Vice Fund - VICEX

The Vice Fund returned 7.22% for the quarter ending March 31, 2011, versus 5.92% for the S&P 500.  For one year ended March 31, 2011, the fund outperformed the S&P 500 by over 300 basis points, returning 19.01% versus 15.65% for the S&P 500. 

Click here for the most recent performance for the Vice Fund.

Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the Funds may be lower or higher than the performance quoted.  Performance data current to the most recent month end can be obtained by calling 866.264.8783.

The last year has been eventful for the Vice Fund. We have seen dividends and dividend growth come back in style. The Fund has focused even more on what historically has driven past stock returns and found vice companies that meet those criteria. Historically, dividends produced over half of the total returns for stocks. P/E expansion has also played a role in stock returns, as people became fonder of equities they paid more for each dollar of earnings produced. Earnings growth has also played a significant role in driving returns. There are three ways to grow EPS:

1. Actual top-line revenue driven growth – price increases, higher volume, general economic growth.
2. Cost cutting, improved efficiency, gaining economies of scale can also improve earnings even without revenue growth.
3. Reducing the number of shares and dividing income by fewer shares also drives EPS.

Our goal is to find stocks that embody these characteristics in abundance and typically this comes back to finding companies with huge cash flows, which vice companies have historically had. Keep in mind, our goal is not to find stocks of a prurient nature. Our goal is to find companies that demonstrate characteristics we just discussed.

Dividends – the market (as measured by the S&P 500 Index) is at 1.8%-2.0% dividend yield. Tobacco currently yields 4%-6%; Alcohol about 3%, Defense 3%-4%, Gaming does not pay a dividend but it gives us some emerging market exposure we’ll discuss below.

Earnings/EPS growth has also been strong and has remained so:

1. Revenue growth comes from annual price hikes and expanding market share. In the case of all our target industries, they have been seeing solid exposure to the industrialization of China, India, Africa, Eastern Europe, Russia, and Latin America. These are countries where growing affluence means people will likely trade up in alcohol or tobacco quality. People in Asia love to gamble and the new casinos in Macau already do more business than Las Vegas. Rising defense budgets overseas also means the prospect of more government orders for aerospace and defense materials.

2. Cost savings – These companies have actively sought to acquire others in their industries. For example, Molson and Coors merged, Inbev bought Anheuser Busch and Raytheon bought Applied Signal. This can enable duplicate overhead costs to be cut and for production facilities to run at a higher rate of utilization. Thus, income should be higher for the combined company than simply adding the results of two separate ones.
3. Share repurchases have been a mainstay of these companies as well. Most of our companies have a history of buying back shares to drive EPS further.

P/E expansion – There is an over-riding aversion to vice stocks. People may think they are going out of business (smokers are aging, older people don’t drink beer, the government will cut the defense budget, there is no disposable cash for gambling). As a result, many of these companies have been trading at discounts to the market’s P/E. As the myths surrounding many of these companies are exposed, valuations have moved higher. One of the big drivers for the Fund’s performance last year was P/E expansion in the tobacco area. We have been expanding our positions in defense to take advantage of low valuations there, looking to take advantage of P/E expansion in that group.

The unique nature of vice stocks can create huge cash flows for investors. These are not products that change radically such as computers, software, or medical tech. Cigarettes, beer, spare parts for FA-18 jets and hotel rooms just do not need the same level of research and development (R&D) and advertising. Nor do they become obsolete every six months.

Demand is not likely to change with the economy – people continue to smoke and drink, governments maintain their militaries, and people still seek entertainment. Moreover, many of these items may be small luxuries to their users and are not something they have to agonize over to purchase.

Upstarts are not likely to enter the market – it’s too expensive. This allows the current players to boost prices and operate in an oligopoly manner. To become a defense contractor requires years of service, evidence of financial stability, and the ability to finance large multi-year projects. A new casino costs $1 billion these days. New cigarettes and alcohol need to push something else off the shelves to gain access to a store, plus they need to win over distributors. The current players can still acquire upstarts that manage to achieve success.

In areas where demand is flat, the companies can consolidate and grow by cutting costs. Thus, capital spending declines too while cash flows rise. All this cash flow can be used to fund dividends, repurchases, and more acquisitions and the cycle can repeat as described above.

Vice stocks can offer the best of both worlds to investors. Vice stocks can grow in good times and have been defensive in bear markets. High dividends may act as a break on pushing these stocks down in bear markets. The high cash flows allow the companies to purchase more shares if the prices fall, which in turn should boost EPS and allows the dividends per share to rise even if total outlay for dividends is flat. More consolidation can occur in bear markets and thus there are normally buyers for these stocks. The end result is the returns have the potential to keep coming in good times or bad times. Dividends are paid and shareholders earn cash returns.

As we moved through 2010 and into 2011, we have sought to rotate more into low P/E stocks like we’re finding in the defense sector, and out of high P/E stocks like we’re seeing in gaming. For example, Wynn Macau is still a fine company. It is one of the less leveraged casino companies in Las Vegas and has new properties to compete against older properties that need to be updated. It has growth potential with its Chinese properties that have continued to see more visitors and increased gambling profits. The issue for us is that it pays a very minor dividend and was trading at 40x forward earnings. That is hardly cheap. We realized profits on Wynn Macau and reallocated the proceeds into defense stocks yielding more than 3% and trading at about 9x earnings.

Early 2011 can be largely summed up with Lorillard. Lorillard was going to hurt performance in 4Q and early 1Q as the market worried about potential negative action on menthol by the FDA in the spring. The stock at the time was in the mid-$80s and fell steadily through January into the low-$70s. As the company is mostly dependent on selling menthol cigarettes, we understood that fear would drive this stock down.

The over-riding issue was that Lorillard was still very cheap in our view. The company was gaining market share, trading at a steep discount to the group, had very little debt, and was boosting its dividend by 30%. On our cost, the stock was yielding over 9%. In the market, it was yielding between 6%-7%, which again was a discount to its group. Plus, we still believe it may eventually get bought out as part of the consolidation of the industry at a higher price. Thus, the potential upside outweighed the short-term risk of holding the full position. Therefore, we held the investment during the down time and endured the fear of potential problems with menthol.

As the initial reports from the FDA subcommittee came in, it was clear that the subcommittee wanted to get tougher with menthol, but it did not want to ban it. The whole thing is getting more study and in our view will probably involve additional labeling when this is all done. In the meantime, lifting the subcommittee risk drove the stock back to $95 and Lorillard’s continued strong results, repurchases, and dividends have now pushed the stock above $105.

The Vice Fund’s outperformance is due largely to three issues (mentioned above): P/E expansion among the tobacco and gaming sectors, high dividend growth with the stocks trading up so that the current yield remained flat (more dividend income valued at the same yield means the stock price rises), and then the sizable appreciation in Lorillard. In a stock market that searched for earnings growth - gaming in Macau stood out as an area that attracted many investors who continued to buy the stocks. As these companies completed their debt offerings for new projects, this risk diminished and the stocks were well-rewarded by investors as the P/E ratios increased. Tobacco companies also saw their P/E ratios expand and generate appreciation. The same was not true of many other S&P 500 Index stocks where earnings rose, but the P/E ratio did not. These two Vice Fund sectors saw both earnings growth and P/E expansion, which helped the outperformance. In addition, nearly every stock we hold saw a dividend increase. With the attention paid to low interest rates, investors have focused more heavily on dividends for income. Companies with growing dividends saw greater appreciation than the S&P 500 Index as a whole.

In terms of portfolio strategy during the 1Q period, we have begun writing covered calls on some positions. Covered calls are a lower risk way to boost total return for the shareholders. It allows us to generate income from some stocks in the portfolio that do not pay a dividend or pay a very nominal one. So far the call writing has centered on defense stocks and some of the alcohol names.

In terms of the overall weightings in the portfolio, we ended 1Q with tobacco at 31%, alcohol at 23%, defense at 27%, gaming is 12%, and cash is 7%. The cheapest sector is by far defense where P/E ratios are less than 10 and dividends are often greater than 3%. We also see more consolidation happening there and have added some smaller companies that appear to be good buy-out candidates, like Applied Signal was for us in 4Q. Mantech International and SAIC Inc. were bought with that thought in mind. Even in the event they are not acquired, they trade at only 12x EPS and are heavily focused on fast-growing areas of defense such as cyber warfare and intelligence gathering.

 Gaming remains the most expensive sector and we have been taking profits there. Moreover, while there has been growth in the foreign areas for gaming, we are up against the limit on foreign stock ownership and would have to reduce our alcohol positions to add more. Given the valuations and lack of dividends versus alcohol, we are opting to stick with alcohol over gaming at this time. The foreign gaming stocks are valued at 20x-35x forward earnings. We sold the most expensive one, Melco Crown in 1Q. Domestic gaming still breaks down into highly leveraged casino companies that have under-spent on maintenance for years and the slot-machine makers that represent pent up demand as that maintenance spending is done. We continue to focus on the slot machine makers for our domestic exposure.

Fund Holdings and sector allocations are subject to change at any time and are not recommendations to buy or sell any security.  Please (click here) for the fund’s holdings.
Opinions expressed are those of the portfolio managers and are subject to change, are not guaranteed and should not be considered a recommendation to buy or sell any security.

The S&P 500 Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general. You cannot invest directly in an index.
Cash flow measures the cash generating capability of a company by adding non-cash charges (e.g. depreciation) and interest expense to pretax income.

Earnings per share (EPS) is calculated by taking the total earnings divided by the number of shares outstanding.

Price/Earnings (P/E) Ratio is a common tool for comparing the prices of different common stocks and is calculated by dividing the current market price of a stock by the earnings per share.
EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization. An approximate measure of a company's operating cash flow based on data from the company's income statement.

Basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.

Free cash flow is revenue less operating expenses including interest expenses and maintenance capital spending. It is the discretionary cash that a company has after all expenses and is available for purposes such as dividend payments, investing back into the business or share repurchases.