December 18, 2006 5:23 pm

Vice beats virtue in the battle for high returns

Bugs Bunny would occasionally have an angel sitting on one shoulder and a devil on the other. Each one would be pulling on his ear, telling him what to do in critical situations. Vice versus virtue. Virtue versus vice. Those two opposing poles distract us at every major decision point during out lives.

This year Vice is the winner. The Vice Fund, run by Charles Norton, is up 20 per cent so far this year, while the Ave Maria Catholic Values Fund is up 14 per cent. While keeping pace with the market - no small feat - Vice has clearly pulled ahead thanks to stalwart companies like Las Vegas Sands (up 131 per cent) and cigarette company Reynolds (up 40 per cent). I had a chance to sit down with Norton and dig a little further on how Charles, a self-described family man, finds value in vice.

Define “vice”?

The Vice Fund (VICEX) is really an alternative sector strategy that focuses on the alcohol, tobacco, gaming and defense industries, and we do so because we believe they offer true investment merit. By the way, many of the most widely held and well-known mutual fund families own shares in companies engaged in the alcohol, tobacco, gaming or defense businesses – Berkshire Hathaway is one of the largest holders of Anheuser-Busch. We just happen to focus exclusively on these four sectors.

Why is that an investment theme?

The ideology is simple: people around the globe have been drinking, smoking, gambling for hundreds, if not thousands, of years. Wars have been around since the earliest, hunter-gatherer societies. Few industry groups have a history that dates back that far. And no matter what is happening in the world economy, people will continue to drink, smoke, gamble and nations will need to defend themselves. As a result, in general these companies tend to be steady performers in good times and bad – they are mostly insulated from economic slowdowns.

Besides the unvarying demand for their goods and services, there are other investment merits in the companies within these sectors. These businesses have high barriers to entry, and, in general, these companies are highly profitable with deep management teams. With regard to tobacco and alcohol specifically, the products are never made obsolete by a newer technology. And these businesses are global in nature; we have roughly 23 per cent of our portfolio invested in foreign companies that trade in the U.S. via ADR, and many of the domestic firms we have a stake in operate internationally.

Do you think the Vice Fund presents a more attractive opportunity than funds like Ave Maria

Virtues Fund?

We do not perceive them as our competitors. It’s a gray area. I should point out that many of the companies we own in the Vice Fund are stand-up corporate citizens.

What are some of your current holdings and why are they cheap?

Our top holding right now is Altria Group. The stock is trading at a significant, 20-plus percent discount to the global consumer staples industry despite in-line earnings growth prospects. I believe there are three issues that have depressed MO’s valuation: litigation risk; its current corporate structure; and the uncertainty surrounding the timing of the break-up of the food and tobacco businesses. All of those issues are now largely removed, but the valuation still doesn’t reflect that. On the litigation front, the industry has enjoyed a huge streak of defense verdicts. Today, the U.S. tobacco industry has a legal risk profile comparable to other large-scale industries. The timing of Altria spinning off Kraft is now certain – it will be announced on January 31 and will likely be effective in the first quarter. As the restructuring approaches, I believe the stock move towards its sum-of-parts valuation, which is conservatively $100, or around 20 per cent higher than current levels.

Las Vegas Sands has been a core holding of ours for well over a year, and it’s been a huge winner for our shareholders. The stock isn’t cheap, but the growth potential here is off the charts. In 2004, Las Vegas Sands opened the first casino in Macao after the long-time monopoly was liberalized in 2001. Macao is just exploding – this year, only two short years after the first non-monopoly casino opened, total Macao gaming revenue is going to surpass the Vegas Strip. The company recently expanded the Sands Macao and is developing the Cotai Strip. As a result, Las Vegas Sands will benefit tremendously as Macao goes from largely a VIP market to a mass market, and convention business booms. Elsewhere in Asia, Singapore ended a 40-year casino ban last year and Las Vegas Sands will open the first casino there 2009. And Japan and Thailand are also studying whether to allow casino gaming; Las Vegas Sands has already been in talks with Japanese officials. Today, roughly 60 per cent of Las Vegas Sands’ revenue and EBITDAR comes from Macao. All told, in the coming years, around 90 per cent of revenue and EBITDAR will come from Asia.

On the alcoholic beverages side, our largest holding is Diageo, the leading premium spirits business in the world by volume, by net sales and by operating profit; it also manages 9 of the world’s top 20 spirits brands. North America is experiencing the fastest growth in spirits volume in the world, as consumers are choosing spirits (and wine) over beer. The market leader in the fast-growing U.S. spirits market is Diageo, with about a quarter of the market. The company is a key supplier of liquor to Wal-Mart, which is aiming to aggressively boost its liquor sales, and it’s buying back stock hand over fist.

What’s your outlook for the US economy over the next year and how do you think the Vice Fund will behave in various economic climates?

The alcohol, tobacco, gaming, and defense sectors, in aggregate, are defensive in nature and tend to outperform the broad market in periods characterized by relatively low returns and periods with relative stagnancy, or worse, in the U.S. economy. Ironically, the Vice Fund was launched in August 2002 and has only operated in an economic expansion. It would logically seem that a defensive fund like the Vice Fund would lag the market in that environment, but in fact the Vice Fund has outperformed the S&P 500 – and is in the top decile of all multi-cap core funds – over every time period, according to Lipper.

But the fact is, when the economy contracts these sectors truly shine. And that is the precise environment we seem to be entering.

The economy is slowing rather dramatically, led by a sharp contraction in the housing market, and the yield curve’s steep inversion suggests a recession cannot be entirely ruled out. The Fed Chairman himself has said that the time lag from when a policy action is taken and when it’s fully felt could be as long as 18 months; there have been 9 interest rate hikes in the past 18 months that might not have made their way through the system, so further slowing is a real possibility. And, of course, geopolitical tensions are high: conflicts in the Middle East, North Korea’s missile tests, and Iran’s nuclear arms intentions.

We think that with time and the changing economic environment, the Vice Fund will perform strongly in all seasons.

Do you use all the products you invest in?

I’m a family man. My wife and I live in the Dallas suburbs with our three-year-old and infant daughters. I don’t smoke, rarely gamble, and drink only on occasion. We are not making a political statement or advocating these activities in any way. Our job is to analyze the fundamentals of these businesses. We are very serious investors and we take a very methodical, analytical approach in investing in these sectors.

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