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VICEX $12.88
AS OF 11/11/2008
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| Vice Fund (VICEX) 2Q 2008 Portfolio Manager Commentary |
As managers of the Vice Fund, we take a global approach in our exclusive focus on
the tobacco, alcoholic beverages, gaming and aerospace/defense sectors. With the
U.S. economy contracting and a global slowdown becoming a real possibility, defensive
sectors like those we concentrate on appear particularly attractive, as the fundamental
outlook of many of the companies in our portfolio is generally not contingent on
robust economic conditions. People around the world continue to consume alcohol
and tobacco, for example, regardless of the state of the economy.
But the long-term and short-term don’t always line up, and the Vice Fund’s
second quarter was a disappointment. That said, we take a long-term perspective
in our focus on what we believe are the highest quality stocks in our investment
universe and we understand that our journey is not a linear one. From that vantage
point, we remain confident about the prospects for the Vice Fund. We continue to
believe that, as the U.S. economy falters, our global focus on historically resilient
sectors – combined with astute stock selection – should pay off.
Here, in brief, are our updated views of each of our target sectors and a summary
of their recent performance.
Within the tobacco sector, we are more tepid on the U.S.-focused cigarette makers
as volume declines are at risk of accelerating in the face of state excise tax increases
and the possibility of a federal excise tax hike next year under a new administration;
the prospect of FDA regulation is also troublesome. There are some select opportunities,
though, particularly for companies with the strongest brand portfolios and those
that have the financial flexibility to repurchase stock. Looking overseas, many
of the global cigarette makers have benefitted from a favorable international operating
environment where they have enjoyed strong pricing power. Consumers in emerging
markets have continued to trade up to higher-priced, international brands. Historically,
the tobacco sector has offered earnings stability and dividend security, vital attributes
in this otherwise uncertain market environment. Cigarette makers, too, benefit from
low input costs that are mostly immune from inflationary pressure.
Our defense-sector view is largely influenced by our expectations that budget authority
on modernization (procurement plus development) should continue to increase for
at least one more year; historically, this has been one of the most critical drivers
of defense-stock relative performance. As a result, we expect the major defense
contractors to do well in this latter part of the budget cycle, once the election
jitters have run their course. On the commercial aerospace side, the aftermarket
suppliers that repair and overhaul older airplanes will likely be impacted by capacity
cuts as U.S. airlines park their older planes in the face of rising fuel costs.
The surging price of oil even threatens to abruptly end the multi-year upcycle in
global demand for commercial aircraft, if worldwide air traffic growth slows and
emerging-market airlines begin cancelling orders. However, we believe this is now
adequately priced in to the U.S.-based original-equipment manufacturer and its key
suppliers. The commercial aircraft backlog is significant and, though it will likely
begin to decline next year, we believe that current prices already reflect a pessimistic
scenario.
The brewers continued to be weighed down as higher input costs, like barley and
aluminum, have compressed their margins. Emerging market exposure remains the key
growth driver for the brewers, and concerns of a global slowdown that engulfs the
developing world has taken a toll on the international brewers, which has long been
one of our areas of focus in the Vice Fund. There has also been some acquisition
activity where an emerging-market focused brewer bought (or is attempting to buy)
a slower-growth, mature-market asset, leading to multiple compression. The distillers
have been relatively less impacted by the cost pressures affecting the brewers,
while spirits growth has remained robust. There, we’re mostly focused on the
large, multi-national players with the greatest distribution networks and brand
portfolios.
The sector that unquestionably has been the most impacted by the current economic
contraction is gaming. Though this is not a surprise – we know that gaming
is more sensitive to the business cycle than the broad stock market 1 – we
admit to being amazed by the severity of the gamingsector sell-off. While we have
long been avoiding the casino operators focused on the regional markets –
ground zero of the gaming implosion – even the Macau-oriented companies have
gotten hit (notwithstanding healthy growth in Macau gaming revenue). Las Vegas,
too, has been experiencing a slowdown, and declining cash flow with high levels
of debt is a recipe for trouble for the casino operators. The significant non-gaming
revenue that has boosted Vegas for years has also served to make it more economically
sensitive, akin to other travel and leisure destinations. The equipment makers are
still on the cusp of a massive replacement cycle that will be driven by server-based
gaming, but in all likelihood it’s now been pushed back by as much as a year.
We’re looking forward to better times ahead and firmly believe that our target
sectors should prove to be resilient in tumultuous times for the equity and credit
markets, as they have before. Combined with good stock selection, that should serve
us well through the rest of the year and beyond.
Sincerely, |
Charles L. Norton, CFA
Portfolio Manager |
Allen R. Gillespie, CFA
Portfolio Manager |
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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.
1 “When is Vice Nice for Investment Portfolios from a Quantitative Perspective?”
Herbert Blank and Andrea Psoras, QED International, Dec. 14, 2005
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