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July, 2015

Performance Highlights:
The Vilas Fund, LP, has substantially outperformed the S&P 500 Index and the HFR Fundamental
Value Index since its inception in August, 2010:
Growth of $1 Million Net of Fees
August 9, 2010, through June 30, 2015

$3,500,000
$3,000,000
$2,500,000
$2,000,000
$1,500,000
$1,000,000
$500,000
$0

Vilas Fund

S&P 500

HFR Fundamental Value Index

The Vilas Fund, LP, has compounded at the following rates for the period ending June 30, 2015:
Vilas Fund
3.87%

S&P 500 TR
Index
1.23%

HFR Fundamental
Value Index
3.94%

1 - Year

17.26%

7.42%

3.01%

3 - Year
Since Inception on
August 9, 2010

50.06%

17.31%

10.73%

25.28%

15.58%

7.77%

Year-to-Date

Further, the Vilas Fund has produced extraordinarily tax-efficient historical returns:
Time Period
1 - Year
3 - Year
Since Inception on
August 9, 2010

After Fees, PreTax Return %


11.52%

After Fees, Estimated


After-Tax Return %
9.89%

50.96%

50.22%

27.40%

26.72%

Assumptions:
1) From 8/9/10 through 12/31/14
2) Filing joint tax return
3) Highest Federal Tax Bracket
4) State effective tax rate of 5%
5) Use standard deduction unless portfolio deductions and
investment interest expense exceed standard
6) Assume investor invested since inception, 8/9/10

Assuming the highest Federal Tax Rate and a state effective tax rate of 5%, an investor in the Vilas
Fund since inception would have lost, on average, only 0.68% per year to taxes.
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Strategy Overview:

Given the large number of new partners in the Fund and the increase in interested parties, we thought it
would be helpful to summarize our investment strategy and the academic foundation of our approach. I
developed the Vilas Funds strategy over the last 22 years through analyzing past mistakes, learning
from great investors, and combing through academic data. Mistakes usually occurred when I paid too
much for a companys stock that didnt live up to expectations. Also, when I tried to be too cheap by
investing in companies with major problems, our results suffered. To learn further, I studied those
individuals who were extremely successful in the field of money management. It became clear that
most of them were value investors, especially over longer periods of time. I studied the great ones,
including Benjamin Graham, Joel Greenblatt, Mason Hawkins, Sam Zell, Warren Buffett, and David
Dreman, among others. It is no secret these famous investors attribute much of their long-term
success to the value philosophy of buying equities of low-priced, out-of-favor companies. While
working on my business degree at the U of C, I was extremely fortunate to take a course in Corporate
Finance from Robert Vishny. Professor Vishny, along with Josef Lakonishok and Andrei Shleifer, coauthored a seminal value investing paper titled Contrarian Investment, Extrapolation and Risk in 1994.
These three professors used their paper as the basis for LSV Asset Management, a firm with a top
industry track record and over $90 billion of assets under management today.
The basic foundation of the Vilas Funds strategy is that cheap, undervalued stocks, defined as those
stocks with low price-to-book, low price-to-earnings, and/or low price-to-cash flow ratios, outperform
expensive companies over time. Further, those companies with low barriers to exit, low supplier power,
low buyer power, strong brand names, little threat of substitutes or new entrants, and higher switching
costs have better economic returns than those companies without these attributes. Lastly, when we
identify materially overvalued equities with less than ideal economic and financial characteristics, we
initiate and hold short positions with the goals of reducing portfolio risk and increasing expected return.
We point to key excerpts from the Contrarian Investment, Extrapolation and Risk paper by
Lakonishok, Shleifer, and Vishny (1994) that form the academic underpinning of our strategy:
Value Stocks Outperform Growth Stocks:
While there is some agreement that value strategies have produced superior returns, the
interpretation of why they have done so is more controversial. Value strategies might produce
higher returns because they are contrarian to naive' strategies followed by other investors.
These naive strategies might range from extrapolating past earnings growth too far into the
future, to assuming a trend in stock prices, to overreacting to good or bad news, or to simply
equating a good investment with a well-run company irrespective of price. Regardless of the
reason, some investors tend to get overly excited about stocks that have done very well in the
past and buy them up, so that these glamour stocks become overpriced. Similarly, they
overreact to stocks that have done very badly, oversell them, and these out-of-favor value
stocks become underpriced. Contrarian investors bet against such naive investors. Because
contrarian strategies invest disproportionately in stocks that are underpriced and underinvest in
stocks that are overpriced, they outperform the market (see De Bondt and Thaler (1985) and
Haugen (1994)).

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On average over the postformation years, the low B/M (high P/B) (glamour) stocks have an
average annual return of 9.3 percent and the high B/M (low P/B) (value) stocks have an average
annual return of 19.8 percent, for a difference of 10.5 percent per year. If portfolios are held with
the limited rebalancing described above, then cumulatively value stocks outperform glamour
stocks by 90 percent over Years 1 through 5.
The results in this article establish (in varying degrees of detail) three propositions. First, a
variety of investment strategies that involve buying out-of-favor (value) stocks have
outperformed glamour strategies over the April 1968 to April 1990 period. Second, a likely
reason that these value strategies have worked so well relative to the glamour strategies is the
fact that the actual future growth rates of earnings, cash flow, etc. of glamour stocks relative to
value stocks turned out to be much lower than they were in the past, or as the multiples on
those stocks indicate the market expected them to be. That is, market participants appear to
have consistently overestimated future growth rates of glamour stocks relative to value stocks.
Third, using conventional approaches to fundamental risk, value strategies appear to be no
riskier than glamour strategies. Reward for bearing fundamental risk does not seem to explain
higher average returns on value stocks than on glamour stocks.

Is It Because Value Stocks Are Riskier?:


Two alternative theories have been proposed to explain why value strategies have produced
higher returns in the past. The first theory says that they have done so because they exploit the
mistakes of naive investors. The previous section showed that investors appear to be
extrapolating the past too far into the future, even though the future does not warrant such
extrapolation. The second explanation of the superior returns to value strategies is that they
expose investors to greater systematic risk. In this section, we examine this explanation
directly.
Value stocks would be fundamentally riskier than glamour stocks if, first, they underperform
glamour stocks in some states of the world, and second, those are on average bad states, in
which the marginal utility of wealth is high, making value stocks unattractive to risk-averse
investors. This simple theory motivates our empirical approach. The results show that value
strategies have consistently outperformed glamour strategies. Using a 1-year horizon, value
outperformed glamour in 17 out of 22 years using C/P (Cash Flow/Price) to classify stocks, in 19
out of 22 years using C/P and GS (Growth Rate of Sales), and in 17 out of 22 years using the
B/M (P/B) ratio. As we move to longer horizons, the consistency of performance of the value
strategy relative to the glamour strategy increases. For all three classification schemes, the
value portfolio outperforms the glamour portfolio over every 5-year horizon in the sample
period.
A second approach is to compare the performance of value and glamour portfolios in the worst
months for the stock market as a whole. Table VII, Panel 1 presents the performance of our
portfolios in each of 4 states of the world; the 25 worst stock return months in the sample based
on the equally weighted index, the remaining 88 negative months other than the 25 worst, the
122 positive months other than the 25 best, and the 25 best months in the sample. The average
difference in returns between value and glamour portfolios for each state is also reported along
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with t-statistics for the test that the difference of returns is equal to zero. The results in this table
are fairly clear. Using both the B/M and (C/P, GS) classification schemes, the value portfolio
outperformed the glamour portfolio in the market's worst 25 months.
...the betas of value portfolios with respect to the value-weighted index tend to be about 0.1
higher than the betas of the glamour portfolios. As we have seen earlier, the high betas
probably come from value stocks having higher up-market betas, and that, if anything, the
superior performance of the value strategy occurs disproportionately during bad realizations of
the stock market. Even if one takes a very strong pro-beta position, the difference in betas of 0.1
can explain a difference in returns of only up to 1 percent per year (assuming a market risk
premium of 8 percent per year) and surely not the 10 to 11 percent difference in returns that we
find.

Conclusion and the Behavioral Tendencies the Vilas Fund Exploits:


This conclusion raises the obvious question: how can the 10 to 11 percent per year in extra
returns on value stocks over glamour stocks have persisted for so long? One possible
explanation is that investors simply did not know about them. This explanation has some
plausibility in that quantitative portfolio selection and evaluation are relatively recent activities.
Most investors might not have been able, until recently, to perform the analysis done in this
article. Of course, advocacy of value strategies is decades old, going back at least to Graham
and Dodd (1934). But such advocacy is usually not accompanied by defensible statistical work
and hence might not be entirely persuasive, especially since many other strategies are
advocated as well.
We conjecture that the results in this article can best be explained by the preference of both
individual and institutional investors for glamour strategies and by their avoidance of value
strategies. Below we suggest some reasons for this preference that might potentially explain the
observed returns anomaly. Individual investors might focus on glamour strategies for a variety of
reasons. First, they may make judgment errors and extrapolate past growth rates of glamour
stocks, such as Wal-Mart or Microsoft, even when such growth rates are highly unlikely to
persist in the future. Putting excessive weight on recent past history, as opposed to a rational
prior, is a common judgment error in psychological experiments and not just in the stock market.
Alternatively, individuals might just equate well-run firms with good investments, regardless of
price. After all, how can you lose money on Microsoft or Wal-Mart? Indeed, brokers typically
recommend good companies with steady' earnings and dividend growth.
Presumably, institutional investors should be somewhat more free from judgment biases and
excitement about good companies than individuals, and so should flock to value strategies.
But institutional investors may have reasons of their own for gravitating toward glamour stocks.
Lakonishok, Shleifer, and Vishny (1992b) focus on the agency context of institutional money
management. Institutions might prefer glamour stocks because they appear to be prudent
investments, and hence are easy to justify to sponsors. Glamour stocks have done well in the
past and are unlikely to become financially distressed in the near future, as opposed to value
stocks, which have previously done poorly and are more likely to run into financial problems.
Many institutions actually screen out stocks of financially distressed firms, many of which are
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value stocks, from the universe of stocks they pick. Indeed, sponsors may mistakenly believe
glamour stocks to be safer than value stocks, even though, as we have seen, a portfolio of
value stocks is no more risky. The strategy of investing in glamour stocks, while appearing
prudent, is not prudent at all in that it earns a lower expected return and is not fundamentally
less risky. Nonetheless, the career concerns of money managers and employees of their
institutional clients may cause money managers to tilt towards glamour stocks.
Another important factor is that most investors have shorter time horizons than are required for
value strategies to consistently pay off (De Long et al. (1990) and Shleifer and Vishny (1990)).
Many individuals look for stocks that will earn them high abnormal returns within a few months,
rather than 4 percent per year over the next 5 years. Institutional money managers often have
even shorter time horizons. They often cannot afford to underperform the index or their peers for
any nontrivial period of time, for if they do, their sponsors will withdraw the funds. A value
strategy that takes 3 to 5 years to pay off but may underperform the market in the meantime
(i.e., have a large tracking error) might simply be too risky for money managers from the
viewpoint of career concerns, especially if the strategy itself is more difficult to justify to
sponsors. If a money manager fears getting fired before a value strategy pays off, he will avoid
using such a strategy. Importantly, while tracking error can explain why a money manager
would not want too strong a tilt toward either value or growth, it does not explain why he would
not tilt slightly toward value given its apparently superior risk/return profile. Hence, these horizon
and tracking error issues can explain why money managers do not more aggressively arbitrage'
the differences in returns across value and glamour stocks, but they cannot explain why such
differences are there in the first place. In our view, such return differences are ultimately
explained by the tendency of investors to make judgmental errors and perhaps also by a
tendency for institutional investors to actively tilt toward glamour to make their lives easier.
It is clear from the above academic analysis and data, which have been expanded through recent
periods and shown to work equally well around the world by firms such as Brandes and others, that The
Vilas Funds strategy is based upon solid footing. We are thankful to have learned from some of the
best investors in the world, listed above, and to have met and studied under Professor Rob Vishny.
The 4 trips to Omaha were also some of the greatest learning experiences an investment professional
could hope for, especially regarding security selection, portfolio construction, and tax efficiency. While
we know that no strategy works every month, quarter, year, or even, occasionally, multi-year periods,
empirical data show cheap stocks outperform expensive ones over longer time horizons.

Investment Commentary:
The Vilas Fund, LP, commenced operations on August 9, 2010. In a few short weeks, the Fund will be
five years old. Our performance continues to exceed the market and our competition by healthy
margins over longer time frames. However, in the summer of three particular years, 2011, 2012, and
now 2015, the exact same external force has caused significant selloffs and market angst: Greece.
After being up ~6% in the middle of the quarter, we finished the quarter slightly in the red. How a
country of 11 million people and $240 billion of GDP (which is smaller than the economy of Wisconsin),
in a world with over 6 billion inhabitants and $87 Trillion in GDP, could cause so much trouble in three
years out of the last five is remarkable. Greece is entirely irrelevant and any selloffs due to the media
circus surrounding its issues were, and will continue to be, wonderful times to buy value stocks.
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Currently, we see attractive opportunities in large financial services companies around the world, select
major integrated oil firms, a Japanese auto manufacturer, and a few consumer staples providers. In a
world of new market highs occurring almost daily, we continue to find companies trading extremely
inexpensively relative to the market, their own histories, and other investment options including cash,
bonds, and real estate.
For example, Deutsche Bank, one of our holdings, is ridiculously cheap. It is trading around $33 today,
down from over $70 five years ago. It would be hard to argue that this stock is extended. In fact, it is
only a few dollars above its five year low and isnt too far above its nadir during the worst of the 2008
2009 Financial Crisis. Its long-term owners are rightfully asking what bull market?
Deutsche Bank has a tangible book value per share of $46. Hypothetically, this means that if DB shut
its doors, sold off all its assets and paid off all its debts, shareholders should receive $46, a gain of
~40% from here. Additionally, DB has a large asset management business, with $1.2 trillion in client
funds, that does not consume much, if any, capital. Thus, in our hypothetical shutdown scenario, this
business unit would remain open because its returns on equity are very, very high. We figure the asset
management business is worth roughly $15 per share as a standalone entity. Further, if the investment
banking and traditional banking businesses were put into run-off instead of liquidation, they would
create massive earnings during the wind-down, creating additional value for shareholders. However,
ignoring this fact and continuing with the thought experiment of shuttering most of the banks activities,
this strategy would create a $15 stock representing the ongoing asset management business and
payout a $46 dividend to shareholders. Our math says that equals $61 in total value per share, nearly
double DBs current stock price today.
We believe the new CEO of Deutsche Bank will create an entity that is worth far more alive than dead.
This value will take time to unfold, however. In five years, we project DBs tangible book value per
share could grow to roughly $60. While this company has sold at well over 2 times book value in the
last 10-15 years, we think that as the industry rationalizes, the price-to-tangible book multiple on a good
day could hit 1.5. Thus, five years out, this stock should trade at $90, inclusive of dividends, indicating
it could compound at over 25% per year on average for the next 5 years. Does this seem farfetched?
Cigna, one of the largest health insurers, recently turned down an offer to be acquired by Anthem for 4
times book value and roughly 20 times tangible book value. The health insurance business, has, at
times, been a tough industry and is heavily regulated, not unlike todays global banking industry.
Further, with the stroke of a government pen, the healthcare industry could be rendered nearly
obsolete if the U.S. eventually allows all citizens into Medicare, the path chosen by every other
industrialized country. Banks do not have the risk of obsolescence by government fiat. They have
other risks, clearly. But, the need for banks can never be supplanted by government programs.
Because banks are the most critical part of any capitalistic economy (witness the effects of the Lehman
bankruptcy and bank closures in Greece), we believe that they will experience material increases in
their operating metrics as the industry rationalizes. Improved returns will drive significant multiple
expansion.
With respect to the expensive tail of the P/B distribution of the equity market, the bubble in many
sectors continues to inflate at an increasing rate. Social media, cloud computing, gadgets like GoPro
and Fitbit, online entertainment, green energy, green transportation, biotechnology, and behavioralbased security software companies are trading at astronomical valuations relative to other parts of the
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market and as compared to history. Seeing this occur so soon after the bubble inflated in 1998 and
1999, which was one of my toughest periods as a value investor, is remarkable. The only salient point
we can think of to explain this is those who fail to learn from history are doomed to repeat it. The
stocks that we are short should offer considerable ballast in the type of market correction that we
expect to occur next: one similar to the 2000-2002 bursting of the Tech Bubble.

Price vs. News and Sentiment:


We are constantly asked questions from prospective investors and industry participants about our
holdings and our strategy vis--vis the news of the day. For example, conversations frequently begin
with, did you see that this company beat their numbers?, or, did you see the fines that company had
to pay and the new regulations that they are facing?, or, isnt the healthcare law hurting the US
economy?, and, of course lately, What about Greece?. In the very short-run, i.e. 30 days, the news
is important. However, over longer periods, todays news is irrelevant and any focus on it in the context
of investment decision-making is highly counterproductive.
Using current economic news, world events, and earnings growth to buy stocks, irrespective of price,
does not work. In 1999, the news of the day could not have been more positive. Budget surpluses led
to some market commentators projecting a shortage of U.S. Treasuries as the U.S. debt was paid off.
Rapid productivity growth due to technological advancements and the Internet, rapid wage growth,
extremely low unemployment, etc were all positives during this time. Buying stocks and holding them in
1999, however, did not work because the price of equity was extremely high. In fact, it worked horribly.
On the other hand, in early 2009, the economic picture could not have appeared bleaker. The news of
the day included unemployment skyrocketing towards 10%, the U.S. banking system on the verge of
collapse, a possible deflationary spiral, a $1.4 Trillion deficit, negative GDP growth, etc. However,
stocks were extremely cheap. They have tripled since.
A similar phenomena occurs with investors interpretation of market news and individual stocks. Better
not buy Deutsche Bank because Greece is in trouble. I recently saw a participant on CNBCs Fast
Money show suggest shorting DB due to the Greek situation. However, Tesla sold 11,500 cars this
quarter, 500 more than the top-end of their range. Buy! There is no mention of the price of these
equities in many publicly available reports and more importantly, the value relative to current price.
It appears that many investors are using the news of the day alone to form their opinions. In the long
run, this will prove to be very foolish. To put Teslas sales in perspective, Acura sold 6,278 cars in May,
which means they sold roughly 18,000 cars in the second quarter. Acuras revenue is a rounding error
inside of its parent company, Honda. However, Tesla has a market capitalization only 40% smaller
than all of Honda (which also makes 15 million mopeds and motorcycles annually, recreational
equipment, generators, and a new high speed, high efficiency private jet, etc). This makes no sense.
Honda sold 355,000 cars in May, roughly 5 times more cars than Tesla has sold since its inception.
This market cap comparison also ignores the roughly 1.2 million motorcycles and mopeds that Honda
sold in May as well as the ATV, boat motor, generator, and lawn mower businesses, and the new $4.5
million HondaJet. The jet is faster than most in its class and is more fuel efficient. Its also quieter,
spacious, and its a Honda, so most would expect greater reliability, which matters a lot in aviation for
obvious reasons. Price is what matters: our money is on Honda at 1 times book value and 10 times
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expected earnings instead of Tesla at 42 times book value and cash flow losses running ~$500 million
per quarter.
News, while interesting to read, is not your friend when making investment decisions. It is the news 5
years from now that matters. At Vilas, we use competitive strategy, balance sheet analysis,
microeconomics, and macroeconomics to attempt to predict the news far into the future. We tend to be
more right than wrong.
Purchasing inexpensive equities protects our clients, to a significant degree, from permanent loss of
capital, our primary goal. Our long portfolio is currently trading at 0.98 times tangible book value per
share and 10.5 times 2016 estimated earnings, both on a weighted average basis. The names we own
include Deutsche Bank, Morgan Stanley, Citigroup, JP Morgan, Metlife, BP, Honda, Coca Cola, and
Wal-Mart. It is a low purchase price plus improving business conditions from higher interest rates, an
improving housing market, and higher consumer incomes that will drive excess returns from these
investments over time. On the other hand, stocks trading at 37 times tangible book value (like those in
our short portfolio) and 145 times non-GAAP earnings estimates for 2016 (which erroneously add back
stock compensation to make earnings appear far better than they really are) perform horribly over the
long-run. They were too expensive to start with. Due to high valuations, capital is drawn into these
high flying businesses, increasing competition and diminishing returns over time. Microeconomics
works.
We are running the Fund in a manner that attempts to rapidly compound our investors capital on an
after-tax basis while positioning ourselves to profit from the next major downdraft in the bubble-like
portions of the market. While our past returns will be difficult to replicate, we do see great opportunities
in the market today. Thank you for your confidence in our firm and in the Vilas Fund.
Sincerely,

John C. Thompson, CFA


CEO and Chief Investment Officer

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Disclosure:

Performance data represents past performance and does not guarantee future results. Performance
includes the reinvestment of dividends and other earnings. Net performance is net of all fees and is
based upon the current investors fee structure. Future performance will vary depending upon each
investors capital account and fee structure. The Vilas Fund, LPs specialized investment program
involves risk. A detailed review of the risk factors are described in the offering materials, which you
should read carefully before considering an investment in The Vilas Fund, LP. The current performance
may be higher or lower than the performance data provided herein. The Vilas Fund, LP, performance
may not be directly comparable to the performance of other private or registered funds.
The Vilas Fund, LP, is a private fund and the securities are offered in reliance on an exemption from the
registration requirements of the Securities Act and are not subject to the protections of the Investment
Company Act. The Securities and Exchange Commission has not reviewed the securities or the
offering materials. The Vilas Fund, LP, securities are subject to legal restrictions on transfer and resale
and investors should not assume they would be able to resell them.
All information contained herein is subject to revision and completion. Should there be a discrepancy
between the offering materials and this document, the offering materials will control. This document is
not intended to be a complete description of the business engaged in by Vilas Capital Management,
LLC, nor is it an offering or solicitation to invest. Any such offer or solicitation may be made only by
means of a confidential private offering memorandum. No subscriptions will be received or accepted
until subscription documents are completed and Vilas Capital Management, LLC, has approved the
subscription agreement and an investors eligibility to invest. Prospective investors must be accredited
investors and must meet certain minimum annual income and/or net worth thresholds in order to be
eligible to invest.
The S&P 500 Index represents 500 of the United States largest stocks from a broad variety of
industries and includes reinvested dividends. The HFRX Equity Hedge Index consists of equity hedge
strategies that maintain positions both long and short in primarily equity and equity derivative securities.
A wide variety of investment processes can be employed to arrive at an investment decision and
strategies can be broadly diversified or narrowly focused and can range broadly in terms of levels of net
exposure, leverage employed, holding period, concentrations and valuation ranges.

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