Looking back at 2009, what were the biggest surprises?

Reflecting back on the past year, we were most surprised by the willingness of market participants to so swiftly forget recent events. It was surprising to see how quickly the sentiment pendulum swung from fear to greed. We’ve seen what happens when too much risk is married with too much leverage. It isn’t pretty. Yet, by March 2009, investors were willing to embrace risk again as if nothing had happened. Yet, in our opinion, lessons have not been learned. We expected the healing process to take longer and carried a healthy cash position. We believe that the lesson on risk will be re-examined this year. As risk gets re-priced again, we expect investors to rotate back into more defensive consumer staples like tobacco and beverages.

In 2009, FDA legislation was passed. Has this thrown a wrinkle in your outlook for tobacco?

We don’t believe this new law will have a material adverse impact on an industry that has been operating in a highly regulated environment for years. Similar laws are already in place in many other developed tobacco markets and have had little discernible effect. For example, consider the new mandate on cigarette packaging. As intrusive as it is, there’s been little correlation between increased warning language and imagery on cigarette packs and consumption in other developed markets. Further, the new FDA legislation will be implemented gradually over many years and won’t have any immediately noticeable impact on the industry. Finally, in the absence of marketing and with the cost of a pack of cigarettes increasing, brand equity is even more important. One last point: While the new FDA regulation also bans flavored cigarettes, these restrictions do not apply to menthol and, in our opinion, the possibility of menthol being banned is slim. We remain positive on tobacco due to tobacco companies’ strong pricing power, an expected moderation in cigarette volume declines and the sector’s attractive valuation. We prefer international tobacco to domestic, but we see great opportunities globally within tobacco.

MGM opened its ambitious (and costly) CityCenter project, which is meant to be literally a city within a city. What’s the status of Vegas? Are you seeing any signs of a rebound? Where are the opportunities within gaming?

We have yet to see any meaningful rebound in Las Vegas, though things are stabilizing. Gaming revenue on the Vegas Strip has declined for 22 of the past 23 months. Average daily room rates have been under $100 since February 2009, still well below their peak of $147 in April 2007. CityCenter has added a ton of supply to an already fragile market, which could have an adverse impact on room rates. Vegas’ fortunes are largely dependant on the health of U.S. consumers and, frankly, they are not well. Trillions of dollars of American household wealth have melted away in recent years. Joblessness is still elevated, mortgage delinquencies and home foreclosures are on the rise, incomes are plummeting and credit availability is contracting at lightening speed. Until these factors abate, we’re in wait-and-see mode on Vegas. But we’re very keen on Macau, where demand continues to be strong. Macau is the ultimate Chinese consumption play; its growth is largely tethered to the fastest-growing major economy in the world and its powerful consumer.

Has your outlook for aerospace or defense changed at all in recent months? What is your outlook for these sectors and how is the Vice Fund positioned?

We’ve been getting incrementally more positive on the aerospace cycle in general and we see value in some of the aerospace suppliers. Load factors are improving (albeit at the expense of prices), traffic is perking up and airline profitability is on the mend. We’re not quite there yet – we need to see yields improve and traffic growth needs to expand to correct the oversupply of aircraft in the system – but we are starting to see some rays of light. New orders are a long way off, but backlogs are so high already that we don’t really need new orders as much as a removal of the risk of orders getting cancelled or deferred, which will happen if yields begin to improve. As for defense, the core defense budget is likely going to continue to rise, despite the market view (and valuations) that reflect a defense budget coming down due to broader U.S. budget deficits. The supplemental budget (now called the “Overseas Contingency Operations” budget), which we thought would come down in the near-term, is actually getting a $33 billion boost to finance a surge in Afghanistan.

Finally, what is your outlook for 2010 and how are you incorporating this view into the portfolio?

Since March of last year, investors have been increasingly more willing to bear risk. Stocks have been driven to a valuation level that now reflects a full and self-sustaining economic recovery. It might happen, but that perfect scenario is already reflected in the price, in our opinion. But there is a wide range of other possible outcomes that might also happen. Uncle Sam’s generosity can only go so far, and without it, the recovery might stumble. At some point in 2010, probably within the first half of the year, we expect the market to re-price downside risk. And we expect that defensive areas – for example, consumer staples like tobacco and beverages – have the potential to dramatically outperform the broader market. The Vice Fund’s portfolio is heavily weighted towards more defensive sectors and we believe that should serve shareholders well in the coming year.

Fund Holdings 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.