Shake Shack Inc. (SHAK)

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

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

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

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

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

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

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

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

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

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

At CMG, you get your food really fast.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

SHAK
OK, so back to SHAK.

SHAK too feels sort of like CMG in many ways.

Here's the blurb from the S-1:

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

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

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

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

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

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

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

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

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

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

Check this out on the growth of SHAK:

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

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

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

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

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

  

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Oh yeah, and Happy New Year!

The Halo Effect

After posting about the Collins book, Good to Great, some people mentioned the book The Halo Effect: . . . and the Eight Other Business Delusions That Deceive Managers by Phil Rosenzweig as a counter to it.

So of course, I got it and read it right away.  And it's a really good book.  I agree with a lot of what Rosenzweig says and this is one of the reasons why I generally don't read management "how-to" books.  If I do read them, I read them quickly and don't think much of them either way because, frankly, I have never really been all that interested in management.  I have never wanted to be a manager or CEO or anything like that at all.  Mostly, I read it to get corporate histories especially if they include case studies.  Ironically, I actually read them precisely for the "stories".  How to improve a business or build a great corporation, to me, is secondary and not all that important.  It's the stories that I want to read.  And it's this "story-telling" that Rosenzweig criticizes.  He says that many of these management books (like the Collins books) are not scientific studies but are just a bunch of great stories.  That's actually totally fine with me.

In any case, I enjoyed reading Good to Great, and think it was useful.

Amazon/Bezos Book
I also just finished reading The Everything Store: Jeff Bezos and the Age of Amazon.  This is a really good read and I think everyone should read it, even people who don't invest in internet companies.  The way Amazon is changing the world goes way beyond internet businesses so I think it's an important piece of the puzzle for anyone who wants to understand business and what's going on in the world now.

This is a really well-researched book and one of the better business profile books.  There are a lot of books that seem to have been thrown together over a single weekend with sources/information seemingly acquired in a bar nearby a company headquarters.  When Apple got hot, a few books came out that were like this; very little new or interesting information and anonymous sources spewing gossip (as if the author hung out in a bar for a few nights and talked to some lower level employees), but no real, substantive information.  (The Walter Isaacson book on Steve Jobs was really good, though).

This one is not like that at all.

One thing that is scary is that it seems like Bezos doesn't even want to raise prices at all.  Some people expected Amazon to lower prices and put everyone out of business and then later raise prices to make a ton of money.  But that seems not to be the case.  At one point in Amazon's history, they were actually contemplating raising prices.  But Bezos' model for Amazon was Sam Walton.  He really dug into his book, Sam Walton: Made in America.  Around the time Amazon was thinking about raising prices, Bezos met with Jim Sinegal of Costco and heard that they won't raise prices to make more money.   Apparently, after this meeting, he resolved never to raise prices for the sake of making money.    I did scratch my head at this part in the book thinking that Costco actually makes money and has a decent return on capital; why won't Amazon raise prices enough to at least make a little bit of money?

Bezos / Good to Great
Anyway, I went off on this tangent for a reason.  As I was reading the Bezos book, I was surprised that Bezos was deeply into Jim Collins and even had him come to Amazon to show them how Amazon can become a great company.

Apparently, a light went on at Amazon due to Collins' presentation (which was based on the then yet-to-be-released book, Good to Great).   The part that clicked with them was finding out what they were really good at and then developing it and get the flywheel moving.

Back to the book.

So what is the Halo Effect?

The Halo Effect
There is a good summary of the book on Wikipedia: Wiki: Halo Effect.

1. The Halo Effect of the book's title refers to the cognitive bias in which the perception of one quality is contaminated by a more readily available quality (for example good-looking people being rated as more intelligent).^[6] In the context of business, observers think they are making judgements of a company's customer-focus, quality of leadership or other virtues, but their judgement is contaminated by indicators of company performance such as share price or profitability. Correlations of, for example, customer-focus with business success then become meaningless, because success was the basis for the measure of customer focus.

There are other delusions (nine in total) that are summarized on the Wiki page.

I agree for the most part with what the book says about these cognitive biases and delusions, but I wouldn't go as far as to say that these biases make Collin's book and many business press articles worthless.  Rosenzweig doesn't go that far, but comes pretty close.

Any time someone says they want to investigate why some companies succeed and why others fail, I am going to be interested.  The methodology may not be perfect and there may be flaws in the assumptions.  But that doesn't really matter so much as just reading about what people did over the years; what worked and what hasn't can be interesting on it's own and you can make your own adjustments about the respective biases.  Rosenzweig uses Cisco as an example of how everyone thought it was such a wonderful company during the internet bubble (great customer service) and then the very same reporters talked about how lousy Cisco is (with horrible customer service) after the bubble popped  (I think most of us, though, recognized Cisco as a huge beneficiary of the internet bubble in a virtuous circle and had no doubt it would eventually reverse).

If you had access to some of the top CEO's in the country and you were able to have lunch or dinner with them, wouldn't you do it?  Of course you would.  And of course you would learn something from doing that a lot.

And of course you would be subject to all of the same biases discussed in Rosenzweig's book. You would be talking to people you see as successful, and they will tell you what they have done, but there is no way to tell what the cause and effect was (were employees happy because the company was successful and the stock prices (and therefore their 401-k's and stock options) were up a lot, or did happy employees create the success?

But you would still do it.   And you would still ask the same sort of questions.  And then you would make adjustments to what you hear  (and even those adjustments would reflect your own biases).

I guess what Rosenzweig has a problem with is how Collins simplifies and distills all of the case studies into a simple formula, but I think most readers read these books to get ideas and inspiration more than any sure-fire, fool-proof method of eternal success.

Managements Don't Matter / Nothing is Forever 
Rosenzweig also presents a study that shows that CEO's don't really matter as much as we think.  This may be true, but taking that to the extreme is not so great either because I don't think anyone would agree that the CEO doesn't matter.  I do think there are good CEO's and bad ones.  But that is not to say that good CEO's can't have bad results and vice versa.   He also points out that it is impossible to build a great company to stay great forever.  You can't build something to last.  He shows that previous excellent companies, companies built to last and good to great companies have done worse than the S&P 500 index, and the less favorable comps did better.  All companies go through a life cycle.  I agree with that too.

I personally believe more in CEO's than corporate cultures.  I would rather invest in a CEO I truly believe in (Warren Buffett, Jamie Dimon etc.) than a company known to have a strong culture of success (even though Goldman Sachs is one that I believe in strongly).

As an investor, I am highly skeptical of corporate cultures in general, unless it has been proven over multiple generations (like Goldman Sachs).  The fact that firms like Starbucks, Uniqlo (Fast Retailing), Dell and others floundered after their founders left (and they had to come back) makes me wonder about the importance of cultures versus CEO's.


Efficient Markets
Anyway, all this talk of CEO's not mattering too much and nothing can be built to last reminds me of the efficient market theory.  In the pure form of efficient market theory, the markets are too efficient for anyone to outperform.

That would make books like Intelligent Investor and Securities Analysis meaningless.  And all those Superinvestors (of Graham and Doddsville), Money Masters, the New Money Masters and the managers/traders in the various Market Wizards books by Jack Schwager would all be monkeys that just happened to flip a few heads in a row.

I haven't checked, but I tend to think that most of the managers covered in these books have done well over time, even after being featured in them (OK, maybe I said that about Good to Great and Rosenzweig has proven otherwise).  Sure, Tiger, Steinhardt and others closed shop after a bad year or two, but they closed out their careers with incredible track records.  I think there might have been some blowups in the commodities trading world (Richard Dennis?), but most people in the above books have gone on with great records (although increased size have lowered returns for many of them; the more common lesson in outperforming managers is that size kills performance).

Markets are Efficient Because Mutual Funds Don't Outperform?
One thing people keep pointing out is that markets are efficient because most mutual funds don't outperform.  This is something that I've been thinking about on and off for years.  Why do some people outperform while others don't?

Most mutual fund companies are asset gatherers.  Their primary goal is to increase earnings of the management company.   And we all know that increasing asset size makes it harder to outperform the market.

So at the asset management company level, they are incentivized to increase AUM.   They are paid a percentage of AUM so this makes sense.  If you want to increase earnings, you have to increase AUM.  It doesn't matter if it gets harder to manage as they don't get paid on performance.

At the fund manager level, managers don't want to diverge too much from the index.   If they stay more or less within a reasonable range of the index, they will be fine and won't get fired.  The risk/return is asymmetric in this case if you want to take big risk to outperform (OK to fail conventionally etc.).

So the asset management industry is often not even trying to outperform.  They are trying to maximize earnings to the management company.

Missing the Trees for the Forest
Anyway, I brought up this efficient market argument because the "CEO's don't matter" argument sort of reminds me of it.  When you look at the data overall, you might find that CEO's actually don't matter, just as if you looked at the performance of mutual fund managers (or research analyst buy/sell recommendations), you would think the market is efficient and fund managers don't matter.

Oftentimes, the big figure can obscure the little facts.

For example, back in 2000 when the stock market was trading at 30x p/e (or whatever it was), people concluded that stocks were not good investments.  That's sort of missing the trees for the forest because BRK and many other value stocks were trading at attractive levels.

CALPERs recently decided not to invest in hedge funds.   This may be the right choice for them; it seems like they couldn't allocate a meaningful amount to hedge funds and the cost of maintaining such a small percentage of the portfolio just didn't make sense.  That's totally reasonable.

On the other hand, I always hear figures about some hedge fund index and how that hasn't done too well.  There are a lot of hedge funds out there and most of them are probably no good.  But there are really good ones.  The problem with hedge funds, usually, is that the good ones are closed.  So again, I wouldn't look at the hedge fund index to decide whether hedge funds are good or not.  I would just look at funds individually and if there is a good one, invest in that and otherwise don't.    A lot of information is lost when you look at the various indices.

Likewise, if a study shows that the CEO doesn't really matter too much, that doesn't mean that much to me.  If you look at a big enough group, then bad industries or bad cycles can easily offset good CEO's and the sum of everything might make it look like CEO's don't matter.

Conclusion
Well, I don't know that there is a conclusion to this post.  I think the Halo book is a good one and very interesting.  The arguments make sense. But on the other hand, there is a bit of an "efficient market" sort of thing going on there too.

I like "stories" and I don't think there is anything particularly wrong with reading them as long as we understand the context and limitations of those stories.  I know I will keep reading articles in the business press, business books (not "how-to" books, but books about businesses and biographies of business people).

Buffett on Market Valuation

I don't really spend too much time on market valuation, but I do think about it and post about it every now and then.  Of course, debate about market valuation is pretty heated these days due to the super-high looking Shiller p/e ratio, high profit margins etc.

I was reading through some old Buffett annual reports and found a great primer on how Buffett thinks about stock market valuation so I thought I'd post it here.  This is similar to what used to be called the Fed model (earnings yield = 10 year treasury yield).  The Fed model has been criticized because it only worked for a very brief period (back in the 1980's) and hasn't worked most of the time.  (Earlier this year I skimmed through all of Buffett's partnership and BRK annual letters to find comments related to the stock market, but I am now rereading all the annual letters from 1965-2012 again slowly, word-for-word).

But we can see that Buffett does in fact think about stocks using a similar approach.  And this makes sense because there is a rational reason why earnings yield can be fairly compared to treasury bond rates.  This is not to say that the stock market will always trade at parity with bond yields (history shows that it doesn't).

This may be relevant now to understand why some people like Buffett keep saying the market is trading in a "zone of reasonableness" while some charts show the market to be way out in terms of historical valuation.

And yes, we do understand that Buffett's comments make sense when you think about where interest rates are today (he does keep saying that stocks are better than bonds).

Anyway, this is a long clip but well worth reading almost as a primer on stock valuation, inflation etc.

From the 1981 Berkshire Hathaway letter to shareholders:

Equity Value-Added

     An additional factor should further subdue any residual enthusiasm you may retain regarding our long-term rate of return. The economic case justifying equity investment is that, in aggregate, additional earnings above passive investment returns - interest on fixed-income securities - will be derived through the employment of managerial and entrepreneurial skills in conjunction with that equity capital. Furthermore, the case says that since the equity capital position is associated with greater risk than passive forms of investment, it is "entitled" to higher returns. A "value-added" bonus from equity capital seems natural and certain.
   
     But is it? Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a "good" business - i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at more than one hundred cents. For, with long-term taxable bonds yielding 5% and long-term tax-exempt bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10% earned by the corporation to perhaps 6%-8% in the hands of the individual investor.

     Investment markets recognized this truth. During that earlier period, American business earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were "good" businesses because they earned far more than their keep (the return on long-term passive money). The value-added produced by equity investment, in aggregate, was substantial.

     That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday's assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.

     During the past year, long-term taxable bond yields exceeded 16% and long-term tax-exempts 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. And this 14% will be substantially reduced by taxation before it can be banked by the individual owner. The extent of such shrinkage depends upon the dividend policy of the corporation and the tax rates applicable to the investor.

     Thus, with interest rates on passive investments at late 1981 levels, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals. (If the business is owned by pension funds or other tax-exempt investors, the arithmetic, although still unenticing, changes substantially for the better.) Assume an investor in a 50% tax bracket; if our typical company pays out all earnings, the income return to the investor will be equivalent to that from a 7% tax-exempt bond. And, if conditions persist - if all earnings are paid out and return on equity stays at 14% - the 7% tax-exempt equivalent to the higher-bracket individual investor is just as frozen as is the coupon on a tax-exempt bond. Such a perpetual 7% tax-exempt bond might be worth fifty cents on the dollar as this is written.

     If, on the other hand, all earnings of our typical American business are retained and return on equity again remains constant, earnings will grow at 14% per year. If the p/e ratio remains constant, the price of our typical stock will also grow at 14% per year. But that 14% is not yet in the pocket of the shareholder. Putting it there will require the payment of a capital gains tax, presently assessed at a maximum rate of 20%. This net return, of course, works out to a poorer rate of return than the currently available passive after-tax rate.

     Unless passive rates fall, companies achieving 14% per year gains in earnings per share while paying no cash dividend are an economic failure for their individual shareholders. The returns from passive capital outstrip the returns from active capital. This is an unpleasant fact for both investors and corporate managers and, therefore, one they may wish to ignore. But facts do not cease to exist, either because they are unpleasant or because they are ignored.
   
     Most American businesses pay out a significant portion of their earnings and thus fall between the two examples. And most American businesses are currently "bad" businesses economically - producing less for their individual investors after-tax than the tax-exempt passive rate of return on money. Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.

     It should be stressed that this depressing situation does not occur because corporations are jumping, economically, less high than previously. In fact, they are jumping somewhat higher: return on equity has improved a few points in the past decade. But the crossbar of passive return has been elevated much faster. Unhappily, most companies can do little but hope that the bar will be lowered significantly; there are few industries in which the prospects seem bright for substantial gains in return on equity.

     Inflationary experience and expectations will be major (but not the only) factors affecting the height of the crossbar in future years. If the causes of long-term inflation can be tempered, passive returns are likely to fall and the intrinsic position of American equity capital should significantly improve. Many businesses that now must be classified as economically "bad" would be restored to the "good" category under such circumstances.
 
     A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the "bad" business. To continue operating in its present mode, such a low-return business usually must retain much of its earnings - no matter what penalty such a policy produces for shareholders.

     Reason, of course, would prescribe just the opposite policy. An individual, stuck with a 5% bond with many years to run before maturity, does not take the coupons from that bond and pay one hundred cents on the dollar for more 5% bonds while similar bonds are available at, say, forty cents on the dollar. Instead, he takes those coupons from his low-return bond and - if inclined to reinvest - looks for the highest return with safety currently available. Good money is not thrown after bad.

     What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas. (The Scriptures concur. In the parable of the talents, the two high-earning servants are rewarded with 100% retention of earnings and encouraged to expand their operations. However, the non-earning third servant is not only chastised - "wicked and slothful" - but also is required to redirect all of his capital to the top performer. Matthew 25: 14-30)

     But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the "bad" business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.

     For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

     Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or "real" dividends. The tapeworm of inflation simply cleans the plate. (The low-return company's inability to pay dividends, understandably, is often disguised. Corporate America increasingly is turning to dividend reinvestment plans, sometimes even embodying a discount arrangement that all but forces shareholders to reinvest. Other companies sell newly issued shares to Peter in order to pay dividends to Paul. Beware of "dividends" that can be paid out only if someone promises to replace the capital distributed.)

     Berkshire continues to retain its earnings for offensive, not defensive or obligatory, reasons. But in no way are we immune from the pressures that escalating passive returns exert on equity capital. We continue to clear the crossbar of after-tax passive return - but barely. Our historic 21% return - not at all assured for the future - still provides, after the current capital gain tax rate (which we expect to rise considerably in future years), a modest margin over current after-tax rates on passive money. It would be a bit humiliating to have our corporate value-added turn negative. But it can happen here as it has elsewhere, either from events outside anyone's control or from poor relative adaptation on our part.

What Would He Say Now? 
So here are current interest rates:

                  U.S. Treasuries                 Munis
10 year           2.5%                              2.2%
30 year           3.3%                              3.1%

Buffett said that stocks should have higher returns than passive, fixed investments.  Actually, he said that that is the economic justification for investing in stocks.  He didn't say that stock returns should equal fixed income investment returns; just that it should be higher.  So we can see the earning yield - bond yield parity model as the upper limit of stock market valuation.

According to this idea the stock market would have to get up to 30-40x p/e (using the pretax U.S. treasury yield for 10 and 30 years) before it starts to look like stocks aren't worth it.

Using Buffett's tax-equivalent model, assuming 20% long term capital gains and qualified dividend tax rates and 3.1% muni yield, the equivalent earnings hurdle for stocks would be 3.9%; this implies a p/e ratio of 26x.   Using the 10 year muni rate you'd get 36x p/e.  Again, this would be the upper end of a valuation range, not the fair value.

(It's kind of stunning to think that Buffett, in 1981, seemed to be saying stocks aren't worth 7x p/e but says they are reasonably valued now (or at least he said so relatively recently)).

But...
That's silly.  I've seen charts showing the differential between earnings yield and interest rates to show how relatively attractive stocks are.   Those charts do imply that stocks can get to 30-40x p/e and I certainly hope stocks don't get up there.   It probably shows more how expensive bonds are.

Buffett has said that bonds are in a big bubble and is unsustainable (even though I still suspect, because of my having watched Japan post-bubble, that rates will stay a lot lower for a lot longer than most people think).

So if bond rates are unnaturally low due to central bank activity, what is a more natural level of interest rates?

Tangent on No-brainers
What's a post on this blog without an off-topic tangent?  Speaking of interest rates, one of the big no-brainers for 2014 was that interest rates would go up due to "tapering".  The Fed has been buying truckloads of treasuries every month for so long, if they reduced their purchases interest rates will go up.  Simple supply and demand.  It's the easiest trade in the world.  You would have to be stupid not to understand that.  Oops.

I remember a very similar trade when people thought treasuries would crash at the end of QE1 (or QE2, I can't keep track).  The no-brainer trade then was the same; everyone knew that the Fed would stop buying bonds (to the exact date), and everyone knew that this would disrupt supply and demand, and it was obvious that bonds had to decline dramatically.  Oops.  (Bonds rallied dramatically on a collapsing Europe)

One of my early posts on this blog was about gold (Ungold), and gold was a no-brainer too back in 2011.  If the economy recovers, inflation would soar and so would gold.  If the economy didn't recover, then central banks will have to print even more money and QE-infinity would take gold to $5,000.  Heads I win, tails you lose.  No-brainer!   Oops.

Where Should Interest Rates Be?
So then, let's see where interest rates would be on a normalized basis.  First, I thought that the range for the 'real' fed funds rate was around 2.00% - 2.50%.  But a quick googling tells me that it averaged 2.7% between 1984 and 2005 (real rates have been deeply negative in recent years, so no need to update).

If inflation is 2.0%, then the Fed Funds rate should be around 4.7%. What about the yield curve?   The spread between the 10-year treasury rate and Fed Funds rate since 1954 was 1% or so.  That would give us long term rates of around 5.7%.   In that case, this would imply a p/e ratio of 17.5x (as the high end).

However, the 20 year and 30 year average spread between the 10-year treasury rate and Fed Funds rate is 1.5% and 1.6% respectively.   Using 1.6%, we get a normalized 10 year rate of 6.3%, or an implied p/e ratio of 15.9x.

The S&P 500 index, on a trailing twelve month basis, is trading at a 19x p/e ratio now, and 16.7x forward earnings estimate.

Nominal GDP Growth Rate
OK, so the above normalized interest rate guesses might be a little "noisy".  I used real Fed Funds rate and then assumed a yield spread. That's too many indirect assumptions.  Don't assume because...
Another more simpler model for normalized long term interest rates is simply the nominal growth in GDP.

I just googled this and cut and paste it from an old BlackRock report.  The data is from 1963, so it shouldn't matter too much that it's not up to date.

Using this idea, I think the expectation for real GDP growth is between 2% and 3%, and inflation is expected to be around 2%.   The 10-year breakeven inflation rate (on TIPs) is currently around 2.1%.  It looks like it gets above 2.5% every now and then so we can use that too to be conservative.

So putting the above together, if you assume 3% real GDP growth and 2% inflation, that's a 5% 10-year treasury rate and implied 20x p/e ratio.

I think at the annual meeting, Charlie said that it would be insane to expect more than 1% growth over the long term.  If that is the case, and inflation is 2%, we'll be looking at bond yields of 3% (and 33x p/e ratio).

But more realistic might be 2.5% real GDP growth and 2% inflation for a bond yield of around 4.5% (22x p/e).  Oh, and that would be 5% and 20x p/e if you used 2.5% inflation.

You can use whatever assumptions you want and get your own 'normalized' long term interest rate.  And yes, I know.  Nobody can really forecast economic growth or inflation with any accuracy; I'm just thinking out loud and trying to get my arms around this stuff.

Low Inflation? Really?!
And yes, of course many of you would laugh at the notion of 2% or even 2.5% inflation.  With what all the central banks are doing around the world, it's not possible for inflation to remain low for long.  Even Buffett said that there will be consequences to all of this and it won't be pretty.  He may be wrong this time too, though; he was wrong in 1981 when he said:

In past reports we have explained how inflation has caused
our apparently satisfactory long-term corporate performance to be
illusory as a measure of true investment results for our owners.
We applaud the efforts of Federal Reserve Chairman Volcker and
note the currently more moderate increases in various price
indices. Nevertheless, our views regarding long-term
inflationary trends are as negative as ever. Like virginity, a
stable price level seems capable of maintenance, but not of
restoration.

I have followed Japan over the years so I suspect we are in a similar situation (but much better, of course).  The old rules of monetary policy and inflation may not apply.  I know this sounds like "this time it's different".  But it sort of is in many ways when you think about it.

High Inflation in the 1970's and 1980's
Many people seem to think that we will have another 1970's-like inflationary situation.  It might happen, but what bothers me about that is that I strongly believe that the 1970's inflation wasn't really a function of bad policy in the 1960's and 1970's (well, the overspending in that period by the government was a catalyst for sure) but more of a huge adjustment of an unsustainable global monetary structure that was in place for decades.

I think the view is that the U.S. leaving the gold standard was one of the reasons why inflation went out of control, and our abandoning of the Bretton-Woods fixed currency system contributed to the chaos.  Books have been written that say things were fine with the gold standard and Bretton-Woods and only after we ditched them did things blow up (so therefore we should go back to them; which makes no sense given the history of price controls!).

Well, my view is exactly the opposite.  I just think the 1970's was a huge adjustment to the huge imbalances that were built up over the decades after World War II.  As we have seen over and over in the past twenty years with the Asian currency crisis, Latin American crises, Euro etc., fixed currency systems just don't work.  And neither did Bretton-Woods.  The 1970's was the global version of the above currency crises that we have seen over and over again since then.  And they were mostly due to fixing exchange rates, not floating them.  Fixing them allowed unsustainable imbalances to build up.

Gold prices were fixed for a long time too (even longer than the currencies in the Bretton-Woods system) so that had an even bigger imbalance built up.  It was quite a coiled spring by the time the price control was lifted.

So when I look at it that way, I don't see what that imbalance is, necessarily, that would cause high inflation now.  As Dimon said, a lot of the QE money is sitting as reserves in the banking system.  When QE is withdrawn, the money will leave bank reserves.  This has no real economic impact.

Where is the coiled spring today?  (Yes, QE is artificially keeping interest rates low.  That is one coiled spring to be sure.)

Conclusion
But anyway, despite all of that, I am not forecasting low inflation forever.  It's more of an expression of my doubts about high inflation on the horizon that so many people expect.  As I've said for a long time, my suspicion is that we go along the road that Japan has, but in a much better situation.

I really have no idea what is going to happen; where GDP or inflation will go etc.  I have no clue.

But playing with these various factors that might impact p/e ratios, I can see why many see the market as reasonably valued despite the really scary looking Shiller p/e charts etc.