Saturday, October 29, 2016

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.  

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...

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.


  1. Great post as usual!

    Why are you not on Twitter / Do you have any thoughts about Twitter ?

    1. Hi, good question. I like to take my time to write posts, and Twitter, to me, just seems too impulsive... I don't want to just write short reactions to things, but would rather think things through and write something more thoughtful. That's why I don't follow anyone on Twitter either... I have no interest in anything like that. As for the company itself? I have no idea. It is interesting and great in certain situations (breaking news, updates from the ground etc...), but other times, it just seems like people blurting out impulsively reactions to whatever they see in the world, and 99% of the time, it's not interesting to me at all...

    2. Just for consideration, if you wish you could use it to alert your followers of new posts and provide a link... I see it used very constructively in that respect.

    3. If you wanted to give Twitter a try (because it might not be what you think it is -- it's a bit more like the comment section of your blog in many ways), there's a member of Financial Twitter that has a list of "high signal to noise" people to follow. In one fell swoop you could plug in the FinTwit stream there:

    4. I'll also add +1, please join Twitter, at least to just notify your readers. It's also a great resource for networking.

  2. In my opinion, you're missing an opportunity KK. I'm on Twitter but only seldom tweet and read other people's tweets. It's a good forum to engage people in thoughtful/long form discussion as long as you choose to use it that way.

  3. Just a head's up. Greenblatt is going WealthTrack this coming week, I think. Doing the dog and pony show for the new fund. I think pimco has a set of those futures funds with the excess/float invested in bonds. I believe they have futures tracking fundamental indexes. Something enhanced. I sold mine because I got freaked out about their use of derivatives generally. I think Gundlach spooked me.

  4. Hi KK, thanks for posting again! What do you think about his new strategy so far (more diversified and mechanical) vs his good old days (high conviction and concentrated)? It seems that his net performance so far hasn't outperformed SPX or even BRK a lot. All his new fund assets added together are still less than $3bn, probably won't prevent him running the old format if he still has conviction.

    As a mutual fund, expense ratio seems a bit high. Don't you think adding a new strategy every year is a bit worrying? Either his focus is diluted or the original thesis doesn't work out as planned.

    What do you think about BRK now? There aren't many stocks in the market with decent growth, limited downside and margin of safety (vs. intrinsic value).


    1. Hi, I think his Gotham project is more about finding solutions for the average individual investor. He is out of the active management game, as far as I know, so he won't be going back to his "genius" stuff, I don't think. He realized that the "genius" book was over the head of the average retail investor so went on to write the magic formula. He then realized that people can't outperform cuz they start and give up too soon, or get out at the bottom etc. And he was asked to run a magic formula portfolio. So he did. And then he realized that still, people get out at bottoms and get in at tops and can't capture the 'edge' cuz they don't stick with it.

      That's why he came up with the various Gotham funds (to replace the Formula investing funds).

      If you read his latest note on the new fund, you will see why he is trying this new thing.

      They are all the same thing, basically, just variations on the magic formula.

      He is trying to find a solution for individual investors, I think, to do well in the market, and he wants it to be fool-proof; he doesn't want to have to be there picking stocks for people etc.

      So it's not that worrying. I think it's very interesting.

      BRK is interesting and a good, solid holding. But keep in mind that they are so big, it takes a lot to move the needle. Even with really great portfolio managers brought in, they may be able to do well with $7 billion each or something, but eventually they will have to figure out what to do with a lot more and when that happens, they won't be able to repeat their historical returns any more than Buffett can... But still, good, solid hold for sure...

  5. Is there good evidence that Greenblatt/Gotham has really outperformed, since "Genius" (or "Little Book", for that matter) was published?

    i.e. I think the claims in these books were for massive outperformance - something like 4-8% per year or more? (I have the books laying around but don't feel like double checking them now.) I have grown weary of those who (claim to) have discovered methods to crush the market, get lots of publicity for same, and then, shockingly, after that wave of publicity, have mediocre returns.

    You say the issue is that investors just can't stick with Greenblatt's methods. But IIRC, his documented returns/projections were very consistent, very strong, but post-publication, that didn't hold up. So maybe, in fact, the problem was not the retail investors, but the methods and their results?

    1. OK, my previous post ("Is there good evidence...") was a little lazy. I grabbed the books and had a look:

      "Little Book", page 56, results of Magic Formula vs. S&P 500, as claimed there:

      1988-2004: Magic Formula averages 30.8% return, S&P 500 12.4%
      Beats market by 18% - sweet! (If replicable)
      Consistency? MF wins in 14 out of the 17 individual years, and the 3 losses are minor - single digit percentage points.

      So, if Greenblatt was able to come up with this fabulous backtested strategy circa 2004-5, that's basically mechanical and therefore easy/cheap to implement, where can I find his mutual fund returns for 2005-2016 showing ~18% annual outperformance? Heck, I'd settle for 10%, allowing him a high E.R. and a bit of slippage...

    2. Oh, and of course "Genius" also has big performance claims. Page 271 of my paperback copy shows a 50.0% annualized return since inception over its lifetime of 1985-1994. I assume those are accurate reflections of his fund. And I know that during THAT timeframe, his strategies weren't mechanical, and aren't directly comparable to what he's been advocating more recently. Still, I'd like to see SOME evidence, post 1995 or post 2005, that publicly available Greenblatt/Gotham vehicles have numbers well above average, even if not 50% annual returns...

    3. Good point. It is always good to be skeptical about these claims. But out of all the authors out there promoting this sort of thing, I think he is the most trustworthy. At least that's my opinion. He does have a real, solid track record.

      For example, when the Genius book came out, his 10 year track record was 50%/year for the period 1985-1994 or something like that. When the magic formula book came out, his returns were 40%/year for 20+ years. That suggests that he was earning 30%/year between 1994-2004 or something like that. The stock market total return was 10%/year between 1994-2004.

      So in that case, he has outperformed even after the first book.

      As for the magic formula, I don't have the figures handy. I think some investors posted here that they did OK.

      One thing to keep in mind is that when he launched the funds, they were different than what he did in the book. The book had a much smaller portfolio, but in the funds, he had to include many more names to be able to handle the liquidity.

      This would necessarily reduce returns.

      It's been a strange period recently for the markets so I wouldn't be too quick to judge on historical returns at this point.

      Over the long term, I would expect the funds to do really well, but again, because of the nature of the portfolio (includes many, many more names than in the book).

      What I like is that the guy has real hands on experience with stocks and the market (so is not just a quant jockey/mathematician).

      The alternative is to go find an active guy to outperform or to index. In that light, I think these are good options, actually.

      Sorry I can't say much more or provide you with more evidence...

    4. Thanks for the reply.

      Yes, the null hypothesis, I think, is to index (or quasi-index or whatever). That's not such a bad option. Requires little effort, is available at super low cost, and is pretty tax efficient. And yet I (and you, and others), try to outperform simple indexes. Still, I think the burden is on the active managers to show evidence they can really beat the market...

      What was Greenblatt's investment vehicle for ~1994-2004 where he perhaps achieved ~30% returns? Was this a public vehicle? Have his public vehicles (post 1994, or post 2004) beaten their benchmarks by any significant margin, or at all? IIRC the recent Barron's article, while praising some recent vehicle based on a really short timeframe (YTD or some such), also noted that his funds overall have been not-stellar in recent years.

      It would take some effort to track down all the publicly available vehicles he's had in the last 10 or so years and compare their performance to an appropriate benchmark - I'm not inclined to do so right now. But if he DID have some stellar recent public vehicles, even if the outperformance was lumpy (i.e. with some underperforming years mixed in), don't you think that such outperformance would be loudly trumpeted? He wasn't shy about showing his great for 1985-1994 in "Genius"...

  6. what are the costs of the new fund?
    the recent PSH call suggested that CMG owns most of their stores.