accelerating economy, a rising equity market, and higher interest rates.
There were two main decisions that were made that account for the Vilas Fund’s results over the last nine years. First, the Fund was fully invested in stocks nearly the entire period. All of the worries over the Euro, Greece/Italy, economic slowdowns, wars, both trade and conventional, and our folks in Washington, amounted to reasons to sell that cost many investors dearly. This proved to be the right strategy.
Second, in hindsight, we owned the wrong types of stocks. Despite earnings growth that largely beat market expectations, book value growth, dividends, rapid stock buybacks, and moderate revenue growth, our companies largely produced total returns that were below the market returns. Why? They were thought to be the targets of the Disruptors. The Disruptors, such as Amazon, would hurt all traditional retail, including pharmacies. Automobile manufacturers were thought to be out maneuvered by Tesla with their electric vehicles. Traditional media was thought of as a dinosaur with the growth of Netflix. And all financials would be displaced by emerging “fintech” companies, such as Square and Chime. We disagree with these assessments, obviously.
The stocks that have performed best over the past decade could largely be described as high revenue growth companies at sky-high valuations, some of which were losing money and had little financial margin for error in case things went wrong. Whether it was Amazon, Uber, Slack, Tesla, Netflix, Wayfair, Carvana, Shopify, etc, all you have to do is grow revenue and earnings will eventually follow, right? Well, we place far higher odds on the banks avoiding large problems and thriving in the next recession than the above companies figuring out how to make large, consistent profits. The market clearly doesn’t agree, however, so we wait.
In the long run, the returns from public equity markets come from three things: earnings increases or decreases, dividends paid or withheld, and price-to-earnings (P/E) multiple expansion or contraction. These three factors, in various combinations depending upon the industry, are all that matters. Earnings add to equity, can be used to pay off debt, or returned to shareholders via dividends. If the future becomes brighter for a company and revenue and earnings growth accelerate, the P/E multiple usually expands, adding to returns. If they slow down or experience margin compression, earnings growth falls and the P/E falls. This is how public markets used to work, that is. However, if a stock is cheap enough, say seven times earnings, the shares should return 14% annually for the owners even if the company never grows again, a fact entirely ignored by the market today. Our portfolio is trading, on a weighted average basis, at 7.2 times 2020 estimated net income.
If a company loses money consistently, by definition it depends upon new investors or lenders to keep it afloat. This “investment” capital has been flowing with, dare we say, reckless abandon the last 5+ years. Softbank appears to be almost the Lehman, Countrywide, or queen bee, of this bubble with their investments at ridiculous valuations into WeWork, Uber, Slack, etc. and other so-called Disruptors. However, Softbank appears to be falling on hard times, due to reported difficulties raising their $100 billion new fund, causing this river of capital to slowly dry up. Perhaps the start of the great unraveling has begun?
While the markets may appear expensive, using the market indices and average multiples, it is an illusion. Again, our portfolio continues to trade at 7.2 times 2020 net income estimates on a weighted average basis. If investors look at a hypothetical two stock market that is comprised of Amazon and Lincoln National, the former at 76 times current year earnings and the latter at 6.3 times, the average multiple of 41 looks pretty scary. But does this average hold any useful information? Our argument is no. Seventy-six is far too high and six is far too low. Averages can be very helpful some of the time, but at this point, due to massive dispersions between cheap and expensive, it is a nearly meaningless number. Thus, we believe our portfolio will thrive as it is concentrated in the cheapest, yet growing, companies.
One other comment is on the behavior of investors. As we indicated above, In the last 6 months, $322 billion has been added to money markets, the fastest rate since late 2008. In addition, money continues to flow away from risk as equity funds saw withdrawls of $60 billion and bond funds saw net inflows of $118 billion last quarter. All of the data points seem to indicate that investors are quite scared of the economy, politics, and world events. Anecdotal conversations with investors and other advisors are consistent with this data. It is our assertion that pessimism is the overall sentiment of the investment community. However, it seems that the following quote is highly pertinent:
“Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria” - Sir John Templeton
When investors eventually determine that they want back in, there is a tremendous amount of dry powder on the sidelines. They will likely look for more reasonable stocks to buy to “catch up”. Thus, we believe that the value portion of the equity market remains the best place to invest capital.
Over the last nine years, we have been waiting for optimism and euphoria to show up in the money flow statistics, i.e. into stocks and out of deposits, money markets and bonds, as an indicator that it was time to take our foot off the gas. However, these conditions have never occurred, at least for more than a few months at a time. In fact, the opposite has been true: money continues to leave equities to invest in low returning but ultra-safe places. This overall bearishness has created many great investment ideas at extremely low valuations that we believe will produce excellent returns, in some cases exceeding 20% into near perpetuity.
Lincoln National and Viacom both are valued for around six times current year earnings. If these companies simply maintained their current sizes, neither growing nor declining, a relatively easy task in business, at this price, the owners will earn 17% annually on their shares nearly forever. How? Due to the lack of growth, they can simply return all of the earnings as dividends or share repurchases. Thus, they become very much like 17% bonds. In theory, if they each retained earnings to grow and reinvest at a decent return on equity, thus producing earnings growth, the returns for the owners of these companies should be even higher. Both Lincoln National and Viacom are retaining most of their earnings and reinvesting at mid-teens to low twenties returns on shareholder equity, above their cost of capital. This should lead to continued revenue and earnings growth. Because of this, the returns to the owners of these stocks should be over 20%, practically into perpetuity, with very low risk.
The rush toward the exit doors for equity investors and the preference for growth investing and indexing has created a huge inefficiency in the market that the Fund is taking advantage of. Someday, it will show up in our performance results as a dramatic re-rating higher, probably occurring over a short period of time.
A sea change has just occurred with the first steps of a China trade compromise and the Fed expanding its balance sheet. The economy will likely re-accelerate, bond yields should rise, and, if both are true, value stocks will shine. With a bunch of extremely cheap stocks in the portfolio, our time is near. We appreciate your continued support and look forward to the future with great optimism.
John C. Thompson, CFA CEO and Chief Investment Officer
Vilas Capital Management, LLC.