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Vilas Capital’s 2Q17 Letter – Barclays, Honda, & When the Bubble Pops

Vilas Capital Management’s 2Q17 Letter, July 2017

“One thing [Amazon] did not do was make much money. In its two decades as a public company, Amazon has had a cumulative profit of $5.7 billion. For a company with a market value of nearly $500 billion, this is negligible. Walmart, which has a market value half that of Amazon, made a profit of $14 billion in 2016 alone” – New York Times

  • Appreciated 0.7% in the second quarter, bringing YTD performance to 4.1%
  • Since inception in August 2010, compounded at 14.26%

Investment Position Discussion

  • In my nearly 25 years of managing money, I have never seen a valuation this high for a top 5 company in S&P 500 (Amazon)
  • If Amazon were to pay out all of its earnings, it would take over 200 years at today’s earnings to “get your money back” from investing in the company
  • Over 60% of historical return of equities has come from dividends – therefore, almost every investment should be paying dividends or be able to easily afford to do so
  • Many of today’s glamour stocks, including both public and private issuers, not only can’t pay dividends, they are selling bonds and equity to finance themselves
  • Fund currently holds $5 long for every $1 short – helps protect our principal if the market for glamour stocks remains irrational and keeps “bidding up” the shares of companies with little to no earnings but who possess revenue growth
  • Long positions are concentrated in Financial Services, Automobile manufacturing, Healthcare, and Energy
  • Some have worried that all stocks will fall when the “bubble” pops – we believe that markets will react along the lines of the 2000-2002 period whereby value stocks generally went up while glamour stocks fell 80-90%

Barclays

  • In the Financial Services space, average holding is trading at 0.86x book value per share
  • Barclays, our largest position, is trading at 0.56x book value
  • In the not too distant past, Barclays had briefly traded over 5x book value and regularly traded at 3x book value
  • We do think that over the next 5 years, Barclays will see its valuation expand to 1.6x book value
  • Company has a great collection of businesses, including credit cards, retail banking, commercial banking, and investment banking – collectively, they should earn a ROE in the low teens and, when they do, we have seen most other banks trade up to that level
  • Global regulatory pendulum has swung about as far as it will in the “tight” direction
  • Interest rate environment is about as bad as it can get for a Global/European bank – as interest rates normalize, this will add to profitability
  • The market, however, sees a business that has paid fines, has massive regulatory burdens, is fighting Britain’s exit from the EU, etc.
  • Issues that are affecting the banks today are transitory and will improve over time

Honda Motor Company

  • Earned $44Bn the last 10 years and paid out roughly $14Bn in dividends
  • Though it has a market cap of $49Bn, which is only $19Bn above the amount of earnings it retained the last decade, stock has fallen 22% in the last 10 years
  • Company grew its revenue 6.6%/year the last 10 years
  • If we assume a normal net margin of 3.5% and assume 5% revenue growth, will earn over $82Bn in the next 10 years – thus, we would pay off the company in roughly 6-7 years
  • Honda, which is trading at 0.78x book value, should see its valuation multiple expand to 2x book value and continue to grow earnings
  • Similar situation exists with Daimler, Ford, and GM, all holdings of the Fund
    • It is as if the market is anticipating a massive recession followed by no recovery due to Tesla taking over the world – we don’t believe that either will occur

Other Positions

  • Purchased a large position in Valeant at roughly $12.88/share
    • Added to the position over time and were able to buy a significant number of shares when a Board member sold their holdings at $11
    • Stock has since rebounded to roughly $17
  • Also purchased Walgreen Boots Alliance the day that Amazon purchased Whole Foods because Walgreen’s had fallen roughly 8% that day
    • We fail to see what Whole Foods has to do with filling prescriptions
    • Fund has made a lot of money in Walgreen’s over the years and are glad that we got another bite at the apple due to short-term selloff
    • Fund also has a smaller holding in CVS and a decent sized position in Target
  • Fund holds a moderate position in BP and a tiny position in Transocean
    • Like BP’s dividend and production profile
    • Attracted to Transocean due to their optionality if oil prices were to increase
    • Of the mindset that oil prices will likely trend lower due to additional supply and reduced demand from fuel economy improvements in the auto fleet and other energy users – however, calling energy prices is next to impossible and we like to have a small weighting in case there is a geopolitical event or OPEC regains its cartel power

Image Source: PGM Capital

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