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. 

 

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.

What to Do in this Market: Gotham Funds Update

So my posts about the perils of market timing and market valuation have led to some interesting discussions in the comments section.

Anyway, I wrote about the Gotham funds last year and since a little more time has passed, I thought I'd look at their performance to see what's going on.

But first, let me just say that if you *must* invest in some sort of hedged vehicle (in mutual funds), or something that mitigates stock market volatility, as I said in my original post (What To Do In This Market II), I would recommend one of the Gotham funds.

As I always say, I am not usually a big fan of long/short (unless they are run by people who have real track records like Loeb, Einhorn etc...).  I would definitely stay away from the long/short stuff that are put out by the mutual fund giants.

Why Gotham?  Well, we all know what a great manager Joel Greenblatt is.  He does have a long track record of outperformance.  OK, so it wasn't a long/short fund.  But he knows stocks and markets very well, and he has often spoken against the idea of long/short.  But he is doing it now.  What does this suggest?  It means that they have really dug in and figured out how to manage the risk inherent in a short book.  Otherwise he wouldn't do it.  He knows why long/short funds usually don't work out.

Plus, the funds will be operated according to the simple ideas laid out in his books, and I feel I do understand those well, and do have faith that they will continue to work over time.

He said on CNBC once (when the first Magic Formula book came out) that if he shorted the most expensive Magic Formula names against the long portfolio, the portfolio volatility would have been far greater than the long only portfolio, and I think he even said that the portfolio lost 90% or something like that at one point.  I'm not sure he said that, but I do remember him mentioning a huge drawdown with the long/short.

So I am sure he will not have a huge drawdown on the long/shorts like that as we know he is aware that is possible if you just bought the cheapest and shortest the dearest names.

Macro Based Mutual Funds
But first, let me get back to the macro, top-down mutual funds that I would caution people away from.  As I said in the comments section, my caution against market-timing funds is simply that there isn't any fund that I am aware of that has done it well over time and through cycles, never seen a newsletter or investment strategist that called things consistently over a long period of time (there are always stars, though, that have called the most recent correction, rally or both.  Maybe we can make a list of them).

As I said, for value investors, there is a Graham and Doddsville and the resident superinvestors.  Where is the Graham and Doddsville of market timers?

One thing you can do is subscribe to Hulbert's Financial Digest for a while and check out the long term performance of timers.  It is dreadful.  And many of them use the same things everyone else uses; P/E ratios etc...

So why do these funds come and go all the time?  And how can a fund like this, below, even exist?  Well, it barely does.  I think AUM is now $34 million.



To understand this, check out the performance figures below.  This is from the fact sheet for the fund from their website,  The above chart only starts at 1994.

So this fund started in 1985.  It is interesting to note that the arguments made back then are very similar to the arguments made today.  Especially going into 1987 and then after that throughout the early 1990's, the argument was about high stock prices, too much leverage (junk bond driven LBO mania), twin tower of deficits (budget and trade deficits), and there were no shortage of calls for another great depression to come.

In that environment, this fund came out and then nailed it in 1987.  Look at that.  They did OK in 1985 and 1986, and then absolutely hit it out of the park in 1987, no doubt due to their cautious stance.  That stance cost them in 1988, but it looked like things will be OK in 1989 (I don't know if that gain is due to the UAL crash, or from longs, but...).

And then from 1990 on, things start to go wrong, and then from 1994 on you can just look at the chart and things go horribly wrong forever after.

If you go to their website, there is a video of Charles Minter making some persuasively bearish statements in 2003.

The funny thing is, as is often the case, I totally agree with so many things the bears talk about.  They are right but I just tend to disagree on what to do about it (Buffett too often says things that are in agreement with the bears but acts totally differently so it's not that he is stupid and he doesn't see it, or that he is complacent.  He just has a time horizon long enough (and holdings solid enough to survive that long) for it not to matter.

These funds get very popular after a bear market because there are usually some people who absolutely nailed it.  Maybe they get the bear right and even get the turn correctly and rides up a rally.  Maybe they can even get the next bear etc.

But it is very hard to keep doing that and at some point, inevitably, your luck runs out and you can't keep calling the turns anymore.  This is true with newsletters and investment strategists too.

Cursed by Early Success
And their early success is the reason why they can't evolve or change.  When their best relative performance (and rise to fame) occurred during bear markets, it's only natural that these managers will almost always lean towards the bearish side.  Looking at the above table of Comstock's early success (1987), you can suspect that the management there has spent the next 27 years trying to replicate that success; kind of like Jay Gatsby trying to relive a summer of his youth.

I suspect other similar funds will do the same thing and if they fail, it will be because of the irresponsibility of the Fed.  In other words, it's won't be their fault.

Speaking of which, I remember in the 1980's and 1990's, the hedge funds and macro guys loved the central banks and governments because they were so inept.  It was very easy to trade against them and make tons of money.  So it's kind of ironic that many of them are now complaining that their bond market / interest rate manipulation is interfering with their ability to make money.  But that's another story for a different post.

And by the way, sometimes in the trading world, we say that making a killing on the very first trade can be the worst thing that can happen to you.  The thinking is that the trader will spend the rest of his career losing what he made and then some trying to replicate it.  (Imagine how much money has been wasted on S&P 500 index puts in the years following Black Monday?)

Value Funds
Of course, this inevitably leads to the argument, "gee, but value funds don't outperform the index either!".  Well, that's why Buffett says index investing (the S&P 500 index) is the right way to go for most people.

But I'll add that even if a value fund underperforms (hopefully they outperform over time, though) usually they end up making money.  You can still do pretty well.  I know someone who has become pretty wealthy just owning the Magellan fund for many years (I mean, many, many years!).

Why Do I Waste Time on This Topic?
Well, as I said in a response in the comments section, when people realize I am involved with the stock market, the discussion almost always ends up not being about stocks, but about what to do because the stock market is dangerous, dishonest and rigged, too expensive and bubbled up etc.

Also, I am not at all against the idea of market timing.  I don't write this stuff because I have something against them and I don't feel like I am trying to prove anything idealogically or anything like that at all.  In fact, I am very curious about these things and have always been.  True, I don't spend a whole lot of time on it, but I am curious about what others have to say about it and about attempts to do it.

If I find someone who can do it consistently and has a track record (or a group of such people), I would be very interested in what they do.

But the fact is that I just haven't found any yet.

In fact, early on in my career, I was very into this stuff and what lead me to value investing is that there was no Graham and Doddsville of market timers.  It turns out most market timers make the bulk of their money selling books / newsletters etc.  Every time I read a book about it, I couldn't verify the author's performance.  If they were newsletter writers, their letters performed horribly.

Back to Gotham Funds
OK, so back to Gotham.  Why am I OK with Gotham versus the others?  Because Gotham does not try to forecast the economy and structure a portfolio around it!  They don't get bearish and put on a hedge, and then get bullish and take off their hedge.  They simply buy the cheapest stocks and short the dearest stocks.

Here are the funds that they offer from their website (gothamfunds.com):

And here is how they've done:

These funds are still too young to really evaluate them, but so far it looks pretty good.

Check out how they have done versus the S&P 500 (Morningstar charts via Gotham's website):

Gotham Absolute Return

Gotham Absolute 500

Gotham Enhanced Return

Gotham Neutral

If I had to choose one to hold for the long haul (or recommend to, say, your sister or some non-market person), I would say Gotham Absolute Return.  Gotham Neutral is interesting, but that seems too cautious.  Also, the Enhanced Return looks exciting, but seems to have more leverage than I might be comfortable with to recommend someone who doesn't follow the markets. The Absolute Return long/short allocation is similar to how the typical long/short hedge fund operates.

Anyway, again, I would be very skeptical of the long/short funds coming out of the big fund families.  Think about how their funds tend to underperform most of the time anyway.  And add the risk of short-selling to that underperforming long portfolio.  Short-selling tends to be very tough, and in my experience, long-only managers suddenly being allowed to short have often lead to dreadful results.  It's just a lot harder to do.

If a stock is cheap you can buy it and if it goes down, you can just buy more.  But if you short a stock and it goes up, you can't just sell more.  If you try, you can really get killed.  And shorting wrong stocks can easily offset gains on longs.

Oh, and not to mention that the best short-sellers/stockpickers tend to go into hedge funds where the fees are higher (and therefore their own salaries/bonuses).

This Time it's Different
Over the years, when I get into this sort of discussion about the markets (and talking people out of market timing), they argue that the bulls are saying "this time it's different".

But it's never different.  Some things do differ, though.

For example, what's not different?

• Value still matters.  Cheap stocks will do better over time, and expensive stocks will do worse.  Gotham funds can exploit that.
• Asset values have always been valued against the U.S. treasury market.  Sure, there might not have been a close correlation in some periods in the past.  For long duration assets, U.S. long bond yields have always been the "risk-free" benchmark.  And against that, the U.S. stock market is not at all overvalued.  
• Even if the stock market is not overvalued versus bonds, it is expensive on an absolute basis which implies lower returns going forward.  This is a mathematical certainty that can't be denied.  But it doesn't necessarily follow that someone can earn a higher return than this projected low return by getting in and out of the market on a timely basis.  All evidence I have seen to date seems to suggest otherwise (most would have been better off in August 1987 to just hold on and ignore the headlines). 
• But having said all of that, even I wouldn't be comfortable if stocks got up to 50x or 100x P/E (to catch up to the bond market).  I think the stock market is acting prudently by not going there! 
• And, in general, people who try to time the market will get one, two or maybe even three turns right and will look good (and get a lot of face time on TV).  But the odds of that success continuing is very low.  This is not a judgement of anyone in particular.  Even Buffett has said that in his fifty+ years of life in the markets, he hasn't seen anyone do it. 

So most things don't change.  I think the world will go on as it always has in the above sense.

But what is different?

I was going to make a list, but I think the biggest difference is monetary policy.  In the old days, the Fed can just lower rates and things were hunky dory.  Now, all sorts of stimuli are having a much lower impact than in the past.  I think that's due to the amount of leverage already built into the system.  There is something going on that most of us don't understand; why are rates so low for so long?  I tend to believe it is not just about the Fed.  Why are rates still lower despite the end of QE?  We may be in a long term Japan scenario where deflationary pressures (and not Fed bond buying/manipulation) keep rates low.   This is sort of uncharted territory so old models may not work as they have in the past.

Conclusion
So maybe I sound like some idealogical extremist in terms of this stuff (anti-market-timing, pro-value investing) but there is a reason.  I have no horse in this race, really.  I don't sell a newsletter or book, don't own a value investing shop or anything like that.  And I have no relationship with Gotham, Greenblatt or anyone associated with either of them.

But I've been in the business a long time (well, maybe not as long as some of you!) and feel like I've seen it all.  I didn't experience Black Monday or any of the big bear markets before then, but I've been through all of the other crises, and they are all the same.

Heroes inevitably emerge from each of them (sometimes multiple heroes).  Some of them are wire-house investment strategist (that go out afterward to start a fund after making a great call), newsletter writers, economists etc.  And most of those guys that make their name in bear markets don't go on to make great long term track records.

Again, I exclude some of the really good trading oriented hedge funds (think traders in the Market Wizards book).  A lot of those guys are very good and have long, consistent records of profit.  But they are very different from the macro-based mutual funds (maybe that would be a topic of a future post).

So in a sense, no, this time is not different.

If you must invest in some hedged vehicle (again, I am only talking about mutual funds), then go with the Gotham funds.  They don't try to do the impossible (guess where the markets go) and they stick to fundamentals / valuation in stock selection.  It is a fund run by a successful manager with a great track record, great books with a method of picking stocks that have worked over time etc.

Of course, it may not work out at all.  Who really knows with these things.  But I can tell you that if you are going to do something in the long/short world, or 'hedged' world (to temper volatility), I can't think of anything (in the mutual fund world) I would feel more comfortable with.

What To Do in this Market II: Gotham Funds

Many people seem to be worried that the market is a little toppy.  This is kind of strange because the market is basically flat and hasn't done anything.  But OK, the market was up 30% last year so if you include that (and the whole rally since the 2009 low) the market has come up quite a bit.

But still, smart folks like Howard Marks (who was just on CNBC yesterday) said that the market is not in bubble territory at all; maybe somewhat overvalued.   The market is still in what Buffett called the "zone of reasonableness". 

Others say the market is in nosebleed territory and is due for a correction or at least subpar returns for a long time. 

David Einhorn is short a basket of really expensive momentum stocks but he says that is only a small part of the market (mid-single-digit percentage of the market bubbled up compared to 30% of the stock market in a bubble back in 1999/2000). 

I wrote about what to do in a market that has gone up a lot and you wonder what to do.   You can see that post here: What to do in this Market.

My thoughts haven't really changed at all.  I also wrote a series of posts on market timing (even including 'pricing' the market instead of 'timing' it).  You can see my posts about Buffett the market timer here. 

In order for people to have earned 10%/year in the last 100 years, you had to own it through the depression, through war and peace, when p/e's were 7x and when p/e's were 30x.  The point is that most people would not have been successful getting in and out of the market and doing better than 10%/year, even if you used market valuation levels (instead of economic forecasts).  10% returns were not earned by being fully invested at 7x p/e, 50% invested at 15x p/e and 0% invested at 25x p/e or anything like that. 

Another way to illustrate this is if you look at something like Berkshire Hathaway.  BRK has gone down 50% three times in the past (or maybe more).  Once in the early 1970's, once in 1999 and then again during the recent crisis.  Of all the investors who owned BRK in 1970, how many have done better than the 20% or so return of the stock over the years by getting in and out of it in order to avoid the 50% drawdowns?  There may be some who were able to improve on that buy and hold.  But I doubt that there are too many people, even if they used very good valuation methods to time the sales and repurchases.

So that's sort of the way to look at the market.  As long as you have faith in the U.S. and the system at work here, you can look at the stock market in the same way.  Most people who sound clever now telling us what the market is worth and getting in and out accordingly is probably not going to outperform the market over time.   They will look good temporarily when the market goes down, though. 

OK.  So we all get that. 

Having said all of that, it is still interesting to look at what's out there in terms of alternatives for people who don't like stock market exposure.  I am really skeptical about those market-timing funds that change asset allocation according to market valuation, economic forecasts and things like that.  A lot of that stuff is great for asset gatherers and marketing; everyone hates volatility and a lot of presentations by these tactical allocators just make a whole lot of sense.  The problem is that I don't think that they perform all that well over time.

So here's the punch line: 

Gotham Funds

As you know, I am a big fan of Joel Greenblatt, and this is the latest iteration of his fund operation.  Initially, he had Formula Investing funds but shut those down and started these new funds.  Why?  Why is he running a long / short fund when he said about shorting that it is really difficult and that guys that do this are like the baseball outfielders that go, "I got it, I got it..." and then inevitably at some point go, "I don't got it..."?

He also said that buying the Magic Formula stocks and shorting the most expensive stocks on the list would have led to much more volatility on the overall portfolio than just being long because you can get really killed on the short positions. 

But here we are with Greenblatt running long/short funds. 

I'll get to that in a second, but first let's take a look at the cool website and his returns so far. 

Here's the website:  

     gothamfunds.com

There are some nice links there of Greenblatt's interviews on Bloomberg and CNBC.  Also, his interview in Value Investor Insight is posted there too and it's a great read.  Read that here. 

The Funds

And these are the funds that they offer: 

I know, I know.  This looks suspiciously like the long/short funds that was popular with the big mutual fund companies not too long ago.  I think most of those haven't done too well over the years.  The problem, I think, with the long/short funds that the mutual fund giants put out was that they were usually run by long only managers who suddenly had to start shorting stocks and they had no idea how to do that. 

They would buy a nice value stock and then short an expensive mo-mo stock.  It makes sense on paper, but then the value stock goes up 15% for a nice return and then the mo-mo stock goes up 50%. Oops.   

So running a long/short portfolio requires different skills than running a long only equity portfolio.  I've actually seen this happen (a long only manager transitioned to a long/short manager) with predictable results (even though this manager turned it around eventually; it helped to have been part of a legendary hedge fund firm). 

Plus, if you are working for one of the big mutual fund firms and can actually do long/short well, you would either get hired at a hedge fund or start your own.  Why would you not go out and earn your own 2 and 20? 

Performance

The funds are too new to really evaluate them, but here are the figures anyway: 

The S&P 500 total return isn't listed with these figures, so here are the year-to-date and one year returns of these funds versus the S&P 500 index  (the figures below are as of June 10, 2014):

                                                            YTD                           1 Year                        

Gotham Enhanced Return                  +10.5%                      +34.4%

Gotham Absolute Return                    +6.4%                        +21.5%

Gotham Neutral                                  +7.4%                          n.a.

S&P 500 Index                                  +5.5%                       +18.7%

So it looks like even the Neutral fund is outperforming the S&P 500 index year-to-date.  Of course, the time period is way too short for this to be relevant.

But, you know, I have been a big fan of this approach (Magic Formula) and I have a lot of confidence in Greenblatt so I would have no problem recommending any of these funds to anyone interested in this sort of thing.  I don't own any mutual funds but if I had to pick funds to invest in, I would definitely consider one of these. 

I usually don't like these long/short type funds unless they are run by people with a proven track record of doing well with the strategy.  

And I am also very skeptical of quantitative/mechanical investment methods.  Yes, value has been proven over and over to work in study after study. But when things get mechanical, I start to worry and have never been a big fan of investing mechanically  (I actually don't know how purely mechanical these funds are because there does seem to be some room for input from the managers).

But Greenblatt is different.  He came up with something after years of experience in the markets.  Usually, it's the other way around:  Some folks in academia or research departments at wire houses come up with some sort of screening method to try to create baskets that outperform.  I've seen tons of these things over the years but never saw anything that was as simple and consistent as Greenblatt's Magic Formula. 

And whatever they do here in these newer funds is an improvement on that (partly going long/short, and then an added layer of weighting the portfolio according to how cheap or expensive something is instead of equal-weighting it). 

The Evolution of Joel Greenblatt

So, let's get back to the question:  After dismissing shorting as too difficult and saying people eventually get killed doing it, why is he now running a long/short fund!? 

In order to understand this, we must go back and look at how Greenblatt has evolved over the past decade or so.

Stock Market Genius

After a nice long run as a hedge fund manager and putting up some impressive figures, Greenblatt wrote You Can Be a Stock Market Genius.  He said that he initially wrote this for individual investors.  After it was published, he realized that much of the material was over the head of most individual investors.  It turns out that this book was used successfully by many young hedge fund managers.  So he said, hmmm...    How can I reach the less experienced, more typical individual investor? 

Magic Formula

Then a few years later he wrote The Little Book That Beats the Market.   This was meant to explain how value investing works, and he even gave readers a formula to calculate return on capital and earnings yield.  He even set up a website to list the cheapest stocks according to this methodology.

Formula Funds

And then he realized that even with all of that stuff provided to the public, people still didn't act correctly and ended up not doing too well.  I think he had a record of people using the formula but human intervention prevented some from actually doing well (I forget the details, but it was something like not wanting to buy the crappy (cheap) stocks on the list, or getting scared out of the market during declines). 

So he set something up where someone will do all the work for them. 

I don't really know what went on between the Formula Funds and Gotham Funds, but my guess is that it went something like this: 

Greenblatt realized that even if Formula Funds did all the work, people will still get scared out of the market at the worst time.   I'm sure he had some experience with that and studies show that individuals tend to do way worse than the funds they own as they put money in at the highs and run away at the lows.  Some research even showed that investors collectively actually lost money in a fund that performed well.

This reminds me of the person (I mentioned this on the blog before) who told me that he has never made money, ever, in the stock market and he has been investing in the stock market during the period the Dow went from 4,000 to 12,000 (or something like that).  How can you be an "investor", have the stock market triple, and not make money?!  I think this is very typical. 

Big Secret

And at some point he wrote The Big Secret for the Small Investor.   This book was about value-weighting the indices.  Market capitalization-weighted indices didn't make sense for value investors because you were forced to own the larger cap names regardless of their valuation level.  Someone improved on this by removing the big-cap bias by equal-weighting the index.  The Big Secret is to take it a step further; the value-weighted index would give a higher weighting to the cheaper stocks and less to the more expensive ones.  This makes a whole lot of sense and I was sort of looking forward to some development in this area. 

I wrote about that here, but it seems to have gone nowhere (the website data only goes through 2010). 

But hold this thought for a second, the idea of putting more into cheaper names (instead of equal-weighting it like the Magic Formula). 

Gotham Funds

So now we get to Gotham Funds.  He once said that shorting is very difficult and that trying to long/short the Magic Formula would create more volatility, not less.  But I guess he revisited the idea after realizing that even if a method worked well, most people won't benefit from it because they can't sit tight long enough to make any money. 

So he must have been working on figuring out a way to get the long/short to work.  Plus the Magic Formula was so incredibly consistent that it must work, somehow.    By consistent, I mean that the 1st decile stocks through the 10th decile stocks performed exactly as expected over time according to their relative cheapness.  This sort of vertical consistency was strongly indicative that some sort of long/short strategy must work.  

By using a larger number of stocks and weighting the components by how cheap/expensive they are, he figured the volatility of the portfolio will be more stable (than say, buying a basket of 20 cheapest stocks and shorting the 20 most expensive ones). 

With the various options above, an investor can choose how much market exposure he wants.  Someone who is comfortable with the stock market can just buy the Enhanced Return fund, and others who don't like stock market volatility can go with the Neutral Fund. 

He did say in an interview that he wouldn't use these funds as market timing devices because most people won't be able to do that well. 

I can see the temptation to roll into the Neutral or Absolute Return funds when things look expensive and then get into the Enhanced Return when the market goes into a bear market (and gets cheap).  I imagine the fund flows would actually be the opposite of that, though.   

There is a fee for redeeming early so there will be a cost to doing that.  

And I wouldn't really advocate that at all. 

But this would still be far better than switching in and out of the stock market versus cash and bonds.  If you have to time and switch, it would be far better to do so between funds that would probably do well either way.

Plus I would guess that that would be far better than owning a fund that tries to outperform over time by switching between stocks, bonds, cash, commodity proxies and whatever else based on economic forecasts, market valuations and things like that.  Again, good luck with that. 

Why Kill Formula Funds? 
So why did he have to get rid of the Formula Funds?  I don't know.  My guess is that he thinks he found a better way so why bother keeping the old funds if these new ones are better?  He doesn't want to build a mutual fund giant by offering many variations of funds.  Most mutual fund companies love putting out new funds and using every new fad to increase AUM.  That works great for them; more funds, more work for their employees (young apprentices can gain experience by trying to run a new fund etc...).

But that's not what Greenblatt is trying to do.  He is trying to help the average individual investor make money in the market, and as long as he finds better ways to do that, he will replace the old strategies with the better ones.  If you invent and start selling refrigerators, maybe you can just stop selling ice.

But this is just my guess.  Plus,  the cost of running multiple funds is probably a big factor too.  He probably wants to keep this a small, simple operation and invest resources into research and improving the product and not wasting money increasing administrative overhead by running a bunch of different funds.

Has Greenblatt Really Evolved? 

One question is, has Greenblatt changed his views on investing after all these years?  He said in the Value Investor Insight interview that he hasn't changed. In fact, if he started all over again he would do exactly what he did the first time;  run a highly focused fund of special situations.  He said that this approach is highly volatile and he was OK with that.  In the early years when he made high returns (40-50%/year), every two or three years he would have a 20%-30% drawdown that happened pretty quickly.  But he didn't mind that. 

These recent ideas are his ideas that he thinks will work better for most people.

So this evolution is more of Greenblatt's evolution in trying to help the average investor make money in the stock market.  He wrote a book.  That didn't work.  He wrote another book. That didn't work.  He did the research for them. That didn't work.  He set up a fund for them.  That may or may not have worked, but he found a better way to make the average individual investor stick to the strategy and not get scared away. 

Bifurcated Market
By the way, here again is the performance figures for the Superinvestors of Graham and Doddsville from 1966 through 1982, a period when the stock market went nowhere.  The market was overvalued back in the late 1960's and the Nifty Fifty peak was in 1972.

But these Superinvestors did well overall through the period.   I use this table to remind myself (and others) that the overall stock market level is not always the most important thing in long term performance.

The other point, looking at this table now, that I realize is that during this time the market was probably highly bifurcated.  The mo-mo stocks were expensive back in the late 1960's, and then having been fooled by the conglomerates boom and tech stocks (-onics was the .com of the time; end your company name with these and the stock price went to the moon), investors rushed into the nifty-fifty one decision stocks (they were high quality blue chips, not fad stocks.  What can go wrong, right?).   My guess is that these Superinvestors did well during this period because they stayed away from the bubbled up areas.

I think we may be in a similar period now.  I don't really see the overvaluation that people keep talking about; I don't see excessive margins in the companies I am interested in and I don't see high p/e ratios there either.

But there are pockets of silliness here and there.  If you look at TSLA, AMZN, NFLX not to mention FB, TWTR, things look a little bubbly.  As Einhorn said, this area is not as big a part of the market as internet/tech bubble back in 1999/2000.   The collapse of some of these names may or may not take down the whole market, but either way, it's not such a big part of the stock market.

This is one reason why I am not a big fan of looking at the stock market valuation as a whole in making investment decisions.  The Superinvestors wouldn't have done so well if they sat out the market in 1966, 1972 etc...   And there was plenty do to even in 1999/2000 despite the market trading at 30x p/e (or whatever it was).

So why is this relevant to this post?

A highly bifurcated market is a great time to be long the market (if you own the right stocks) but can also be really interesting for a long/short strategy.  But of course, only if the person running it is competent.  I don't think just any long/short fund will do well;  I think most will do horribly; they will get killed on both sides (the shorts will go up and the longs will underperform!).  But if I'm right, Gotham Funds may do well on both sides; at least relatively.

Conclusion

So although nothing has changed as far as I'm concerned (with respect to what to do in the markets) I like to follow Greenblatt and I think he is the real deal. 

I am usually not a fan of long/short mutual funds (or even hedge funds unless run by someone with a good track record; never buy these things offered by the large mutual fund companies!), and I am not really a big fan of mechanical investing either. 

But again, Greenblatt is a veteran that has a proven track record in the markets so he is not just some academic coming up with a nice theory trying to sell you something.  So I wouldn't have much reservation about these funds based on it being a long/short strategy and quant-based. 

Also, I know that the Magic Formula has been controversial in the past; that people have not been able to duplicate Greenblatt's results.  I haven't done any work on that myself but I suspect a lot of that is going to be because of the data. 

When I worked at big firms, a lot of resources went into cleaning up the database (that were presumably already cleaned up by the vendor).  So it would be really difficult in any case to duplicate results without a good staff actually going over the raw data first.  You'd be surprised how much silliness gets into these backtests if you don't actually check the data yourself (or have someone do it for you).  This would include things like dropping stocks where the financial data is suspect or meaningless (data vendors won't do that).

So,

• In this bifurcated market we know that there are decent stocks to buy and the Magic Formula type things will outperform over time.  No need to get out of the market even if the whole market is expensive (and some great investors say it's not) if there are reasonably priced stocks to own.  And the Magic Formula is not a bad way to be long (assuming the Gotham Funds use a similar methodology). 
• On top of that, the returns in these funds will be enhanced by the weighting strategy of buying more of things that are cheaper instead of equal weighting them (read the The Big Secret for the Small Investor and go to the website (valueweightedindex.com) to see how that works).
• And then you have a short portfolio overlay on top of this using the same strategy in reverse; shorting more of the more expensive things.  The short book is risk managed by having smaller positions per name so as not to get killed by the occasional NFLX / AMZNs.  
• People will always be afraid of some stocks due to recent bad news (and therefore underprice them) and will always adore others (and therefore overprice them).  As long as this continues to be the case, the strategy should work.  

It's such a simple idea and it sounds too good to be true. And yes, the mutual fund industry is littered with funds that tried similar things in the past.  

I will tell you, though, that this is different than those past attempts by a wide margin; mostly due to the experience of Joel Greenblatt, the research that he has done and disclosed to demonstrate that the ideas actually work etc...  

The $250,000 minimum investment might be a high hurdle for some younger individual investors, but if I wasn't actively managing my own account, I would certainly consider putting a decent chunk of my risk capital into these funds. 

Anyway, I don't recommend mutual funds here all that often, but take a look! 

Greenblatt on CNBC: Market Reasonably Valued

So Joel Greenblatt was just on CNBC and said some interesting things.  I don't intend to post every time someone I respect shows up on TV, but this appearance was especially interesting to me for a couple of reasons.  One major reason is, of course, market valuation.

I don't really care about the many folks that call for a crash or call the market overvalued and whatnot, as many of those people have no track record of turning their market views into long term profits.  If you think about the guys that show up on TV as bears most of the time in the past ten or twenty years, most of them don't have good long term track records.

But the other day, Seth Klarman was reported to have been pretty bearish saying that there is an impending asset price bubble (in his letter to investors).  It's true that he has been cautious since the 1980's (and yet still manages to make a lot of money year after year), but still, his recent warning is not to be taken lightly.

On the other hand, Warren Buffett has said recently that the market remains in the "zone of reasonableness" or some such.  He doesn't feel that the market is particularly overvalued but not especially cheap.

And then of course there is the Robert Shiller P/E ratio (CAPE) that shows serious overvaluation.

What are we to make of all of this?  I have posted in the past about market valuation, but since it seems to be such a hot topic again now, I thought Greenblatt's input on this would be interesting.  He is one of my favorite investor/authors so I do take what he says seriously.

Here is the link to his appearance:  CNBC Greenblatt video

Anyway, this is what he said:

What he likes
Hewlett Packard (HPQ) and Apple (AAPL).  They trade very low on measures of free cash flow with "huge return-on-capital businesses".  Most people don't like them because they're old and stodgy (referring to HPQ).

AAPL
This is one of the parts that was really interesting to me.  I always wondered why Greenblatt liked Apple.  If you look at Greenblatt as the author of "You Can Be a Stock Market Genius", it doesn't make a whole lot of sense.  The future of Apple is hard to predict; it doesn't pass the five or ten year test of what the business will look like etc.

Greenblatt explained that when there is a business with a lot of change, where the technology changes, competition changes and you don't even know what the company will be selling three or four years from now, he tells students to skip it and find something they can figure out.

But if you buy these businesses at such low valuations as a group, then you can do well.  You don't buy one Apple, you buy a basket of Apples.  And when you buy a basket at such low valuations, it's good.  This bucket of technology stocks is cheap.  He later mentions Microsoft (MSFT) as also one of the large, cheap tech stocks.

So now I understand that this is the author of "The Little Book That Beats the Market" talking.  He doesn't know or understand the future of Apple, but he is confident that a basket of tech stocks trading so cheaply will do well going forward.  He has no view on the sort of things we talked about here regarding AAPL.  I should have known that since every recommendation he has made on TV since the Little Book was published were basically magic formula stocks.

Large Caps Reasonable
Greenblatt said that looking back over the past several decades, the Russell 1000 index is trading at the 42nd percentile in terms of valuation; the index has been cheaper 58% of the time over the past several decades.   So it is reasonable.  His data shows that from here, the one year forward returns is somewhere between 7-12%.  That's not bad. 

Small Caps Not
He said that the Russell 2000 index tells a "very different story".  That index is in the top 5 percentile of valuation, meaning it has been cheaper 95% of the time in the past several decades.  The one year forward return from this level is a negative 3%. 

Super-Large Caps Reasonable
He said that the top 20 names in the S&P 500 index, which is 30% of the index by weighting, are reasonably priced, even Google (GOOG).

What Do I think?
So this is all very interesting.  You have some of the smartest investors saying all sorts of things about the market and not in agreement.  Klarman said that on almost any metric, the market is "quite expensive", and that a "skeptic would have to be blind not to see bubbles inflating..."

And yet we have Buffett pretty mellow about it all, still buying stocks and his underlings still buying and Greenblatt saying things are reasonable.

I personally don't spend too much time on this stuff.  I would rather spend time on bottom up and not worry too much about the top down.

For example, of all the posts I've made about investment ideas, the overall market doesn't really make a difference to me.  I wouldn't say that JPM is attractive here only because the market p/e is 20x or some such.  I like what I talk about here pretty much on an absolute basis.  Of course, if the market was really overvalued at 30-40x p/e, then I would like my ideas more (at the current valuation), and if the market was trading at 7x p/e, then I would probably like the market more.   But those are extremes on both ends.

I think the key is what Buffett said in the annual letter.  If you own a business that you like that is a good business run by good people and is reasonably valued, why sell it just because some people think the overall market is overvalued?  (Well, Buffett talks about macro factors, but I think the same applies to overall market valuation; why sell your business you like just because something else is overvalued?).

Identifying the market as overvalued and undervalued is fun stuff, but it is really hard to turn into long term profit.  You can always guess one or two turns.  You will always run into the guy that sold everything in August 1987 or early 2007.  You may even run into folks that got out in August 1987 and then got back in in December 1987, or got out in 2007 and got back in in early 2009.  But you really won't find people who did that over several cycles.

In my previous life, I read just about every investment newsletter (of course courtesy of my employer), followed every guru and nobody calls the market continuously through cycles, even using rational, simple tools such as valuation.

Even recently, there is one prominent strategist that is a good read, but this strategist jumped in and bought gold just about at the top of the market.  Another fund manager/economist who writes an interesting, well-written, convincing and widely-read newsletter has performed horribly over the long term.  Yes, maybe the market is toppy so the fund looks the worst now (just as value investors look really bad at bear market lows), but I don't think losing money is really acceptable for something that is not supposed to be a bear fund (it's supposed to be hedged, which is not the same thing).

Klarman has been cautious for a very long time but still manages to make money, so that's a bit different (and rare!).

I've talked about how Greenblatt and the Superinvestors of Graham and Doddsville made money over time (see here), not to mention Warren Buffett.  These guys didn't do it by getting in and out of the market based on market p/e, market cap to GDP, CAPE or anything else that I know of.

So What to Do?
So for stockpickers, just look at your stocks and if you like the business and where it is valued, who cares about the market?

What about folks invested in the S&P 500 index?  Well, Greenblatt did say that the 20 largest names in the index are reasonably valued, so the index should be fine to own.

Even if Greenblatt didn't say that, the stock market overall returned 10%/year or so historically, and that was only achieved by owning the index during good times, bad times, when they were cheap and when they were expensive.  10% was not achieved by getting in when they were cheap and sitting out the market when it was expensive.

If the market is expensive, the correct thing to do is not to sell out, but to adjust your expectations.  Greenblatt did say something like that; if the market typically earns 8-10%/year and it's a little overvalued now, then the returns will be a little lower, but still good.

I think the mistake is that when markets are overvalued, people think that it then must go down.   So they take a short position or buy puts.   Or they get out completely and wait to get back in cheaper.

Maybe the correct way to look at it is that when markets are higher we should expect lower returns going forward and that's that.  To assume that when markets are expensive, that we can sell out now and get back in cheaper later is a risky assumption, and one that hasn't worked out over time (again, show me someone who has done that successfully over many cycles!).

Recapitalizing Berkshire Hathaway

So I had a conversation recently and I mentioned LEAPS and leveraged recapitalizations (or synthetic recapitalizations) as one idea mentioned in Greenblatt's You Can Be a Stock Market Genius  (see the book here). 

Actually, Greenblatt calls this "creating your own stub stock".  A stub stock is the post recapitalized shares of a company that borrowed a bunch of money and paid it out to shareholders (or swapped debt for equity in some combination;  see chapter six, page 201, "'Baby Needs New Shoes' Meets 'Other People's Money': Recapitalizations and Stub Stocks, LEAPS, Warrants and Options")

I thought I wrote this up before but can't seem to find it.  I probably mentioned it within some post somewhere, but I'll take a look at this idea again, maybe in more detail than when I wrote it up last time.  I also know that buying LEAPS on BRK is not a new idea; people have been doing this and talking about it for years.

But anyway, when you listen to Berkshire Hathaway (BRK) shareholders, the two biggest complaints I tend to hear are:

1. BRK should pay dividends!
2. BRK is underleveraged; all that cash and bonds are holding down returns; why doesn't BRK buy back a ton of stock?!

Dividends
This gets debated to death on the internet and I don't want to get into that.  Buffett has said quite simply that he won't pay dividends as long as he thinks he can outdo the S&P 500 index with the retained earnings.   

For people who want dividends, the answer is easy.  They can just sell 2% or 4% of their BRK holding every year as a 'synthetic', self-created dividend.  With intrinsic value growing 10%/year over time, the value of their holdings should increase over time too.

I guess the problem with that is people hate the idea of selling BRK stock below what they consider intrinsic value.  But then again, if BRK pays out a dividend, that reduces book value on a dollar for dollar basis and at the same price-to-book ratio, the value of BRK goes down a like amount.

At least BRK is trading at above book value, so selling shares may be better than getting a payout at book value (which is what happens when you get a dividend; $1.00 valued at 1.2x by the market ($1.20) held at BRK becomes $1.00 (at 1.0x) in your pocket).

For now, dividends have a low tax rate but in normal times selling stock over time can be better too.  Most of the time (at least in my time), capital gains tax rates were lower than ordinary income rates (which is what dividends are usually taxed at until the Bush tax cuts).

Plus, you have to pay the entire amount of tax on dividends received but only on the 'gain' in the case of capital gains realized when you create your own dividend.

Anyway, that's just my thought; I am no tax expert so I may have missed something.  In any case, this is not really the topic of this post.

Recapitalization
For those who haven't read Greenblatt's book, I would encourage you to go and read it.  Readers here know by now that I am a big fan of his work.  I do really put You Can Be a Stock Market Genius as probably the worst titled book ever, but one of the best investment books ever written.

It goes right up there with Securities Analysis and Intelligent Investor (and Seth Klarman's Margin of Safety).  But it's more like Intelligent Investor in the readability than Securities Analysis, which tends to intimidate people; it's a big, heavy book. 

Most people would be able to read the Genius book over a single weekend (and it's funny).

Anyway, in that book Greenblatt talks about a special situation that was popular in the 1980s.  It was the recapitalization trade.  Sometimes it's called leveraged recapitalization.  The idea is that if a company borrows a ton of money and pays it out to shareholders (or repurchases stock), the value of the left over (called the stub) increases in value.  This is due to the tax effect; interest payments on the debt reduce pretax income but also reduces the tax burden so at the same multiple, the post recap firm would have a higher value (excluding the paid out cash).

Even if the post recap P/E ratio is somewhat lower (due to higher leverage), the value of the stub (and of course the value of the combined cash + stub) is higher than before the recap.

Greenblatt pointed out that recaps were no long popular (he wrote this in 1997) due to the bankruptcies of many highly leveraged companies in the late 1980s and early 1990s.

But he said, not to worry!  There are hundreds of LEAPS listed on the exchanges so we can create our own stub stocks.

So, this is what we're going to do.  I will take a quick look at creating our own BRK stub stock.

Stubbing BRK
OK, so here's the deal.  BRK, as of June-end 2012 had $182 billion in shareholders equity.  Of that, $36.8 billion was in cash and $30.5 billion was in fixed income investments.   That's a total of $67.3 billion in low return assets.   So 37% of BRK's net worth is invested at very low rates.  No wonder why the P/B ratio has come down so much (compared to when BRK was highly levered to the stock market long ago.  I took a look at that a while ago; you can just look for posts labeled BRK for that).

Wouldn't it be great if we can just have BRK pay that 37% out?  Yes, of course it would.  But we know that they can't do that.  BRK is an insurance company with a lot of obligations.  One of BRK's strengths is their rock solid balance sheet and high credit rating.  So much of the fixed income and cash is not really pay outable.  Buffett has said he wants $20 billion cash, minimum, so there is maybe a bit more than $16 billion usable, though.

And the fixed income portfolio is also pretty much mandated by insurance regulation to support the 'float'.

So it's clear that the insurance companies will have to hold a lot of these cash and bonds, so let's just fantasize for a second and ignore credit ratings and reality.

Let's Dream For a Moment
Since the insurance companies can't pay out the cash and bonds, let's look at the holding company.  Let's say BRK can just borrow, say, $70 billion at the holding company level and then pay that out to shareholders.  Wow, that would be huge.  And yes, I know, impossible.  A $70 billion debt offering is insane too.

But we are just trying to get our arms around what leverage can do.

BRK borrows $70 billion and pays that out to shareholders.  What will that do?  Of course, it will reduce shareholders equity by $70 billion (and leaves $70 billion new debt on the balance sheet). 

So BRK's net worth goes down to $112 billion.   BRK's structure, earnings and balance sheet is complicated, but to keep it simple, let's just say that BRK earns around 10% on book every year (including all the businesses and increases in value of stock holdings etc.).

BRK was able to earn 10% before the recap, so that's a $18.2 billion run rate.  With $70 billion in new debt on the balance sheet, BRK will incur interest expense.

A quick search tells me that BRK's credit spreads versus governments and funding costs were:

              BRK credit spread                Treasury yld                  BRK cost of funds
5 year        T+49 bps                             0.6%                           1.1%
10 year      T+105 bps                           1.6%                           2.7%
30 year      T+131 bps                           2.8%                           4.1%

So let's use the really long term rate since this is a complete recapitalization.  We don't want to have to worry about refinancing and stuff like that.

At 4.1%, that's an after tax interest cost of 2.5%.   On $70 billion of debt, that's an annual interest expense of $1.75 billion.

We said that BRK earns, at 10% return on book, around $18.2 billion/year on the $182 billion in book value.  After the recap, BRK would earn $16.5 billion (accounting for the $1.75 billion after tax interest expense).

But the new book value is $112 billion so the post recap return at BRK is 14.7%, almost 1.5x what it would do before the recap.  The stub would be worth 1.5x what is was before the recap (excluding the cash paid out) if we assume a 10% discount rate for fair value.  Actually, you would have to value it a little lower as the market would demand a discount due to the leverage.

Still, that's not bad at all.

But of course, if BRK really had $70 billion of debt on the balance sheet, the credit rating would not be the same, and it probably wouldn't be the preferred provider of reinsurance etc.  This would be a very different animal.

Creating Your Own Stub
Of course, this will never happen but let's see what happens if we create our own stub.  We do this by buying LEAPS.  What are LEAPS?  A LEAPS is an acronym (presumably trademarked) for Long Term Equity AnticiPation Securities.  They are just long term options on stocks.  Maturities tend to go out two years.

The bottom line is that if the company isn't going to go out and borrow money to lever up (and enhance the value of the firm), the stockholder can add leverage at the stockholders' level to create leverage.  Leverage is leverage, right?

So if we bought stock on margin, for example, we are creating our own leverage.  The final economics of the position can be similar (although there will be plenty of differences too).   But margin can be tricky as you can get margin calls, be sold out (what if we have another flash crash or worse?) and who knows what margin rates will be over time.

With LEAPS, once you buy an option, you don't have to worry about anything else; you can only lose your initial investment.

Let's look at the above recap and see what it looks like when we do it ourselves. 

In the above example, BRK borrowed 40% of it's net worth to pay it out.  BRK is now trading at close to $90/share, so if we wanted to create our own stub (post-recap stock), we would go out and buy the $36 ($90 x 40%) strike price LEAPS as far out as is available, which happens to be January 14, 2014.   Since there is no $36 strike, we will just use the $40 strike price.  Close enough.

So what happens when we buy a $40 strike call?

Here are the facts:

$40 strike call price:    $49.38  (mid-point of truck-wide spread)
BRK/B share price:      $88.70

Intrinsic value of call:  $48.70  (current stock price minus strike price)
Premium:                      $ 0.68

Intrinsic value of the call option is simply the amount the option is in-the-money.  If a stock price is $50 and the strike price is $40, then the intrinsic value is $10 (the value realized if option is exercised right now).

So what happens when you buy a LEAPS now at $49.38 is:

1. You are borrowing $40/share worth from the market as you only have to pay that when you exercise the option and
2. You are buying downside protection on BRK because if BRK goes to below $40/share, the option is worth zero and you can't lose more whereas the stockholder will continue to lose money beyond a decline below $40/share.

So compared to just buying BRK/B today at $88.70/share, when you own the above LEAPS, you essentially have a loan and a put option (exercisable at $40/share).

Let's break that down:

BRK/B share value:       $88.70

BRK/B LEAPS value:   $49.38
Implied Loan:                $40.00  (strike price)
Premium:                       $0.68   (includes interest on loan and put option value)

So the 'loan' on your balance sheet is 40% of the full value of BRK/B shares, similar to the above dream recap when BRK borrowed $70 billion.

Pricing the LEAPS
So the intrinsic value of the January 2014 $40 strike call is $48.70, but it is trading now at $49.38, a little higher.  This premium includes: the financing cost of the $40 strike price (which is the amount you are borrowing until expiration:  a call buyer puts up $40 less than the buyer of the stock) and the put option value of a $40 strike put.

Since the put option is so out of the money, let's just ignore that and see what the implied financing cost is on our $40 loan (or we can see it as a loan that includes this insurance).

The difference between the current LEAPS price and intrinsic value is $0.68.  If that is the interest cost on the $40 loan, that comes to 1.7%.  But wait, that's not annualized.

Since the option expires 473 days away, that's 1.3 years away.  So the 1.7% interest expense is actually just 1.3%/year.

So by buying the LEAP, you are essentially buying a $88.70 stock by putting up only $49.38 and borrowing $40 at an interest rate of 1.3%/year with insurance (you can walk away from the loan if the stock is under $40 at expiration).

That's not a bad deal at all.

If we do the above return analysis, you can see that the stockholder can expect to earn $8.9/share (10% increase in value per year; we assume 10% growth in book value per share and constant P/B ratio.  I initially used the increase in book value per share for these calculations, but realized that that would understate the return to shareholders if they assume a constant P/B ratio since BRK is trading at around 1.2x book).  You can do the same using 10% increase in book value per share as a proxy for EPS instead of 10% increase in share price and the results would be a little lower). 

What will the LEAPS holder earn on an equivalent basis?  Since he only put up $49.38/share, he will get a levered return.  But he is also paying interest on the loan (premium on the LEAPS).  The loan costs 1.3%/year on the $40 loan, so that comes to $0.52/share.  If the BRK stockholder can earn $8.9/share, then the LEAPS holder is earning $8.4/share.  $8.4/share on $49.38/share investment is a return of 17%.

So by levering up with LEAPS, the BRK holder has created his own stub stock and bumped up his return from 10%/year to 17%/year.

Of course, these returns assume that the P/B ratio of BRK remains the same and BRK increases book value at 10%/year.

Some upside can be had if the P/B ratio expands too for some upside kicker (and of course, it would be lower if P/B contracts, but most Berkshire holders aren't expecting that).

And what's really great about this self-stubbing or synthetic leveraged recapping or whatever you want to call it is that it does nothing to BRK's credit rating!  And BRK doesn't scare the credit markets (and compete with the Feds) with a $70 billion bond offering.

Of course, there is a big downside too.  Options have maturities, so if the stock does nothing until January, you lose 1.0%/year right off the bat (that doesn't sound too bad, actually.  You are essentially betting 1.0% to earn 7% extra, not a bad risk/return?   But not really; you do have leverage to the downside, so the 1% is the cost of the leverage (and you get it both ways).   The 1% comes from the premium (implied interest expense) of $0.52/year against the $49.38/share price of the LEAPS, which is around 1%).

If the stock goes to below $40/share by expiration, the LEAPS will expire worthless but BRK owners will still own the stock so if it comes back up, they can still be OK.

I looked at this from the point of view of a fundamental analyst looking at earnings;  pre and post recap earnings and returns.

But let's just look at it from the point of view of an investor/trader. What is the difference in returns between owning the stock and the LEAPS?

Returns Comparison for $40 Strike LEAPS

This table is pretty self explanatory.  The left column is the stock price at expiration of the LEAPS and the following column is the intrinsic value of the LEAPS (or value of LEAPS at expiration given stock price levels).  The two columns that follow just look at what the returns would be assuming various levels for the LEAPS and BRK stock.  The last column is just the leverage you get on the LEAPS compared to just buying the stock.

Of course, this ratio is similar to the above "return on book" calculation above, which is similar to the "dream recap" scenario above that.  

Let's Look at Another Strike
OK, so that one is really deep in the money.   What about getting even more leverage?  We all really like BRK and think it's really undervalued and it's a coiled spring ready to jump up 30-40% to intrinsic value very soon.  (OK, maybe that's a bit much.  But it does look OK around here, doesn't it?)

So let's look at a more realistic, higher strike price for a LEAPS, which actually makes it more leveraged.  I say 'realistic' because it's a litte more liquid at the higher strikes.

Let's look at the $60 strike, January 18, 2014 calls.  This should give us almost triple leverage since we are borrowing $60 against a $89 stock price.

Here is the relevant information:

Stock price:       $88.52  (yes, it has moved while I'm writing this)
LEAPS price:    $30.50
Intrinsic value:  $28.52
Premium:            $1.98  (LEAPS price minus intrinsic value (of LEAPS))

So again, ignoring the put option value, the implied financing cost on our $60 loan would be ($1.98 / 1.3 (annualize it) / $60) 2.5%.

At 10% return on unleveraged BRK, the BRK shareholder earns $8.9/share.  The annualized cost of the loan (including put option value) is $1.52, so the LEAPS holder would earn $7.38/share ($8.90 - $1.52).  Against the purchase price of the LEAPS of $30.50, the return for the LEAPS holder is 24%.

So with this self-stubbing of BRK, we created a security with an implied rate of return of 24% from a stock with an expected return of around 10%.

Again, let's look at a table of this for those who only care about what the LEAPS will do according to various stock price scenarios:

Returns Comparison For $60 Strike LEAPS

The above table shows that we get substantial upside leverage by creating our own stub stock.  We turn a $90 stock into a $30 leveraged stub stock and the returns shows how the earnings can be geared up.

Of course, leverage is a double-edge sword so you lose a lot more on the downside too.  If the stock goes down 10%, the LEAPS value goes down more than 30%.   If the stock goes down to $70, the stockholder loses only 21% but a LEAPS holder loses 67%.

But this would be true if BRK did a real leveraged recap too. The net worth of the company would go down much faster post-recap than as it is currently as a conservative-balance-sheet high grade credit (but this would be driven by company fundamentals, not the stock price).

Rolling LEAPS over time can be quite expensive if the stock stays flat over long time periods.  I know that BRK LEAPS have been popular in the past few years.  One value investor owned LEAPS and long term OTC call options, and I wonder how that worked out as the stock price of BRK has been flat over the years.

The cost, though, is easily calculable.  Your carry cost is basically the premium you pay above and beyond the intrinsic value of the option.  The more deep-in-the-money the option is, the less premium you pay and the less cost of carry (due to lower interest cost on smaller implied loan and lower value of the put option).  This is offset, of course, by the lower leverage you get.   You can think of an option with a zero strike price as being similar to a stock (even though you wouldn't have stockholders' rights and other things).

Also, there may be tax implications even if the stock does well; if you roll LEAPS, you will have to realize gains and pay taxes on each roll etc.  

Conclusion
So with this simple idea, we can take a stock with expected returns of 10% and turn it into one that earns 17% or 24% (depending on which strike price).  And the cost seems very reasonable. The interest expense (which includes the put option value) was 1.3% and 2.4% for the 40 strike and 60 strike call options.  Who would lend you money at those rates?  (I have seen margin loans advertised at very low rates but margin rates seem to be pretty high).

If you buy LEAPS, you do borrow and lock in those rates for the term of the option; margin loan rates can change at any time.

So, the benefits are:

• Even if Buffett doesn't want to lever up BRK, we can do it ourselves at very attractive rates.
• We can turn a 10% returning stock into a 17% or 24% returning leveraged stub.  The risk is the initial investment so there is no margin call worries.
• Buy doing the recap at the investor level, it doesn't impact BRK's credit rating and won't impact the credit markets.

Of course, there are cons:

• If the stock goes down, you get leveraged downside too.  If it stays flat over the years, this may be costly, even though it seems at current levels the 'cost' seems cheap (and therefore attractive?)
• Even if BRK does well, the stock market can be irrational.  This can obviously be bad for the  LEAPS holder (but this could be bad for BRK holders too if it did a real recapitalization).
• LEAPS do expire, so that's an issue.  A real recapitalized firm has to deal with rolling debt, but not expiration every two or three years.
• There is some risk in owning LEAPS; if BRK starts to pay a regular dividend the strike price isn't adjusted so LEAPS holders would lose out on unexpected dividends.  Special cash dividends and other corporate actions are adjusted, though.
• There are tax issues; you may have to realize gains every time you roll your LEAPS whereas long time BRK shareholders can compound continuosly without paying taxes (until they sell).

These are just some of the things that immediately come to mind.  I'm sure there are other things.   But this is just a quick sketch of this concept.  It can work with any other company, of course.  You can take a stock you like, lever it up and create your very own, personal stub stock.   You can also do all of the above with other strike prices too.

I should say that leverage is dangerous.  Buffett always says don't risk something you need for something you don't need.  Why lever up if you don't have to?   So it feels funny to make a post about levering up by using options on BRK.  But hey, this is an idea out of Greenblatt's book.  Don't blame me!  (Greenblatt didn't mention BRK, though).

They say most options expire worthless (well, that's not true for deep in-the-money options, of course); you can really piss away a lot of capital being long options so I would caution people to be very careful with these things. 

As usual, do your own work and only do something if you really understand it!