Gotham’s New Fund

Joel Greenblatt was in Barron’s recently.  He is one of my favorite investors so maybe it’s a good time for another post.

Anyway, this new fund is kind of interesting as I am sort of a tinkerer;  this is like the product of some financial tinkering.  I don’t know if it’s the right product for many, but we’ll take a look.

But first, let’s see what he has to say about the stock market in general.

The Market
Greenblatt says that the market is “expensive”.  The market is in the 21st percentile of expensive in the past 25 years. Either a typo or he misspoke, he is quoted as saying that the market has been more expensive 79% of the time in the past 25 years.  Of course, he means the market has been cheaper 79% of the time.

The year forward expected return from this price level is between 2% to 7%, so he figures it averages out to 4% to 6% per year.  In the past 25 years, the market has returned 9% to 10%/year so he figures the market is 12% to 13% more expensive than it used to be.

He says:

Well, one scenario could be that it drops 12% to 13% tomorrow and future returns would go back to 9% to 10%.  Or you could underearn for three years at 4% to 6%.  We’re still expecting positive returns, just more muted. The intelligent strategy is to buy the cheapest things you can find and short the most expensive.  

But…
Immediately, bears will say that this 25 year history is based during a period when interest rates went down.  The 10 year bond rate was around 8% back in 1991, and is now 1.8%.  In terms of valuation, this would have pushed up asset values by 6.2%/year ($1.00 discounted at 8%/year then and $1.00 discounted by 1.8% now).

Declining rates were certainly a factor in stock returns over the past 25 years.  Of course, the stock market didn’t keep going up as rates kept going down.  The P/E ratio of the S&P 500 index at the end of 1990 was around 15x, and now it’s 25x according to Shiller’s database (raw P/E, not CAPE).   So the valuation gain over the 25 years accounted for around 2%/year of the 9-10% return Greenblatt states.

Here are the EPS estimates for the S&P 500 index according to Goldman Sachs:

          EPS     P/E
2016  $105    20.4x
2017  $116    18.5x
2018  $122    17.6x

Earnings estimates are not all that reliable (estimates have been coming down consistently in the past year or so).  But since most of 2016 is done, I suppose the $105 figure should be OK to use.

I don’t know if it’s apples to apples (reported versus operating etc.), but if we assume the ‘current’ P/E of the market is 20x, then the valuation tailwind accounted for 1.2%/year of the 9-10%.  But then of course, even if this was a fair comparison, there is still the aspect of lower interest rates boosting the economy by borrowing future demand (and therefore overstating historical earnings).

In any case, one of the main bearish arguments is that this interest rate tailwind in the past will become a headwind going forward.  Just about everyone agrees with that.

But as I have mentioned before, calling turns in interest rates is very hard, Japan being a great example.  If you look at interest rates over the past 100 years or more, you see that major turns in trend don’t happen all that often; it’s been a single trend of declining rates since the 1980/81 peak, basically.  What are the chances that you are going to call the next big turn correctly?  I would bet against anyone trying.  OK, that didn’t come out right.  I wouldn’t necessarily be long the bond market either.

Gotham Index Plus
So, back to the topic of Gotham’s new fund.  It is a fascinating idea. The fund will go long the S&P 500 index, 100% long, and then overlay a 90%/90% long/short portfolio of the S&P 500 stocks based on their valuations.

The built-in leverage alone makes this sort of interesting. Many institutions may have an allocation to the S&P 500 index, and then some allocation to long/short equity hedge funds.  The return of the Gotham Index plus would be much higher (when things go well).

I think this sort of thing was popular at some point in the pension world; index plus alpha etc.  Except I think a lot of those were institutions replacing their S&P 500 index portfolios with futures positions, and then using the cash raised to buy mortgage securities.  Of course, when things turned bad, oops; they took big hits in S&P 500 futures, tried to post cash for the margin call and realized that their mortgage funds weren’t liquid  (and was worth a lot less than they thought).

Or something like that.

There is risk here too, of course.  You are overlaying two risk positions on top of each other. When things turn bad, things can certainly get ugly.

I think Greenblatt’s calculation is that when things turn bad, the long/short usually does well.  I haven’t seen any backtests or anything, so I don’t know what the odds of a blowup are.

Expensive stocks tend to be high-beta stocks and cheaper stocks may be lower beta, so in a market correction, the high-beta, expensive names may go down a lot harder.

To some extent, lower valuations may reflect more cyclicality, lower credit risk / lower balance sheet quality too so you have to be a little careful. In a financial crisis-like situation, lower valuation (lower credit quality) can tank and some higher valuation names may hold up (like the FANG-like stocks).

But Greenblatt’s screen is not just raw P/E or P/B, but is tied to return on capital, so maybe this is not as much of an issue compared to a pure P/B model.

The argument for this structure is that people can’t stay with a strategy if it can’t keep up with the market.  Here, the market return is built in from the beginning and you just hope for the “Plus” part to kick in. In a long/short portfolio, the beta is netted out to a large extent so can lower potential returns.  This fixes that.  But there is a cost to that.

In any case, I do think it’s a really interesting product, but keep in mind that it is a little riskier than Gotham’s other offerings.

Oh, and go read the article on why this new fund is a good idea.  Greenblatt is always a great read.

Chipotle (CMG)
Well, Chipotle earnings came out and it was predictably horrible.  The stock is not cheap so it hasn’t been recommendable in a while, but I really like the company.  There was a really long article on them recently which was a great read.  It didn’t really change my view of them all that much.  I think they will get a lot of business back, eventually.

The earnings call was OK, but what was depressing about it was that they decided to ditch  Shophouse.  I don’t think any analysts asked about it so it was a given, I guess.  I had it a couple of times in DC and liked it and was looking forward to it in NY, but I guess that’s not going to happen.  As an investor, that was not baked into the cake, I don’t think, even though there was probably some hope that the CMG brand can be extended into other categories.

This puts a lot of doubt into that idea.  Someone said that brand extensions in restaurants/retail never work, and that has proven to be the case here.  I wouldn’t get too excited about pizza and burgers either.  Burgers are really crowded now and will only get more so.

If CMG has to look to Europe for growth, that is not so great either as the record of U.S. companies expanding into Europe is not good.  I would not count on Europe growth.

Anyway, this doesn’t mean it’s all over for CMG. I think they will come back, but there are some serious headwinds now other than their food poisoning problem; more competition etc.  They were the only game in town for a while, but now everyone seemingly wants to become the next Chipotle, so there are a lot of options out there now.

As for Ackman’s interest in CMG, I have no idea what his plan is.  There is no real estate here as CMG rents all their restaurants, and their restaurants had high 20’s operating margins at their peak.  I don’t know if they will ever get back up there, but it’s not like these guys don’t know how to run an efficient operation.  Maybe Ackman sees SGA opportunities, but pre-crisis, SGA was less than 7%, so there wouldn’t be that much of a boost from cutting SGA. Or maybe he thinks it’s time for CMG to do what everyone else is doing and go for the franchise model.  Who knows?  I look forward to seeing what his thoughts are; hopefully some 500 page presentation pops up somewhere…

McDonalds
I don’t want to turn this into a food blog, but I can’t resist mentioning this.  I have been a lifelong MCD customer; I have no problem with it.  OK, it may not be my first choice of a meal in most cases, but it’s fine.  And when you have a kid, you tend to go more often that you’d like.  But still, it’s OK. It is what it is, right?

I like the remodelling that they are doing, and the fact that they have free wifi is great too.
But here’s a big clustermuck they had with their recent custom burger and kiosk idea.  I walked into a MCD without knowing anything about any of this recently.  A lady said I can order at the kiosk and I said, no, I’ll just go to the counter, thank you.

And I waited 10 minutes or so in line, looking up at the tasty looking special hamburgers on the HD, LCD menu board.  It was finally my turn at the cash register and I said I want that tasty looking hamburger up there on the screen.  And the lady said, oh, you can only order that at the kiosk. I was like, huh?  That was really annoying.  So I wait all this time and I can’t get what I want; I have to walk all the way back and get in another line again? Come on!  At that point, I didn’t want any other burger so I just ordered a salad (and the usual for my kid).

OK, so it’s my fault, probably.  User error.  But as a service company, as far as I’m concerned, that was a massive fail on the part of MCD.

OK, Now That I started…
And by the way, since I got myself started, let me get these two out too.  Yes, I spend too much time at fast food joints.  Guilty.  But still, here are my two peeves related to two of my favorite fast casual places:

Shake Shack:   Being dragged there all the time, I have learned to love the Shack-cago hot dog. Chicken Shack is awesome too, in case you don’t want to eat hamburgers all the time. But I can’t tell you how often they get take-out and stay wrong.  I had a long run where they didn’t get it right at all and had to ask for things to be packed to go.  It is really annoying and wastes everyone’s time.

Chipotle:  This hasn’t happened to me the last couple of times, but this is the usual conversation that happens to me just about every time I go to Chipotle.

CMG: “Hi, what can we get you today?” (or some such)
Me: “Um, I’ll have a burrito…”
CMG: putting the tortilla in the tortilla warmer/cooker, “and would you like white rice or brown rice?
Me: “White rice is fine”
CMG: with tortilla still in the cooker, “and black beans or pinto beans?”
Me: “black beans”.
CMG: laying a sheet of aluminum foil on the counter and placing the tortilla on it, moving over to the rice area, “Was that white rice or brown rice?”
Me: “white rice”
CMG: sliding over to the beans, “and black beans or pinto beans?”.
Me: “black”.

I can’t tell you how many times this exact thing happened to me.  If you can’t remember what I say, don’t ask beforehand!  Just ask when we get to whatever you are going to ask me about!  This is not rocket science, lol…  Incredibly annoying.

Anyway, I still love CMG and will keep eating there.

Oh, and to make things interesting, I decided to post a contact email address in the “about” section of the blog.  I will try to respond to every email, but keep in mind I may not look in that email box all the time.

I will try to post more, though.