Tsunami etc.

Yes, it's a tsunami. Tsunami of liquidity. A fiscal tsunami. Both at the same time. People seem baffled at the strength of the stock market; they keep saying the market is 'divorced from economic reality' and things like that. Others say this is a big bubble waiting to implode. 

I don't mean to argue that the market is always right or anything like that, but the market is reacting to some massive, massive stimulus and liquidity injection. Some of that is bound to leak into the stock market. As I said earlier about  Covid-19, this is forcing governments around the world to try to offset the negative effects of the virus. And as usual, they are going to overdo it. And this, in turn, will lead potentially to a really massive bubble. 

As of now, with S&P 500 forward P/E of 23, or whatever they say, it doesn't really seem all that bubblish. Too, the median P/E ratio of S&P 500 companies on a forward basis is around 18.5x vs. a 15.2x average since 1982, I think. So that is not that crazy looking either, given much lower interest rates now than most of this time period. 

 

People say the S&P 500 forward P/E is as high as it was back in 1999/2000, but don't forget, interest rates were a lot higher back then. Also, the median P/E is much lower than that, which is again, just like 1999/2000. And if you remember 1999/2000, if you didn't own the bubble stocks, you actually did really well throughout the 2000-2002 bear market. It is very possible that this will happen again. Many of the frothy names can have large declines, maybe the S&P 500 index even goes down 50% or more, and people who didn't own the most expensive stocks might actually still do well. So, don't let people scare you out of the market with this talk of market P/E's. If you are happy with what you own and how they are valued, hold on and things should be fine (like it was in 1999/2000). 

This rickety house can symbolize a highly levered equity fund vulnerable to a bear market, but when I saw this picture, the first thing I thought of was all the shorts being steam-rolled by this tsunami (or simultaneous tsunamis). 

Greenblatt and Marks

Anyway, I wouldn't necessarily put this in a category of good news; some would say this is really bad news. But a recent Howard Marks note talked about all the reasons why current market valuations might be reasonable; that the current tech companies leading the market actually has really good, strong business models. Also, Joel Greenblatt was on Bloomberg TV the other day saying we are not in a bubble like 1999/2000 for the same reason; that the recent market leaders have real business models and are really good businesses that might actually deserve high valuations.

 

While not pointing to any individual names, I have been thinking the same thing over the years.

Buffett, Gold and JPM

So, as usual, the financial media is going crazy over the fact that Buffett bought ABX. Most of them didn't even mention that this could be a Ted or Todd pick and not a Buffett pick. Also, he dumped a bunch of JPM, which is actually kind of surprising. Not sure what is going on there. Maybe it's a valuation play as BAC is cheaper. I think Dimon is a much better CEO than Moynihan (who hasn't really been tested yet, whereas Dimon has been through many crises). Maybe BAC has a longer runway as Dimon has health issues. I don't know. Maybe he is a lot more worried about this pandemic than most of us. 

 

Market

Anyway, back to the market. So yes, it's kind of acting contrary to the expectations of many, but not really. If you look at the market leaders, they are really doing well earnings-wise. Sure, this may be a one-time bump for some of these names, but for the most part, Covid-19 is only accelerating what was going to happen anyway (move to cloud, retailers dying off etc...). So there is nothing wrong with being in companies who have been enjoying a tailwind for years and then suddenly gets a big gust from behind. 

As for consumption, as Dimon said, some unemployed, I think he said 60%+, were making even more money from the $600/week assistance than they were making when employed. So that explains the consumption figures. Of course, this is not sustainable forever (new plan hasn't been passed yet as of now). 

I have been spending more time recently looking at things to do due to the extraordinary nature of the what is happening, but I have to say nothing is really jumping out at me. 

I am tempted, of course, to jump into airlines, hotels, real estate, energy, anything travel-related and some other areas hit hard, but nothing is really jumping out at me. If you like any of these businesses and believe in them for the long term and are fairly sure they will survive this crisis without too much dilution, then it's a great idea to buy. 

But the problem is that most of the above businesses are not in areas I would have been interested in pre-crisis. So if I got into any of them now, they would just be 'trades'. I would get in, hold until normalization, and then get out. They would not be situations where I would want to buy and hold forever. So that makes me a little hesitant. 

 

 

Election Stuff

There is a lot of uncertainty about the elections. But as usual, I would say, look back at all the other times we were worried about something. We should never forget 2016 election day. What about the fiscal cliff? All sorts of problems, uncertainties over the years. 

 

So, as usual, I would just say ignore it all. I don't want to talk about politics here as there is plenty of other places to talk about it, and I don't think I have anything to add to what everybody is saying anyway. 

 

But I would say that whatever people worry about, I wouldn't worry too much about it. Whether it's pharmaceutical stocks when Clinton got elected, insurance companies with Obama, financial stocks when Elizabeth Warren was looking good etc. Whenever you have big moves on those worries, as traders, it's actually probably a good idea to trade against it. 

 

Books

I am reading this new book about GE, Lights Out, and it is terrifying. I'm only 1/3 way through it but it sort of confirms what we suspected all along, but at least for me, it's a lot worse than I thought.  

If you always wondered why Buffett always spoke so highly of Immelt and GE but never bought stock (other than emergency financial crisis financing), this would help explain it. I've always wanted to love GE, and it was always on my to-do list to do a detailed analysis of GE and even buy some shares at some point, but it never got to that point because of Immelt. He came across to me as this rah-rah cheerleading type; the kind of manager I would not want to put money with. And his denials and lies throughout the crisis was worrisome too (I didn't realize how much he was lying, though...)

And Immelt apparently still blames Welch, but jeez, the guy ran the place (into the ground) over 16 years; that's enough time to fix things, and many of the big moves / mistakes were his own. It's like a 40 year old man blaming his parents for his behavior.

I am still looking at it and wanting to jump in, but it is quite scary.

Long Book Excerpt

So, during this pandemic, I have been reading a lot as usual, and I started reading an old book that I am embarrassed to say I've never read before. 

Paths to Wealth Through Common Stocks

This is a Philip Fisher book. I think Philip Fisher is sort of underrated compared to Benjamin Graham. Everyone (including me) always talks about Security Analysis and Intelligent Investor, but not everyone talks about Common Stocks and Uncommon Profits or this book. 

That's probably for a good reason. First of all, Graham was the first in setting the ground rules of value investing so comprehensively. But on the other hand, I feel that Fisher has had more of an impact on Buffett (and he admits it) than even many Buffett followers realize. Buffett is still referred to as a 'value' investor, and 'value' is still viewed as things with low P/E ratios and P/B ratios. But Buffett has for decades been saying that he would much rather pay a fair price for a decent business than a good price for a mediocre business (OK, I totally butchered that one, but I'm a little rusty, you see...). 

Anyway, I was reading it and this whole section made me jump out of my seat as I immediately thought of quite a few people I would need to send this book to:

The Economists Go out -- The Psychologists Come In

    I have already commented on the strange tendency of the supposedly forward-looking financial community so often to fail to recognize a changed set of circumstances until the new influence has been in existence for years. I believe this is why the man who attempted to forecast the course of general business was regarded as so important a factor in the making of investment decisions during all of the 1940's and much of the 1950's. Even today, a surprising number of both investors and professional investment men still believe that the heart of a wise investment policy is to obtain the best business forecast you can. If the outlook is one of expanding business, then buy. If the outlook is for a decline, sell.

    Many years ago there was probably considerably more merit to such a policy than there could possibly be today. The banking structure was weaker. There was no assurance it would be shored up by the government in times of real trouble -- a process bound to produce a massive dose of inflation. There was no tax system of a type that can hardly fail to produce strong inflationary spending whenever business (and therefore federal tax revenues) are at abnormally low levels. No public opinion had crystallized to assure that whenever business levels dipped sharply, the government would take strong countermeasures to stem the tide. Finally, the industrial base was much more narrow. The large number of industries in today's complex economy that bear little relationship to each other in their basic characteristics probably assures that even without the actions of government, modern business recession would be somewhat less severe than its former counterpart. Some industries would be enjoying unusual background conditions enabling them to expand, while the majority might be in a declining phase. This tends somewhat to stabilize the economy as a whole.

    All this means that a depression is of less significance to the investor than it was many years ago. It does not mean knowing what business is going to do would not be quite useful information to have. But having such information is not vital for obtaining magnificent results from common stock investments. Simple arithmetic should show this. When a stock market decline coincides with a fairly sizable economic slump as happened in 1937 to 1938 or 1957 to 1958, most stocks sell off from 35 to 50 percent. The better ones then recover when the slump ends and usually go on to new high levels. Even in the greatest slump of all time, only a small percentage of all companies failed, that is, went down 100 per cent. Most of these companies were companies which had had fantastic amounts of debt and senior securities placed ahead of their common. After one of the wildest speculative booms ever known, much of it financed by borrowed money, the average stock slumped 80 or 90 per cent. In contrast, when stocks rise over a period of years, even the most casual study of stock market history shows many figures of a very much greater order of magnitude. Compared to the temporary declines, usually of 35 to 50 per cent, that frequently accompany depressions, the outstanding stocks (those of the unusually well-run companies that have maneuvered themselves into growth fields) go up several hundred per cent, stay at these levels, and then go still higher. Many can be found for which a decade's progress can be measured in multiples of 1000 per cent rather than 100 per cent. 

...

    From the standpoint of obtaining results, I have noticed that investors who place heavy emphasis on economic forecasts in the making of investment decisions usually fall into one of two main groups. Those who are inclined to be cautious by nature can nearly always find an impressive sounding forecast that for quite plausible and persuasive reasons makes it appear that important economic difficulties lie ahead for the business community. Therefore, they seldom take advantage of opportunities when they present themselves and, on balance, these missed opportunities mean the economic forecasts have done them considerable harm. The other group are the perpetual optimists who can always find a favorable forecast to satisfy them. Since they always decide to go ahead with whatever action they are considering, it is hard to see how all the time they spend on business forecasting does much good. 

    More and more investors are coming to recognize the wisdom of making their decisions about common stocks largely on the basis of such outright business factors as appraisal of the quality of the management and the growth potential of the individual company's product line. These things both can be measured with a fair degree of preciseness and have a far greater influence on how good a long-range investment will be... 

This book was published in 1960, and it is amazing as it still applies to this day; there are still people who think that predicting the economy accurately will lead to superior investment results. 

So...
Anyway, this is a fascinating time to be living in. This pandemic is really terrible and I hope we at least find some sort of treatment to take death off the table. I feel this is the key to normalization rather than vaccines. Of course, a vaccine would be great, but it is probably unrealistic to expect one to come within a year. If we can figure out how to treat the worst cases, and this treatment becomes widely available, this would sort of turn Covid-19 into something like the flu.

But who knows, really. 

As for stocks, there is certainly a lot of trading opportunities, but for us long term investors, I would stick to things that have secular growth potential. I don't really feel that excited about buying the dip on something in a long term downtrend. Not to say those can't be great trades. I would rather buy the dip on things in long term uptrends. If things are in secular downtrends but got a bump up due to this, then that's probably a great time to sell.

As for the market, it may seem like it's crazy, but keep in mind the amount of stimulus and liquidity injected into the system. It's not just lower interest rates. Also, people keep talking about overoptimism about the virus, but if you look at hotels, airlines etc., the market is clearly not all that optimistic about anything returning to normal any time soon.

Also, keep in mind that a lot of the big winners this year are making a lot of money; revenues are growing at incredible rates, profits etc. Other than the cloud players, look at COST, WMT, TGT etc. What is happening is that the smaller operators are suffering. Fast food is taking share away from the independent restaurants. As those are closed, if you want to eat out, you have fewer choices so you end up at CMG or QSR (Popeye's). A lot of the eating out money is moving to eating at home (groceries, again, COST, WMT, TGT etc...). 

 

If airline and hotel stocks were making new highs, then I would think the market is nuts. But that's not what's happening. You have to sort of look under the hood to see what's going on, but of course, that's too much work for most! I get it. 

Also, a lot of the revenues / profits that were not listed (small, mom-and-pop restaurants / stores) are moving to listed companies; as independents go under, the only ones left standing are the big ones, and often those are listed companies.

So there is a lot about this market that does make sense. This is not to say the market is always right, or that the valuations of each of these businesses at this point is correct. I am just pointing out that it may not be as crazy as some suggest. Airlines and hotels, REITS are down, and they are down big. Cloud players, stay-at-home beneficiaries are up big. What is so crazy about that? I don't know. 

Also, I think there has been a lot of tech adoption from the never-adopters. I see all these posts about kids teaching their grandparents how to use a tablet, how to get on a Zoom call with family, how to chat on FB, Line, or how to use email. People (many of them seniors) who only used land-line phones and didn't know how to turn on their TV (well, I have trouble with that too with so many remotes and buttons...) are chatting with their kids / grandkids on Skype on their tablets. They are learning how to order things online. 

A lot of this will be permanent. When things clear, many of these newbies will keep using their new devices and will continue to shop in their new ways. Not all of them, of course, and maybe not as often as right now. But this has caused an increase in this market for sure.

 

As for all the talk about how things will never go back to the way it was, that people will never go to conventions ever again, and that client visits will never happen again as Zoom calls work just as well, and offices will decline as people get used to working from home, I think, is rubbish. People always extrapolate what they see. Sure, it may take some time to get back to normal, but things will get back to normal, eventually. 

 

Surely there will be some permanent changes for the better, utilizing things we have learned during this time, and that's great. But I wouldn't expect a lot of this stuff to be permanent by any means. 

 

Wow!

It's been quite a few weeks since my last post. I haven't really changed my thoughts since then, but maybe the economic impact of this will have more than a blip on the long term charts after all.

So far, the economy seems to be doing much worse (or will soon) than the stock market. The initial decline was shocking, but not at all unexpected. The recovery rally is kind of incredible too.

As I watch all these commentators, I realize nobody really has any idea. The commentators / pundits that survive a long time are masters at saying things that will make them look 'correct' in hindsight later on. You make enough calls and predictions, you will at least be able to pick one and say you were right. Also, they are very careful to word their comments so that they can't be called out for being wrong. 'If this happens, then this will happen, if that happens, then that might happen...' etc. You say enough of that, and you will be right about something, eventually... It's kind of a joke, but whatever.

Buffett and Airlines

A lot of things have happened since my last post, including the virtual BRK annual meeting. Nothing really new or unexpected, as usual, but one thing that may have shocked people was how Buffett dumped all his airline stocks. We are supposed to be long term investors, and are not supposed to be reacting to headlines, however scary.

But if you look at their income statements and realize that their revenues are down 90% and may be down for a year or more, it's hard to imagine them surviving. Most of them will be out of business by the end of the year or long before that. The government will have to bail them out, but that will be costly. Either they will have to take on a lot of debt that will take years to pay off, or they will have to issue a lot of equity, basically wiping out current shareholders.

Many businesses will not survive this, and even if they do, there will be big losses to equity investors.

A lot of restaurants will go out of business too, but mostly the independent ones. Major chains, especially fast food and fast casual should be fine.

Retailers are out too, for the most part. A lot of retailers should probably not even exist, and this pandemic is just accelerating what is going to happen anyway. The Micrsoft CEO, Nadella, said that there was two years worth of virtualization in two months since the pandemic. I think that's the case with retailers. This will just accelerate the demise of retailers with flawed (or out of date) business models.

No Bargains?

One thing Buffett said was that he didn't really see any bargains during the decline in March. We know from the 2008-2009 crisis that Buffett is not really a trader, so he is not going to be buying the lows on big down days, necessarily. So on fast declines with quick rebounds, he is not going to get much done.

If you look at what's going on, the stocks that were really hit are the ones that you don't really want to own, necessarily. Airlines, real estate, retail, travel-related stocks etc. And the ones you want to own didn't really get cheap. I can see Buffett piling into things like Amazon or Google if they were dumped with the bath water, but they weren't, really. Neither was Microsoft. Not sure what he thinks of Netflix, but that wasn't dumped either.

So crappy stocks got cheap, but as Buffett said, the way to succeed in the stock market (or at least not lose money) is "don't buy crummy businesses". And there are a lot of them out there now.

People also view Buffett as being 'bearish' because he sold stocks, and he is still sitting on a growing cash balance. He did mention during the meeting that he has a lot of cash, but he has a lot of equity exposure too. I wrote about it a while back, but his equity exposure is not limited to his listed equity portfolio. Kraft is not included in his list of stock holdings, but he still owns it. Same with Burlington Northern, and his many other operating companies (some of which were listed until recently).  If you add it all up, BRK is still fully exposed and is not as conservative as it seems if one were to look only at his listed equity portfolio and cash balance.

Which leads to the next thing being talked about a lot these days (as it has been for the last few years).

Value Investing is Dead?

One thing people need to keep in mind about value investing is that the way the general press talks about it and the way investors talk about it are completely different. The press just looks at nominal valuation and that's it. There is no concept of what something should be worth, and whether it is trading above or below that. They don't understand the concept of intrinsic value. Indexes split between growth and value don't help either.

Value investing used to be about low P/E's and things like that, I suppose, but the more modern approach is what something is trading at versus intrinsic value. This is not that modern, actually, as Buffett has been saying that for many decades.

Here is something from the second edition of Graham's Securities Analysis. This is in the section where he discusses the difference between investment and speculation.

It may be helpful to elaborate our definition from a somewhat different angle, which will stress the fact that investment must always consider the price as well as the quality of the security. Strictly speaking, there can be no such thing as an “investment issue” in the absolute sense, i.e., implying that it remains an investment regardless of price. In the case of high-grade bonds, this point may not be important, for it is rare that their prices are so inflated as to introduce serious risk of loss of principal. But in the common-stock field this risk may frequently be created by an undue advance in price—so much so, indeed, that in our opinion the great majority of common stocks of strong companies must be considered speculative during most of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase. We must warn the reader that prevailing Wall Street opinion does not agree with us on this point; and he must make up his own mind which of us is wrong.

Nevertheless, we shall embody our principle in the following additional criterion of investment:

An investment operation is one that can be justified on both qualitative and quantitative grounds

I would look at the opposite of this example and say that many cheap stocks may not necessarily be safe. Would you buy junk bonds just on yield? Nope. Someone showed me years ago a quantitative report basically showing that the valuation of a stock is pretty much determined by it's credit quality (I don't know if there was an adjustment for long-term growth or returns on capital), but it made sense to me. The industrial cyclicals were always 'cheap', like steel, auto manufacturing etc. And consumer stocks were always expensive.

Anyway, today, I think a lot of this gap between value and growth just may be reflecting huge secular changes in the economy. You can say AMZN is overpriced and BBBY is cheap. But really, who would short AMZN and go long BBBY?

MKL Dumping Stocks

On the 1Q earnings call, MKL said they dumped a few stocks they thought would be hugely affected by Covid-19. Here are the stocks they dumped:

Anheuser-Busch Inbev ADR	0	0.00%	13,000	-13,000	-100%
CDK Global Inc	0	0.00%	176,897	-176,897	-100%
Discovery Communications	0	0.00%	117,000	-117,000	-100%
Dollar Tree Inc	0	0.00%	123,100	-123,100	-100%
Hasbro, Inc	0	0.00%	364,000	-364,000	-100%
Kraft Heinz Co	0	0.00%	68,000	-68,000	-100%
Rockwell Automation Inc	0	0.00%	140,100	-140,100	-100%
Scotts Miracle-Gro Co	0	0.00%	422,000	-422,000	-100%
Unilever PLC ADR	0	0.00%	1,527,600	-1,527,600	-100%
United Health Group Inc	0	0.00%	599,000	-599,000	-100%

This is as of end the March, and they may have dumped more things in April. Buffett dumped airline stocks in April, so that dumpage doesn't show up on his 13-F, which is here, by the way:

BERKSHIRE HATHAWAY INC

Filing Date: 2020-05-15

Name	dollar amt	%port	#shares	change	%chg
APPLE INC	62,340,609	35.52%	245,155,566
BANK AMER CORP	19,637,932	11.19%	925,008,600
COCA COLA CO	17,700,001	10.09%	400,000,000
AMERICAN EXPRESS CO	12,979,391	7.40%	151,610,700
WELLS FARGO & CO NEW	9,276,210	5.29%	323,212,918
KRAFT HEINZ CO	8,056,205	4.59%	325,634,818
MOODYS CORP	5,217,658	2.97%	24,669,778
JPMORGAN CHASE & CO	5,196,030	2.96%	57,714,433	-1,800,499	-3%
US BANCORP DEL	4,563,233	2.60%	132,459,618
DAVITA HEALTHCARE PARTNERS I	2,897,549	1.65%	38,095,570	-470,000	-1%
BANK OF NEW YORK MELLON CORP	2,686,487	1.53%	79,765,057
CHARTER COMMUNICATIONS INC N	2,367,684	1.35%	5,426,609
VERISIGN INC	2,307,964	1.32%	12,815,613	-137,132	-1%
DELTA AIR LINES INC DEL	2,050,935	1.17%	71,886,963	976,507	1%
SOUTHWEST AIRLS CO	1,910,218	1.09%	53,642,713	-6,500	0%
VISA INC	1,701,823	0.97%	10,562,460
GENERAL MTRS CO	1,551,872	0.88%	74,681,000	-319,000	0%
LIBERTY MEDIA CORP DELAWARE	1,446,433	0.82%	45,711,345	-240,000	-1%
COSTCO WHSL CORP NEW	1,235,572	0.70%	4,333,363
MASTERCARD INC	1,192,040	0.68%	4,934,756
AMAZON COM INC	1,039,786	0.59%	533,300	-4,000	-1%
PNC FINL SVCS GROUP INC	880,431	0.50%	9,197,984	526,930	6%
UNITED CONTL HLDGS INC	699,073	0.40%	22,157,608	218,966	1%
SIRIUS XM HLDGS INC	654,149	0.37%	132,418,729	-3,857,000	-3%
KROGER CO	570,475	0.33%	18,940,079
M & T BK CORP	556,665	0.32%	5,382,040
AMERICAN AIRLS GROUP INC	510,871	0.29%	41,909,000	-591,000	-1%
GLOBE LIFE INC	457,278	0.26%	6,353,727
LIBERTY GLOBAL PLC	434,229	0.25%	26,656,968	-481,000	-2%
AXALTA COATING SYS LTD	415,689	0.24%	24,070,000	-194,000	-1%
TEVA PHARMACEUTICAL INDS LTD	384,248	0.22%	42,789,295	-460,000	-1%
RESTAURANT BRANDS INTL INC	337,782	0.19%	8,438,225
STORE CAP CORP	337,425	0.19%	18,621,674
SYNCHRONY FINL	323,860	0.18%	20,128,000	-675,000	-3%
STONECO LTD	308,410	0.18%	14,166,748
GOLDMAN SACHS GROUP INC	296,841	0.17%	1,920,180	-10,084,571	-84%
SUNCOR ENERGY INC NEW	236,195	0.13%	14,949,031	-70,000	0%
OCCIDENTAL PETE CORP	219,245	0.12%	18,933,054
BIOGEN INC	203,440	0.12%	643,022	-5,425	-1%
RH	171,638	0.10%	1,708,348
JOHNSON & JOHNSON	42,893	0.02%	327,100
PROCTER & GAMBLE CO	34,694	0.02%	315,400
MONDELEZ INTL INC	28,946	0.02%	578,000
VANGUARD INDEX FDS	10,183	0.01%	43,000
SPDR S&P 500 ETF TR	10,155	0.01%	39,400
UNITED PARCEL SERVICE INC	5,549	0.00%	59,400
PHILLIPS 66	0	0.00%	227,436	-227,436	-100%
TRAVELERS COMPANIES INC	0	0.00%	312,379	-312,379	-100%
Total	175,485,996

Insurance Companies

By the way, insurance companies are going to hurt for a while. People keep saying that business disruption doesn't cover pandemics, or that it requires physical damage etc. But the way things work in this country, that doesn't matter. We have enough lawyers with a poorly structured incentive system so insurance companies can get bogged down in years and years of lawsuits. Even if insurance companies win, who knows how much all of that is going to cost.

Plus, interest rates are now 0% all the way out to 5 years, and 1% to 20 years. That's going to be painful, and makes BRK's float basically worthless. Yes, this may be temporary, but we have been saying that for more than 10 years now. I have always suspected we will follow Japan in terms of interest rates. I didn't expect a pandemic to cause rates to go to zero, though.

I still think BRK, MKL and others are great investments for the long haul, but there are serious issues for them out there for sure.

Banks
JPM and other banks are going to take some huge credit losses. There is no way around that. One rule of thumb is that credit card losses will follow the unemployment rate. Unemployment got up to 10% during the financial crisis, and sure enough, JPM's credit card charge-offs peaked at 10% or so. Total charge offs were 5%, I think, back then.

Unemployment is now over 15%, and headed to 20%. JPM has $160 billion in credit card loans, so credit card charge-offs can get over $30 billion. Total credit losses may get to 10% and they have around $1 trillion in loans outstanding. Who knows, really.

JPM is still the best managed big bank and they will get through this for sure, but they face some very serious problems. I think the view expressed during the 1Q conference call (expecting rebound in second half of the year) is way too optimistic.

Even if we start to reopen the economy, we can't really have a real recovery as a lot of events won't come back, and restaurant / bars / retailers will run at 30-50% capacity.

An interesting thing to look at is Sweden. They didn't have a hard lockdown like the U.S. and European countries, but their economy is taking a hit anyway. Reopening the economy doesn't mean we are all going to go back to the way we were right away. Many people tell me that they won't change anything even if the economy reopens until they get a vaccine. This could be years away.

I tend to believe things will normalize when we get a treatment that makes Covid-19 far less fatal. If we take that off the table, people will start to get back to normal.

I have no idea about these things, but I tend to think the odds of us finding a treatment is far higher than us finding a vaccine (there is a chance we may never find a vaccine).

Anyway, the mitigating factor to the above bank credit disaster is the amount of money being injected into the economy. I don't know if people are going to use their stimulus / Covid-19 help checks to pay off their credit card (they seem not to be paying their rent), but it will have some positive impact on bank credit, I assume (and hope).  Well, but don't assume because...

Is the Market Being Rational?

So, people are saying that the market is being too optimistic about a return to normal, but it's hard to tell. The market is full of stocks with different exposure. If the airline stocks got back to their highs, I would agree that the market is being too optimistic. But that hasn't happened; not even close. Same with retailers. And restaurant stocks.  OK, Amazon, Netflix, and others are going to new highs, but I doubt that is reflective of the market's optimism about a return to normal.

So when the markets move, I think we have to look by sector, and by stock, to see what they're expecting. It makes no sense to look at the index itself.

What to do?

When this started, I told people the same thing I always told them. Ignore the headlines and just think 3-5 years ahead. This works, though, for people with diversified portfolios. I wouldn't know what to say if they owned a lot of airlines, hotel and other travel related businesses, or other areas that may not recover so quickly. I have no idea.

I haven't owned any retail stocks in a long time (except BRK, which is the closest thing to a retailer I own), and the only restaurant stocks I own are CMG, QSR and SHAK.  Well, SHAK was never cheap so it's a token position that is not significant; it's more of a moral support, I like this company, kind of position. CMG was a large position that I scaled back and had to do again as it went over $1,000. It's not a cheap stock, and I have no idea why it's above $1,000; maybe they are going to take market share after many of their competitors go out of business within a few months). Oops, after writing this, I just realized I do own Costco. So I lied. I own Costco and have no problem with it. I will hold on to it. Yes, it's expensive, but I really like the business for all the reasons we've all heard already a gazillion times.

If you own the S&P 500 index, it doesn't really matter. Many companies will go bust, but that happens all the time. Some big banks, AIG and FNM went bust (or was massively diluted) during the financial crisis and yet the S&P 500 index was fine. It should be fine over the long term this time too, but many of the components won't be.

As usual, just don't invest based on the headlines. OK, evaluating your holdings on long term potential incorporating Covid-19 might not be a bad idea (like Buffett's dumping of airlines), but I would be careful about that too.

One thing is for sure. You really don't want to go chase Covid-19 stocks. You can buy AMZN, NFLX, MSFT thinking these are the pandemic-proof stocks, but the worst time to buy stocks is when everyone piles into them for the same reason (I wouldn't short them either!). For example, I wouldn't touch Zoom stock, of course.

Things are Interesting

I have to admit I have sort of been lazy about my investments over the past few years, kind of just let it go... Looking for things to do wasn't all that interesting as things got expensive.

But things are getting interesting again. I haven't read through so many conference calls and 10-Q's in a long time, and it's been fun. I have to say, though, that the 10-Q's only reflect a small portion of what's happening as the 1Q included the relatively healthy January and February. NYC shut down in mid-March. So there was only 2 weeks of really bad data included in 1Q. The 2Q reports are going to be really scary, but I can't wait to sift through that stuff.

Maybe this will lead to more blog posts. That would be fun, as I do enjoy this process. Until now, though, things are more interesting, but nothing really stands out to me. The really devastated industries are just 'too hard' for now, like cruise lines, airlines, casinos, and the solid businesses that you want to own are not cheap (AMZN, MSFT, COST etc...).

So to those who feel that ETFs and the indexing bubble has lead to a lack of differentiation in the evaluation of individual stocks, it is quite obvious that this is not the case at all. I've always maintained that this is not the case. Sure, there may be excess valuation in some large cap index stocks where index funds are 'forced' to buy regardless. I think overall, crummy stocks are cheap and higher quality stocks are expensive.

OK, banks and insurance companies are cheap now, and not all of them are crummy. But there are massive uncertainties they are facing now. The market is probably wrong and these stocks are probably too cheap.

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.

Shake Shack Inc. (SHAK)

Wow, it's been a long time since my last post.  This wasn't an intentional break but just one of those things where times flies before you realize it.   It's been busy around here for various things (all good / normal things; nothing bad, thankfully).

Anyway, I noticed that Shake Shack (SHAK) has filed their S-1.  I do enjoy reading S-1's even though most of the time they are a complete waste of time (as Munger put it).  Value investors seek to buy assets on the cheap, and this happens only because Mr. Market is very emotional and overreacts.

For IPO's, though, this is not the case at all.  The investment bankers and companies decide both the time and price of the offering so obviously an IPO is not going to be grossly underpriced (even though one can argue that first day price pops suggest otherwise).  Of course, the bankers try to underprice it a little bit (15%?) to 'reward' IPO buyers and to make sure the deal gets done.

But having said that, I am such a big fan of SHAK that I had to take a look at it.

Chipotle (CMG)
I do have a confession to make before I go on.  I talk about value investing here but I do, at times, do things that are totally contrary to what I believe.  I do act "irrationally" sometimes.  For example, one of my biggest winners as an investment has been Chipotle (CMG).   CMG has never been a value stock.  But CMG is a company I have followed from their spinoff and have been a stockholder on and off ever since.  I have bought and sold it over the years, usually buying the dips and selling when it got expensive.  I had a bunch towards the end of last year (2014) and sold most of it due to valuation.

Why'd I take so long to dump it as it was pretty expensive for a while?  I held on just because of the operational momentum that CMG seemed to have (closet momentum investor am I?!).

There was a lot of bear talk on CMG, but that has been the case from the very beginning.  The view was that CMG is just another burrito place.  Where's the moat?  Where's the competitive edge?

This may not be interesting to most value investors (as this isn't a value stock), but since this is relevant to other fast food and fast casual restaurants, I thought I'd mention some things I've been thinking about.

First of all, CMG does not have the best burritos.  Many New Yorkers would be able to name a bunch of places with better burritos.  One of them is Calexico, which I think started in Brooklyn (I have no relationship with Calexico other than as a big fan; make sure to get crack sauce on whatever you order there!).   There are many other burrito places in NYC that are really good.

But here's the deal.  At most burrito places, you go up and order a burrito and then they start making it after you order it.  So it takes time.  That, right there, is the big factor.

At CMG, you get your food really fast.

Fast Service
This is a true story:  I usually only go to CMG right before lunchtime.  If I can't get there by 11:30 or something like that, I don't bother.  But one time (actually more than once) I did go during the rush.  The line was really long going all the way to the front door (the line was the full length of the store).  Out of curiousity, I looked at my watch and noted the time.   I got my burrito in five minutes.

Here's another true story:  Not too long after that, I was at McDonald's (MCD) and I was second in line.  And MCD wasn't crowded; I wasn't second in line with five or ten registers open.  I was second in line, period.  There was nobody else.  And it took me TEN minutes to get a happy meal (not for me) and a chicken club sandwich meal.  How does this happen?  I have no idea.   But it happens all the time.  I remember when MCD used to give something back (food is free or something) if you don't get your stuff within a minute or two.  Now it's a disaster whenever I go (and I do go to many different MCD's quite often).

The speed at CMG is really critical.  That is the key to their high margins (via higher throughput / volumes) and also to their happy customers.   I remember the hoopla surrounding the Noodles and Company (NDLS) IPO.  I love fast food and fast casual restaurants, so I was more excited about it as a place to go rather than as an investment.  But the fact that NDLS was run by ex-CMG guys got me curious as an investment too.

Unfortunately, I didn't get to try it out until I was in Washington D.C. last year.  NDLS is an interesting idea, but what I noticed right away is that their model didn't work in terms of speed and throughput like CMG.  It is certainly better than casual sit-down restaurants.  But you still had to sit down and wait for your food.  They were not going to get the volumes/turnover like CMG.    That doesn't mean that NDLS won't work out; it's just not the same model.  (At NDLS, you order your food like at a fast food restaurant and then you sit down and they bring the food to your table when it's ready.  So it's like a hybrid of fast food and sit-down.   Some people seem to like it as it's a little faster than a sit-down restaurant).

Ambiance
David Einhorn shorted CMG based on new competition from Taco Bell (among other factors).  First, I have to say that I really love fast food.  I really do.   When the YouTube video about pink slime went viral, the first thing that came to mind after watching the video was, damn, I want a Big Mac!

I love Taco Bell too.  One bummer about living in NYC is that we are often the last to get a chance to try out some of the new restaurant concepts.

But anyway, I do spend a lot of time at these places.

Having said that, when Einhorn said what he said about CMG and Taco Bell, I wondered if he ever actually ate at these places.  As much as I love Taco Bell, it is usually a nightmare of a scene.  You go at lunchtime and it's a totally chaotic mosh-pit.  When you get your food, you are basically climbing over people, fighting for a seat.  And then you have to squeeze between a bunch of slobs (like me) to get into a cheap plastic chair.

I love their food, but their premium and 'better' burritos still tasted like microwaved airline food (but I still like that sort of thing too).

Compare that dining experience with CMG.   CMG lines may be long, but it's a single line and usually pretty fast.  I usually get stressed at those MCD/Taco Bell mosh pits trying to get into a line and not getting cut out, and worried that someone else will take my food (after ordering it; where are we supposed to stand while we wait for the food?!) and I will have to reorder again.  Not to mention that they usually forget something and then you have to push your way to the front again to demand the missing item (I don't know if it's corporate policy to cut costs, but honestly, they almost NEVER put the barbecue sauce in a happy meal even though they ask you which sauce you want when you order!).   At CMG, it's quick and easy (and yes, a little more expensive, but that's fine).

Speaking of Taco Bell, it's run by the same folks that run KFC, another old favorite of mine.  I love KFC too.  But you know, it's a totally different experience.  The bathrooms are usually unusably disgusting and maybe this is just NYC, but there are often homeless people sleeping somewhere inside.  Oh, and even if you go to Taco Bell/KFC when it's not crowded (which I have done too), it is just really depressing to sit in those places; just horrible interiors and vibe  (And I say this as someone who actually likes the food!).

Oh, and the simple menus at CMG is key too.  It's not just that it's easier in the kitchen.  It's also easier for the customers. When the menu is so simple, you will never get that guy just staring up at a huge menu wondering what to get.

And the other thing that made me want to hang on to CMG for a little longer (I still own some, but not that big anymore) was their new A model restaurants.  The A models are smaller than the usual restaurants.  Some of these A model stores were grossing as much as their regular restaurants and maybe in some cases even more.

While many people thought that CMG was reaching saturation (with the low hanging fruit already picked), the success of the A model stores meant two things (at least two things; there are probably other things):  Higher returns (as their return on investments were much higher than their original models due to lower initial investment and similar AUV's) and more potential store locations (less saturated than they themselves thought at one point) since they were smaller (fit into more different places).

Having said all of that, CMG is an expensive stock and I can't really defend the valuation.

Oh, and one more thing about CMG.  I went down (to D.C.) and tried out their Shophouse Southeast Asian Kitchen and really liked it.  I would love for one of those (or more) to open in NYC.  There are a lot of authentic Asian places in the city, but then again, there were a lot of burrito places in NYC before CMG came along too (and yet, the lines are still really long at CMG here).

It seems like CMG is taking forever to expand that concept.  I do like that they take their time and perfect the model before trying to expand.   Expanding too quickly is probably one of the biggest mistakes at retailers / restaurants (check out Fairway Group Holdings (FWM), a New York City institution).

It was interesting as I read the SHAK S-1 to learn that it took them five years before they opened their second restaurant.   They really wanted to get it right before opening another store. So in that sense, it's good for CMG to take their time with Shophouse before expanding quickly.

Speaking of Shophouse, I recently stumbled upon this chain:  Wok to Walk.   It is apparently a chain that started in Amsterdam and is similar in concept to Shophouse.  But the key difference is that they actually stir-fry every dish in a wok when it is ordered (right in front of you, just like street food in Southeast Asia).  The food tasted great (but again, I'm not comparing to Chinatown; I am thinking of it as fast casual food, not restaurant food).

But of course, I got to thinking that with stir-frying everything each time it is ordered is going to limit the throughput there.  Think of how quickly CMG can assemble a burrito, and how quickly and instantly they can prepare your dish at Shophouse.  And then think about these guys at Wok to Walk actually heating something up in a wok one dish at a time.

Well, they can still do well.  Not everyone has to have the same model as CMG.  That's what I was thinking as I ate there ( I gotta keep an eye on the competition, right?).

By the way, what's up with the mozzarella sticks at MCD?   That's like the randomest thing.  Why?  It makes no sense to me.  Never mind.

SHAK
OK, so back to SHAK.

SHAK too feels sort of like CMG in many ways.

Here's the blurb from the S-1:

Overview of Shake Shack
        Shake Shack is a modern day "roadside" burger stand serving a classic American menu of premium burgers, hot dogs, crinkle-cut fries, shakes, frozen custard, beer and wine. Founded by Danny Meyer's Union Square Hospitality Group, LLC ("USHG"), Shake Shack was created leveraging USHG's expertise in community building, hospitality, fine dining, restaurant operations and sourcing premium ingredients. Danny's vision of Enlightened Hospitality guided the creation of the unique Shake Shack culture that, we believe, creates a differentiated experience for our guests across all demographics at each of the 63 Shacks around the world. As Shake Shack's Board Chairman and USHG's Chief Executive Officer, Danny has drawn from USHG's experience creating and operating some of New York City's most acclaimed and popular restaurants, including Union Square Cafe, Gramercy Tavern, Blue Smoke, The Modern, Maialino and Marta, to build what we believe is a new fine casual restaurant category in Shake Shack. 

        Shake Shack originated from a hot dog cart that USHG established in 2001 to support the rejuvenation of New York City's Madison Square Park through its Conservancy's first art installation—"I © Taxi." The hot dog cart was an instant hit, with lines forming daily throughout the summer months for the next three years. In response to this success, the city's Department of Parks and Recreation awarded Shake Shack a contract to create a kiosk to help fund the park's future. In 2004, Shake Shack officially opened and immediately became a community gathering place for New Yorkers and visitors from all over the world. Over the last decade, Shake Shack has become a beloved New York City institution that generates significant media attention, critical acclaim and a passionately devoted following. We have since grown rapidly, with 63 Shacks in nine countries and 34 cities. 

        Our vision is to Stand For Something Good in all aspects of Shake Shack's business, including the exceptional team we hire and train, the premium ingredients making up our menu, our community engagement and the design of our Shacks. Stand For Something Good is a call to action to all of our stakeholders—our team, guests, communities, suppliers and investors—and we actively invite them all to share in this philosophy with us. This commitment drives our integration into the local communities in which we operate and fosters a lasting connection with our guests. We continually invest in our "Shack Team," as we believe that team members who are treated and trained well will deliver Enlightened Hospitality and a superior guest experience. Through our leadership development program, The Shacksperience, we teach our team members the principles of Enlightened Hospitality and how to live and breathe our Shack Pact, the agreement that encompasses our value system and brand ethos. Our people make all the difference, as they embody the sense of community necessary to create the complete Shake Shack experience. This vision reflects our goal to be the best burger company in the world, for the world and for our team. 

I know, I know.  This is just another burger joint.  In-N-Out Burger, Five Guys, Habit Restaurants, who cares, right?

But for us New Yorkers, this is not just another burger joint.  It is one that was created by Danny Meyer, a pretty successful restaurateur.  But so what?  It's still just a burger, right?

Well, again, as in my comments about CMG, sometimes it's not just the food.  The food is important.  So is price.  But so is ambiance and the overall dining experience.  I really do like Five Guys too.  But it does feel like you're eating in an over-sized bathroom with loud 80's classic rock relentlessly pounding your eardrums (I love rock, so it's OK.  But still...).  It's a place that I like to eat when I need fast food, but I also want to leave right away when I finish (I guess that's good for turnover!).   The service at Five Guys, in my experience, has been pretty good.  Unlike, say, MCD when most of the time I feel like I am disturbing the employees by being there.

Growth
SHAK is growing pretty quickly now, but it seems like they are growing profitably, at least.  Contrast that with, say, again, Fairway Group Holdings (FWM).  Fairway Markets has long been a NYC favorite supermarket on the Upper West Side of Manhattan.  These guys were really good.  But they were taken over by a private equity firm and started growing quickly, and so far, disastrously.  I took a good look at them when they IPO'ed, but the rapid expansion scared me.  FWM was really great when they had a few stores in NYC, but I wondered how they would do growing so fast.  

Of course, in NYC, for a long time there was no Whole Foods or Trader Joe's, so FWM was a great alternative.  It was really a no-brainer running a decent supermarket in NYC as most large chains here were just awful.  But outside NYC, even not too far out, you had those major chains like Whole Foods and Trader Joe's but also regional competitors like Stew Leonard's (in Yonkers).  I don't know for sure, but I sort of think there must be a Stew Leonard's-like store in every region; somewhat upscale and better than the national chains etc.

Anyway, FWM might still work out over time, but who knows.  One thing I noticed reading the SHAK S-1 was that they smartly separated the financials of the Manhattan restaurants from the non-Manhattan ones.  This way, investors can see that the overall decline in margins and AUV's are due to expansion outside of Manhattan.  FWM didn't do that, I don't think, so their metrics just collapsed as they expanded.  Well, of course the metrics will collapse.  The Upper West Side store had extraordinary economics that would be almost impossible to duplicate, even within Manhattan! Their sales per square foot in the original store is just not replicable.

Maybe the bankers for SHAK noticed that and that's why they separated the Manhattan and non-Manhattan stores.   Maybe not.  Either way, it's a smart move.

Check this out on the growth of SHAK:

       Of the 63 Shacks, there are 31 domestic company-operated Shacks, five domestic licensed Shacks and 27 international licensed Shacks. We open Shacks in areas where communities gather, often with high foot traffic and substantial commercial density such as New York City's Theater District, London's Covent Garden and Dubai's Mall of the Emirates. We have been able to successfully grow across a variety of locations due to our versatile Shack formats and designs that are tailored to reflect each Shack community's core attributes. During the three fiscal years ended December 25, 2013, we grew from seven Shacks in two states to 40 Shacks across six states, Washington, D.C. and eight other countries, representing a 79% compound annual growth rate ("CAGR"). In fiscal 2013, our domestic company-operated Shacks had AUVs of approximately $5.0 million, of which our Manhattan Shacks had AUVs of approximately $7.4 million and our non-Manhattan Shacks had AUVs of approximately $3.8 million. During the three fiscal years ended December 25, 2013, our total revenue grew from $19.5 million to $82.5 million, a 62% CAGR, our net income grew from $0.2 million to $5.4 million, and Adjusted EBITDA grew to $14.5 million. For a reconciliation of Adjusted EBITDA, a non-GAAP measure, to net income, see "—Summary Historical and Pro Forma Consolidated Financial and Other Data."

You can just read the S-1 for most of this, but here is a cut-and-paste of what makes SHAK different:

What Makes Shake Shack Special
        1. Our culture of Enlightened Hospitality: taking care of each other.    We believe that the culture of our team is the single most important factor in our success. We aim to recruit and develop a team with the innate "personality to please" that cannot be taught. We look for people who are warm, friendly, motivated, caring, self-aware and intellectually curious team members, or what we call "51%'ers." We use the term "51%" to describe the emotional skills needed to thrive at the job and "49%" to describe the technical skills needed for the job. Our 51%'ers are excited and committed to championship performance, remarkable and enriching hospitality, embodying our culture and actively growing themselves and the brand. Our team is trained to understand and practice the values of Enlightened Hospitality: caring for each other, caring for our guests, caring for our community, caring for our suppliers and caring for our investors. These principles have been championed by Danny Meyer throughout his career and are detailed in his New York Times best-selling book Setting the Table: The Transforming Power of Hospitality in Business; they are fundamental to the way Shake Shack operates its business. We invest in our team through extensive leadership development programs to ensure that Shake Shack remains a great place to work and an exciting career choice for team members at every level. We have built a culture of active learning and we foster an environment of leadership development throughout the entire lifecycle of employment. We seek to be the employer of choice by offering above industry average compensation in most markets, comprehensive benefits and a variety of incentive programs, including a monthly revenue-sharing program with our employees. We believe that our culture of Enlightened Hospitality enables us to develop future leaders from within and deliver a consistent Shack experience as we continue to grow.
        2. Fine Casual: inspired food and drink.    We embrace our Company's fine-dining heritage and are committed to sourcing premium, sustainable ingredients, such as all-natural, hormone and antibiotic-free beef, while offering excellent value to our guests. Our core menu remains focused and is supplemented with targeted innovation inspired by the best versions of the classic American roadside burger stands. As a result of culinary creativity and excellence, we attract continued interest from partners such as award-winning chefs, talented bakers, farmers and artisanal purveyors who want to collaborate with us in different and engaging ways. We never stop looking for the best culinary ingredients and the best partners in order to exceed our guests' expectations in every aspect of their experience.
        3. Beloved lifestyle brand.    In Shake Shack's 10-year history, we have become a globally recognized brand with outsized consumer awareness relative to our current footprint. Shake Shack is a New York City institution, a vibrant and authentic community gathering place that delivers an unparalleled experience to loyal, passionate guests and a broad, global demographic. Born in 2004, Shake Shack grew up alongside the emergence of social media and has benefited from an ongoing love affair with passionate fans who share their real-time experiences with friends. We aim to establish genuine connections with our guests and the communities in which they live. Each Shack is localized with design and menu options that we believe drive a sense of appreciation and enthusiasm for the Shake Shack brand. Shake Shack has been recognized with numerous accolades, including Bon Appétit's "The 20 Most Important Restaurants in America" (ranked #16), TIME Magazine's "17 Most Influential Burgers of All Time" (ranked #7 for the ShackBurger) and winning "Best Burger" in 2007 and 2014 at the South Beach Wine and Food Festival's Burger Bash.
        4. Versatile real estate model built for growth.    During fiscal 2013, we grew the number of our domestic company-operated Shacks by 62% with the opening of eight new Shacks, and have opened 10 domestic company-operated Shacks during fiscal 2014. We will continue to not only fill in existing markets such as New York, Boston, Philadelphia, Washington, D.C., Atlanta, Chicago and South Florida to leverage operational effectiveness as we cluster in high-density markets, but also enter new markets, such as Austin, where we have signed leases. Although we currently have only 63 Shacks around the world, we have identified many attractive and differentiated markets for the Shake Shack experience. In major metropolitan areas, we seek locations where communities gather, often with characteristics such as high foot traffic, substantial commercial density, reputable co-tenants and other traffic drivers such as proximity to parks, museums, schools, hospitals and tourist attractions. For every potential domestic company-operated Shack we consider, we apply rigorous financial metrics to ensure we maintain our targeted profitability. We measure much of our financial success by analyzing Shack-level operating profit margins, cash-on-cash returns and payback periods. Our flexible model allows us to design our Shacks so that we can pursue a variety of property types. We have successfully launched different layouts and sizes of Shacks in varied locations throughout urban high density areas, suburban in-line and pad sites, regional malls, lifestyle centers, ballparks, airports and train stations. Each design is critical to the Shake Shack experience and we blend our core brand identifiers with features specifically designed for each Shack to be of its place and connect directly with its neighborhood. With a disciplined approach to new Shack development and a successful track record in site selection, we are positioned well for future growth.
        5. Shack-onomics.    Our brand power and thoughtful approach to growth have resulted in strong Shack performance across a variety of geographic areas and formats and during both strong and weak economic environments. Our Shack model is designed to generate attractive Shack-level operating profit margins, strong cash flow and high returns on invested capital. We have notable AUVs at both Manhattan Shacks and non-Manhattan Shacks. In fiscal 2013, our domestic company-operated Shacks had AUVs of approximately $5.0 million, of which our Manhattan Shacks generated AUVs of approximately $7.4 million with Shack-level operating profit margins of approximately 30% and our non-Manhattan Shacks generated AUVs of approximately $3.8 million with Shack-level operating profit margins of approximately 22%. Historically, our domestic company-operated Shacks have delivered an attractive average cash-on-cash return of 65% and payback period of 1.5 years, of which our Manhattan Shacks generated an average cash-on-cash return of 82% and payback period of 1.2 years and our non-Manhattan Shacks generated an average cash-on-cash return of 31% and payback period of 3.2 years. Since the vast majority of future Shacks will be non-Manhattan locations, we are targeting AUVs in the $2.8 to $3.2 million range, Shack-level operating profit margins in the 18 to 22% range and cash-on-cash returns in the 30 to 33% range.
        6. The Shack travels abroad.    With 27 licensed Shacks outside the United States, we believe that we have proven to be an internationally desirable restaurant concept. Our track record of opening successful Shacks in both the United States and overseas demonstrates the global appeal of Shake Shack and validates our belief in our significant whitespace opportunity internationally. We currently have license agreements for four major international territories, with Shacks operating in eight countries. The Middle East has been our most prominent growth market with 20 Shacks in operation, followed by Turkey with four, Russia with two and the United Kingdom with one. In fiscal 2013, our international licensed Shacks had AUVs of approximately $6.1 million, which resulted in license fees of approximately $3.5 million. In addition to license fees, we also receive exclusive territory fees, which help us fund further domestic growth.
        7. Leaders training future leaders.    Our team is led by passionate and experienced senior leaders, balanced with professionals formerly from USHG's fine dining operations and industry veterans from larger restaurant companies. Randy Garutti, our Chief Executive Officer, combines strategic multi-unit leadership experience with fine dining expertise. Randy has worked in restaurants since he was 13 and joined USHG in 2000 as General Manager of Tabla, followed by Union Square Cafe, and later took on the role of Director of Operations overseeing all USHG restaurants, prior to launching the first Shake Shack in 2004. Randy has led the development of the Shake Shack concept from its earliest stages and guided every aspect of the business. Jeff Uttz, our Chief Financial Officer, brings valuable experience managing high growth restaurant concepts drawing from his 22 years of restaurant finance experience, most recently as Chief Financial Officer at Yard House Restaurants. Jeff led the expansion of Yard House from three units when he began to over 40 units when Yard House was acquired by Darden Restaurants, Inc. Randy and Jeff are supported by a talented executive leadership team that has deep experience in operations, culinary arts, supply chain, finance and accounting, training and leadership development, people resources, real estate and design, construction and facilities, information technology, legal, marketing and communications.

 Here are some unit metrics to get a feel for the business:

		Fiscal year ended						Thirty-nine weeks ended
(Dollar amounts in thousands)		December 26, 2012			December 25, 2013			September 25, 2013			September 24, 2014
Other data:
Number of Shacks			21			40			33			53
Domestic company-operated			13			21			16			26
Domestic licensed			3			4			4			5
International licensed			5			15			13			22
Same Shack sales growth			7.1	%		5.9	%		5.5	%		3.0	%
Average unit volumes
Domestic company-operated Shacks		$	5,367		$	5,017
Manhattan Shacks			7,034			7,387
Non-Manhattan Shacks			3,791			3,840
International licensed Shacks(5)			9,665			6,077
Shack system-wide sales(5)		$	81,048		$	139,903		$	98,931		$	156,080
Shack-level operating profit margins(6)			25.6	%		26.0	%		27.2	%		24.7	%
Manhattan Shacks			29.0	%		30.3	%		31.7	%		31.2	%
Non-Manhattan Shacks			19.8	%		21.9	%		22.8	%		20.8	%
Adjusted EBITDA(7)		$	9,998		$	14,459		$	11,417		$	14,063
As a percentage of revenue			17.5	%		17.5	%		19.2	%		16.8	%
Capital expenditures		$	11,036		$	16,194		$	10,359		$	17,885

  

Labor Cost
And check this out.  I know this will be used by labor activists to try to boost the minimum wage, but I find this very interesting.  This reminds me of Costco (COST); they pay their employees well and they make plenty of money because of the higher quality of their work force as a result.  This is the opposite of many fast food chains and retailers that try to keep labor costs as low as possible (they pay for it in higher employee turnover (higher costs of training) and poor service (employees that don't care and treat customers as a nuisance (so often, I find myself resisting saying things like, "Excuse me, when you finish that game on your iPhone, can you take my order please?".  This never seems to happen at CMG or SHAK).

Labor and Benefits Costs
        At our domestic company-operated Shacks, we have historically provided a starting wage that is above the minimum wage in place for that particular state. For instance, in Manhattan Shacks, we start our new employees at $10.00 per hour even though the minimum wage in New York is $8.00 per hour. We believe that this enables us to attract a higher caliber employee and this translates directly to better guest service. Our desire is to continue to do so and, as such, there can be no assurance that we will generate same Shack sales growth in an amount sufficient to offset increases in minimum wage or other inflationary pressures. 

Good to Great to Gone
And by the way, I recently finished a great book;  Good to Great to Gone: The 60 Year Rise and Fall of Circuit City.   We've talked about the books Good to Great and Halo Effect here, so naturally, I had to read a book about one of the "Good to Great" companies that actually failed.  This is not just any old business book, by the way.  It is written by the son of the founder who actually ran Circuit City for many years.  Obviously, because of that, it may not be a totally objective, unbiased look at what happened.  But it is still very interesting.

It's not only a book about the history of Circuit City, but also sort of a history of the electronics retailing industry (which I always thought was very unstable and fast-changing.  We New Yorkers all remember Crazy Eddie, and then Nobody Beats the Wiz etc... )

So why do I bring this up?   Well, all of this stuff (Good to Great, Halo Effect) is always somewhere in my mind  when reading about businesses.

SHAK seems to have a great culture, and I can confirm that as a customer from my frequent visits to various locations (the food is great too, but I know I have no credibility as a food critic as I have already admitted to liking MCD and KFC food!).  I have also known about the reputation of Danny Meyer for years and have been a customer at his various restaurants over the years, so I know there is consistency in execution and getting the culture right.

But at the end of the day, I still think it's really about the people.  The big deal to me is that SHAK (although Danny Meyer is not the CEO of SHAK) has Meyer behind it.   Meyer is a passionate food guy and he has been executing amazingly well for decades.

I think this is why CMG is doing so well too; It is run by a real food guy, not some corporate guy.

PBPB
For example, Potbelly (PBPB) is another great idea; I do like the sandwiches there and think it's a cut above Subway.  I love that they heat the sandwiches, and the ambiance is definitely much better than a Subway (which tends to be pretty depressing if you eat-in there).  And it's much cheaper than Panera (PNRA).  I don't follow PBPB too closely, but I always scratch my head; how hard can this be?  Just open up a bunch of stores near PNRA and Subway; get the people who want something cheaper than PNRA (and maybe with a shorter line) and the people who want to upgrade from Subway.  Maybe that's what they are doing; who knows.

But the point here is that PBPB is not run by the founders anymore (they haven't been for years), and is now run by some corporate guy (a former Sears Holdings CEO, in fact.  OK, so he was with YUM Brands for a long time, but that sort of counts more as a "corporate guy" than a "food guy" in my book).

This is not to say that PBPB can't work out over the long term.

But for me, as an investor, it really makes a difference to me who runs an operation.  And it goes beyond just the culture (unless the culture has been proven through generations like at Goldman Sachs).

So What to Do with SHAK?
Well, first of all, we all know this is going to pop up a lot on the first day, especially since this brand is well-known to Wall Street (there is a Shake Shack, in fact, right across from the Goldman Sachs headquarters).  And Danny Meyer has been known for decades on Wall Street because of his restaurants.   Everybody is going to want a piece of SHAK.

I said I've owned CMG for years on and off, but I have to say that it is a rare growth stock investment for me.  I don't usually do growth stocks.  My only other high P/E stock at the moment is Costco (COST).

I will invest in high P/E stocks every now and then, but all the pieces have to be aligned; it has to be a really awesome company with awesome products and incredible management.  I have to constantly be impressed with both their financial performance, management, products etc.  It really has to check on all of those things.  And then of course, the price can't be that crazy.  I never paid 50x P/E for CMG (but have owned it at that level).

SHAK to me comes close to checking all the boxes in that sense, so it would be a potential rule-breaking investment.  I would temper the valuation risk by buying only a small amount if it looks crazy expensive.  Maybe I wouldn't touch it if it got insane.

So anyway, this is not some big overview of this sector.  There are a bunch of other companies out there like Habit Restaurants and Zoe's Kitchen, but as interesting as those places sound I can't comment on them as I have never been to any of their restaurants.

These are just some random thoughts that came to mind as I read through the SHAK S-1 (and sort of an excuse to make a post about something to break the silence here).

Oh yeah, and Happy New Year!