Interview with Jeff Middleswart of the Vice Fund
Chimps and Chimpettes,
As promised, here is your interview with a Portfolio Manager. Mr. Jeff Middleswart of the Vice Fund was kind enough to answer a few questions from the list of queries you guys posed last week.
Hope you enjoy.
3M: What is your outlook on markets in general and on the Vice Fund itself, going forward?
JM: I feel, the market is probably overbought at this time after doubling of late. The investment world is not as leveraged as it was in 2008, but of the problems that lead to the sell-off: how many have actually been fixed?
Housing is just now being allowed to go to the foreclosure process, which is likely to push prices lower as will the higher mortgage rates we’re seeing now. Government spending has gone beyond absurd since we were going to scale back and that’s a world-wide issue. Banks have rebuilt equity thanks to a fat interest spread, but now they have to deal with commercial loan problems, housing, and rising rates, plus the liquidation of Fannie and Freddie hasn’t happened yet.
On the positive side for the market, I believe the level of inflation that may hit from all the government printing will crush the bond market via higher interest rates and most likely lead more people back into stocks. Stock inflows have been largely negative for a couple years while bond inflows were very positive. So there is considerable money that can swing back.
On Vice stocks, I’m extremely positive on continued growth in many of the emerging markets where the countries have real economic growth, developing local markets rather than relying 95% on exporting, and they don’t have nearly the level of debt. That should enable beer, spirits, and cigarette consumption to continue growing in those areas along with rising populations. Moreover, the vice stocks have successfully boosted prices in the recession and grown market share. They do not need external funding and have been able to drive shareholder returns with share repurchases and increases in dividends. That will be big if interest rates rise because fixed rate bonds will get hit, while rising dividend stocks will be touted as a great hedge and seemingly many companies in the Vice Fund have shown the ability to boost dividends repeatedly.
Defense/aerospace is one of my favorite areas now because those stocks are the cheapest among our universe. They pay big dividends and there is consolidation going on so many companies will be acquired at premiums in the coming years. We had a two year collapse in aerospace spending that is starting to return now, so these stocks are cheap on historically low earnings. In defense, other governments are buying more systems and the US government continues to spend increasing amounts for cyber-warfare, intelligence, homeland security, and anti-terrorism systems such as perimeter defenses that stop attacks on chemical plants. Older weapons systems will be maintained and modernized as well. There will be areas of defense where spending will decline, but many others will continue to show growth and we think returns in that area could be very strong in the future.
3M: Do you plan on adding any categories to the Vice Fund? What is your approach to marketing? How do you get your name out there?
JM: Our rules require a minimum of 80% of assets to be allocated to tobacco, alcohol, defense/aerospace, and gaming. So that is not something that is going to change. We are always exploring new opportunities and we are currently taking a closer look at some chemicals and perhaps nuclear power, as well. Our over-riding theme is to own companies that provide solid cash flows regardless of the economy, that have high barriers to entry, that can reward shareholders with that cash flow via dividends and share repurchases, and where they may be further consolidation down the line.
Marketing – We have the best of both worlds in that we can show studies which have shown how this investment philosophy can beat the stock index over time. We have growth with emerging markets and acquisitions. We have a defensive portfolio for bear markets with high yields and lower valuations. We can also provide high income levels that can beat many bond funds. Furthermore, unlike most mutual funds, this is one where the investor can actually fully understand our investment strategy, as well as, familiarize themselves with many of the companies in which we invest. We post our all of our holdings each quarter as well as provide monthly commentary at vicefund.com. Our philosophy is Invest Your Knowledge, and we feel shareholders of the Vice Fund have the unique ability to leverage their own experience and our insights to become more informed investors.
3M: How are you taking positions in foreign companies? Are you buying into their ADR equivalents or trading them in local markets? Additionally, are your positions solely limited to the equity markets or do you used Fixed Income products and "approved" derivatives in order to help generate real returns for the fund?
JM: We are limited to 33% foreign holdings. We own only equities and do use a combination of ADRs and stocks owned in local markets. We can buy fixed income products but have no intention of doing that at this time. Our derivative use has been very minor to this point and has focused on low risk and ideally producing additional income – such as writing covered calls.
3M: How do you account for the production risks, particularly within commodities with respect to increased costs of grains, potatoes, and other basic ingredients for alcohol, in selecting what beverage companies to invest in?
JM: Thus far, the alcohol companies have had little trouble passing through higher costs. The largest costs that these companies face is actually packaging and marketing. We tend to focus on the larger firms that have better economies of scale in terms of purchasing power and the ability to support new brands with cash flow from existing ones (basically incremental cost of distributing a new type of beer or vodka is very minimal as they are already dropping off shipments at warehouses and stores – this gives them a huge advantage over a start-up company that has to build its distribution system.) Much of the focus of these companies has been to consolidate so that total duplicate costs can be eliminated. This strategy works very well. The commodity cost of grains has not been a major issue for them. By dealing with the larger players though, they have the ability to contract for grains in advance and hedge their costs.
3M: Of the small universe of alcohol companies, how do you view InBEV with respect to other companies involved. Additionally, what do you think of the smaller publicly traded beer brewers in the US, namely SAM, The Boston Brewing Company, HOOK, Craft Brewers Alliance, and whether or not we will see the further emergence of other publicly traded small breweries?
InBev is a favorite because it has been rapidly paying down debt since the merger. They are very dominant in Latin America (Brazil in particular) which is a growing market. I expect InBev to pay debt down to about 2x EBITDA by the end of 2011, which will move another $15b from debt to the stock and then paying a sizeable dividend that would be about $5 billion annually. Valuing that at a 3% yield, would make BUD stock worth over $160b vs about $90b now.
Small brewers will always exist to some degree. Their future will be using the distribution systems that the major breweries have in place. Some of them will be acquired by BUD, SABMiller, TAP if they larger ones think they can grow the niche market further. For the most part though, small craft brewers will be popular in local markets and find it difficult to take-on a nationwide/worldwide audience as they simply lack the plant, distribution, and capital to pull it off.
3M: What type of education would you personally say is desirable within the portfolio management field? MSF, CFA, Engineering/Math Degree, MBA in Finance, etc? How does one progress from the junior/analyst level up the ladder to managing a portfolio? What is the best way to set yourself up on this route?
JM: I have a finance degree with an heavy emphasis on accounting and also took a great deal of history. To a large degree the finance and accounting issues can be learned at any time. What is very valuable is having knowledge of other areas in order to gain an edge on competition. For example, there is a huge investment world that focuses on start-up drug/biotech companies. These are stocks where 80% are worthless, 20% work out and 5% of those are home runs. Nearly all of them rise and fall in huge swings. People who have a background in biology and chemistry can laugh at some of the business plans on the surface because they know that certain things simply do not work. That type of non-finance knowledge would be valuable in cutting through the obvious losers in that field. The same can be said with regards to geology and engineering helping sort winners and losers in oil/gas drilling, gold mining, copper smelting, etc.
I’ve found history does repeat itself over and over and it’s amazing how many solid companies look the same and how the frauds circle back, as well. Also, don’t get lost in tiny details. Finance and accounting teach precise calculations.
You’re much better off understanding what makes a ratio improve or collapse than what the number is now. This way you will understand the business model better and where a company is in its cycle. Too many people focus on ROI for this company is 5.998339485% and can’t put that in context, which is if their borrowing costs are 10% and ROI is less than that, this doesn’t work.
Analyst – step one is to learn a couple of industries very well and follow those. Then step two is to become a generalist that looks at opportunistic situations that can exist in any industry. Be proactive with PMs – if you know they own company A and you think company B is better – propose the swap. People like to hear ideas and will hash them out with you. Don’t be afraid to take something that sounds off-the-wall or is contingent on another event. Those type of discussions will teach you risk/reward evaluation. Normally, you will become an assistant PM and basically work more closely on a specific portfolio – then if your group does well – you can be a PM.
A few quick questions to close it out...
3M: Wine, Liquor or Beer?
JM: Not liquor. With food – wine, other times beer
3M: Favorite Beer?
JM: Samuel Smith’s Pale Ale
3M: Favorite Liquor?
JM: Appleton Rum
3M: Favorite Personal Vice? – JM: Horse racing
3M: Favorite Brand of Vice Product Sold? JM: Premium vodka always fascinates me – it’s not aged, it’s pure distilled alcohol with almost no such thing as a “family secret recipe” and probably the closest pure commodity in vice. And yet, distributors manage to sell 80 different bottles to every bar
Many thanks to Jeff and the folks over at the Vice Fund.
Nice Midas, nice. But you forgot to ask him if he is taking interns.
Good job Midas, would love to see more of this!
Appleton is a Jamaican rum by the way
Fantastic interview thanks.
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