Date of this interview: 2-20-09

Dian: I've read that Donald Trump's casinos aren't doing well and that gambling stocks aren't doing well either. I thought that the Vice Fund and the kinds of companies it invests in would be hot stuff given current market conditions. Where have I gone wrong?

Charles: From a business perspective, many of the sectors that we focus on are proving to be somewhat resilient on an operating level.

Dian: What does that mean?

Charles: For example, there is sort of a disconnect right now between what is driving stocks and the actual fundamentals of the businesses. Right now, stocks are being driven by macro-level variables like the need for liquidity, deleveraging and unprecedented government policy actions globally. That's really trumping anything fundamental.

So what we're seeing in some of our businesses, in particular tobacco, is that operationally they are doing very well. The demand for cigarettes is actually proving to be very resilient and that might not necessarily be reflected in the stock prices. But from an operating performance basis the companies are still doing well. In terms of gaming, which you specifically asked about, that's sort of the outlier. We have actively reduced our gaming exposure over the past 12-18 months, and that sector has really collapsed.

Dian: Why?

Charles: First of all it's a very capital-intensive business at a time when capital is not available.

Dian: Meaning individuals need to have a lot of disposable cash to spend to gamble with?

Charles: No. Meaning they ---the companies---are constantly building and expanding and developing new properties and that's extremely capital intensive.

It costs billions of dollars to build a new property these days. So access to debt is important and unfortunately a lot of companies with large-scale development plans dreamed up during better times, bit off more than they could chew as reflected in today's more difficult environment. Access to capital is not in existence and at the same time consumer discretionary spending is being extremely curtailed. So they are sort of getting hit at the EBITDA level at the same time they are choking on their balance sheets. (EBITDA is an acronym for "earnings before interest, taxes, depreciation and amortization".)

Dian: Now take me to the war. Isn't wartime supposed to be prosperity time?

Charles: The most important variable that drives defense stocks is growth in the defense budget. Specifically, budget authority on two parts of the defense budget: procurement and research and development (R&D). As long as procurement and R&D are growing typically defense stocks outperform. Now defense budget growth is not economically sensitive: Sometimes it grows in recession; sometimes it declines in good times. It's not linked to economic crisis.

We happen to think that it (defense spending) will continue to grow for at least the next two years, based on three bipartisan growth drivers. One, and most importantly, is that we still have a very high threat level globally and there is a very tight link between the global geopolitical threat and spending on defense.

The second factor is the need to maintain jobs. The industry employs about two million middle class jobs. I think that there's a strong need to see that middle class people continue to have jobs.

And then third is to recapitalize our aging military. Today our military equipment is excessively old and needs to be recapitalized.

So you can sort of tie all three of those factors together and I think that we will still see budget growth. At least in the two most important parts--- procurement and research and development ---for the next few years.

The part of the budget where I think that there is risk of seeing some decline is the supplemental budget.

Dian: So standing here and looking forward, what do you think regarding the fund?

Charles: We're seeing a lot of opportunities. They are selective opportunities. It's not an across-the-board sector bet, because there's a significant skew between winners and losers in our sectors. We're especially attracted to tobacco right now on the international side in particular. We see some opportunities in large-cap pure play defense contractors, too, for the reasons I just talked about. Neither of those, tobacco or defense, is driven by economically sensitive variables.

Dian: Like gaming is?

Charles: Right. Like gaming is. Gaming is more sensitive to GDP growth and so we continue to still sort of be on the sidelines to gaming.

In the Vice Fund we can also short stocks and so in gaming, while we have had shorter-term shorts within the sector over the past year, we're on the sidelines right now because I think most of the money has been made from the short side. And the short side is pretty crowded. At the same time, it's too early to get aggressive on the long side. So we're mostly out of the sector except for very small plays.

We're also finding opportunities in beverages, as well. They are different than they were six or 12 months ago but opportunities are still there.

Dian: I've heard sales of beer were way off?

Charles: It depends on what market you're talking about. In the US we're seeing a trade down so domestic beer is doing okay because they have strong pricing. But import and craft beer is not doing as well. If you look at the UK, beer sales are down significantly. But, there are opportunities elsewhere.

The Vice Fund is a globally oriented fund in strategy so we seek out growth around the world and there are certainly parts of the world where there is growth. It may be decelerating but it's still positive.

Dian: How many stocks in the fund?

Charles: As of 12.31.08 there were 20 stocks held in the fund.

Dian: So what are the reasons that I can use to conclude why Donald Trump's casino properties are in trouble? Will it be because of everything you've just told me?

Charles: His properties in particular have been in trouble because they were just sub-par relative to competitors, and, they just needed major upgrades. At the same time, they didn't have the balance sheets to be able to do that.

Dian: Back to your fund. Are you optimistic about the near-term future?

Charles: Although I am selectively optimistic on the near term, as I believe there are pockets of opportunity within the industries we invest, our focus has always been on providing long-term value, and we are proud of our long-term performance afforded to shareholders.

Like I said, it's not an across-the-board sector, meaning that there are pockets of opportunities within our universe.

Dian: How do you like managing this fund?

Charles: I love it. We're very deep in these sectors and it's great to be focused on a part of the market many other investors are not. I think really that creates a big opportunity. There has actually been some academic research. Because of investor constraints these sectors tend to be under-followed and overlooked, so that creates some inefficiencies that we try to exploit by focusing exclusively on them.

Dian: That's it for now, Charles. And thanks for your time.