Last week I sat down with John Thompson, head of Vilas Capital, to talk about value investing, and why everyone should do it.
Many of the biggest names in finance – from Warren Buffett to Bill Ackman to Benjamin Graham – all proudly call themselves value investors. The group of investors who tout the practice is so large, that I was beginning to wonder why everyone wasn't a value investor. So I sat down with one, John Thompson of Chicago's Vilas Capital, to figure out why.
Why are you a value investor?
I went to U Chicago – and there’s a lot of academic research out of there which shows how value stocks outperform growth stocks by a decent margin. If you just cut the S&P 500 in half, that proves to be true. If you only look at the top and bottom deciles, the cheapest and the most expensive tenth of the S&P, the cheaper decile outperforms the most expensive decile by about 11% over a 5-year-period, statistically.
So that’s the basic reality or trend that our fund seeks to take advantage of – on both sides. We’re long on the value side and short on the really expensive growth.
How do you pick them on each side?
Our longs are trading at less than 0.87 % of book value and our shorts are trading at 21 times book value, and the S&P is like 2.5 or 3 – just to give you a general idea. Citibank (C) is one of our biggest holdings right now, and BP (BP) on the oil side.
What are you long on now?
Most of the big banks are under valued. I own them all, except Wells Fargo (WFC), which is just too expensive. My biggest holdings are Citibank, Bank of America (BAC), and Morgan Stanley (MS). I think that eventually the market and the political climate will change so that it becomes unpopular to keep bashing on the big banks.
Click on the interactive charts below to view data over time.
What about community banks and such? Wouldn't those stocks be cheaper?
Big banks are roughly half the price of local banks. Usually it’s the other way around, but small-caps have outperformed large caps to begin with for a while now, since 1999, I would argue. Also small banks have lower capital requirements than the bigger banks, so that drives their ROE up, which means they trade a little higher on price to book.
But bigger banks have their advantages too, they’re a little more global, etc. Especially Citibank. Roughly half their earnings come from emerging markets.
And you think that's an important advantage for them?
Certainly, the number of people in the middle class worldwide in the next 10-20 years is probably going to double, which means not only more people buying consumer goods (toothpaste and stuff like that) but also opening up checking accounts.
Citibank’s the best equipped to take advantage of that situation by far, they operate in over 160 countries so far, and if you’re in an emerging market and you have a lot of wealth, those customers are still interested in using western banks.
Although, it's important to keep track of what they're doing with their loans because they go bankrupt every 30 or 40 years, but we think this thing can really move, and will be in the hundreds within the next couple years.
What about the flip side, what are your shorts?
LinkedIn (LNKD), Netflix (NFLX)… A lot of tech stocks are just way too expensive right now. One of our biggest shorts is Amazon (AMZN). When I did the math on Amazon about a week ago, the stock was $360 bucks a share with earnings of about 80 cents per share. Let's say over the next 10 years you want to earn about 11% per year, because as an equity holder you should earn something right?
Bear with me here.
For you to earn that 11% a year, 10 years from now that stock would have to be worth about $1000 a share. Let's say at the end of that period its price to earnings is about where old tech trades – keeping in mind that by then it’ll be about 26 years old a la Microsoft (MSFT) today.
Those stocks trade at 13-14 times earnings. If I’m giving Amazon a 17 times multiple by them I’m being very fair. So, a thousand bucks divided by 17, they need to earn like 60 bucks a share, up from 80 cents. In 10 years.
And you don't think that's going to happen?
The math is so incredibly bad, there’s just probably no way that’s going to happen. If that actually happens, great, I was wrong. But Amazon has only made about $2 billion in profits in its existence, in 16 years. Citibank has the same market cap and earned over $3 billion last quarter. People are essentially sitting at the black jack table with a 20, betting on an Ace. That’s what they’re doing with these stocks. If people are going to do that, I’d just as soon be the dealer.
Are there other tech stocks that are closer to fair value?
Well yeah things like Microsoft or Cisco (CSCO) trade with way lower price to book, but they're also probably not going to grow very much. No one's lining up to buy desktop computers anymore.
So should someone invest in tech at all?
Tech investing right now is just really hard, so I’m avoiding it entirely. I made some money off of Hewlett Packard (HPQ) this year but I sold it. By and large tech investing is not really investing; it’s speculation. Generally speaking the earnings of most of these firms will go to zero eventually. Companies come around and they have a great product for a while, and then they go away.
Investors shouldn’t think about how to get a lot of money quick by finding the next Twitter (TWTR) or Google (GOOG) or Facebook (FB). They should think, hey, this money’s precious, I don’t want to lose it: How about Pepsi (PEP), or Procter & Gamble (PG), or Citibank? Something you know could be around forever?
So if value stocks are so much more reliable why doesn't everyone do it?
There's a great paper from one of my old teachers at Chicago, “Contrarian Investments: Extrapolation and Risk” which basically says that value outperforms growth. Well if we know that, then why doesn’t everyone do this? And what they basically said was that it was two factors, naiveté on one hand and institutional pressures on the other.
So let's say you run a mutual fund, and Twitter and Google are going up like crazy, and you’re sitting there on BP, and it’s not really keeping up. After two years you start looking really dumb if you’re surrounded by people making easy money and you’re not.
And then your clients are probably reading about Twitter in the paper, and they want to know why you don’t own Twitter. So unless you control the fund, you’re going to have some pressure to do what everyone else is doing, even if it's not necessarily optimal things for client and job retention. Not owning Apple (AAPL) could get you fired.
Do you see investing opportunities in some of John's stock picks? Use the interactive list below to begin your analysis.
1. Citigroup, Inc. (C, Earnings, Analysts, Financials): Provides consumers, corporations, governments, and institutions with a range of financial products and services. Market cap at $151.68B, most recent closing price at $49.99.
2. Morgan Stanley (MS, Earnings, Analysts, Financials): Provides various financial products and services to corporations, governments, financial institutions, and individuals worldwide. Market cap at $57.37B, most recent closing price at $30.05.
3. BP plc (BP, Earnings, Analysts, Financials): Provides fuel for transportation, energy for heat and light, retail services, and petrochemicals products. Market cap at $146.06B, most recent closing price at $46.45.
4. Hewlett-Packard Company (HPQ, Earnings, Analysts, Financials): Offers various products, technologies, software, solutions, and services to individual consumers and small- and medium-sized businesses (SMBs), as well as to the government, health, and education sectors worldwide. Market cap at $51.1B, most recent closing price at $26.49.
5. Bank of America Corporation (BAC, Earnings, Analysts, Financials): Provides banking and financial services to individuals, small- and middle-market businesses, corporations, and governments primarily in the United States and internationally. Market cap at $156.92B, most recent closing price at $14.64.
6. MetLife, Inc. (MET, Earnings, Analysts, Financials): Provides insurance, annuities, and employee benefit programs primarily in the United States, Japan, Latin America, the Asia Pacific, Europe, and the Middle East. Market cap at $55.9B, most recent closing price at $50.03.
8. Netflix, Inc. (NFLX, Earnings, Analysts, Financials): Provides subscription based Internet services for TV shows and movies in the United States and internationally. Market cap at $19.82B, most recent closing price at $335.28.
(Interview conducted by James Dennin, with John C. Thompson, CEO and Chief Investment Officer of Vilas Capital Management. All opinions expressed in the interview are his and his alone, and do not consitute an offer to sell securities of any kind.)
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