What to Do in this Market: Gotham Funds Update

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

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

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

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

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

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

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

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

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

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

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

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



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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And here is how they've done:

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

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

Gotham Absolute Return

Gotham Absolute 500

Gotham Enhanced Return

Gotham Neutral

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

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

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

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

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

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

For example, what's not different?

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

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

But what is different?

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

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

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

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

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

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

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

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

Overvalued Market!?

This is sort of a followup to my last post; it's just another thought that came to mind as I was typing up a response to someone in the comment section, and I thought I'd expand the thought into a quick post as I think it's pretty important.  (Blog readers take note:  This is my Irving Fisher moment!)

Known Unknowns and Unknown Unknowns
Donald Rumsfeld said a long time ago:

There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.

And also Howard Marks said, it's what you think you know that just ain't so that is going to kill you. Maybe this would go into Rumsfeld's "unknown, unknown".

But OK.  Enough of that.  Where am I going with this?

I think a lot of people get caught up with the fact that the stock market is way overvalued.  Buffett (and Tepper and some others) has said many times that the market is not bubbled up and is in a zone of reasonableness.

Many people put up Shiller's CAPE chart to show how egregiously overvalued the stock market is.  However, I have pointed out many times here that sometimes those macro, big picture charts can be very misleading.  People look at charts like that and conclude that the market must go down.  However, that is a total fallacy.

For example, for a very long time stock dividend yields were higher than bond yields because stocks were viewed as speculative.

Look at this chart:

Dividend Yield, Bond Yield and 1/CAPE  1900 - 1970

(data from Shiller's website:  http://www.econ.yale.edu/~shiller/data.htm)
*for CAPE, I used the inverse so it can be compared to bond and dividend yields.

The data goes back to before 1900, but I couldn't convert the dates from before 1900 in Excel (I used to be good at spreadsheets, but now seem to have forgotten a lot!  Or they changed too much.), so we will just deal with post 1900 data.  It shouldn't really change anything.   Oh, and I wasn't able to put the entire time series in one chart so I divided it up into two sections; 1900 - 1970 and 1970 - 2014.

As you notice, throughout history, dividend yields were higher (and often much higher) than bond yields.  But this flipped over in the 1950's.  This is around the time that Buffett started his partnership, and both his father and Benjamin Graham warned him against getting into the stock market.

I don't know if this yield flip had anything to do with it, but you can imagine all the pundits warning people against investing in speculative stocks with dividend yields lower than bond yields and therefore not compensating investors for the additional risk taken.  Since the 1800's, dividend yields were always higher than bond yields.

Anyone who held that view would have been out of the market for the rest of the century, and only recently would have been able to get back in.

So, caution number one:  The past can be a great guide in assessing the market, but clinging too much to one indicator, however effective and foolproof it looks historically, can be dangerous.

Dividend yield itself has been used for a long time as an indication of an overvalued market.  I remember hearing as long ago as the early 1990's that dividend yields of 3% (or below 4%) is just way too low.  When it went under 2%, it was ridiculous.  Some said it should be more like 4-5%.  Well, if you needed 4-5% dividend yields, you would have been out of the market (or short) since the early to mid-1980's.

This is the chart for 1970 - 2014:

Dividend Yield, Bond Yield and 1/CAPE 1970 - 2014

Now look at this.  We keep hearing how CAPE is way out of bounds and we are going to have a serious correction.  OK.  Maybe.

But look really carefully here at the chart back in the late 1980's.  One reason the stock market crashed in 1987 was because the stock and bond markets diverged.  Look how the stock market earnings yield plunged lower as bond yields spiked.  This discrepancy was corrected severely in a single day. Someone showed me an X-Y scatterplot of what happened (after the fact; I wasn't in the business back then) and how neatly earnings yield tracked bond yields and how they diverged in 1986 and 1987, and then how it snapped back.

Today, if you look at the chart we are in the opposite situation.  Bond yields continue to plunge lower, but it seems like CAPE is sort of stuck where it was for much of the 2000's.

Of course, I would not go so far as to say that the market is undervalued and should actually be trading at a 50x p/e ratio.

But I don't see a need for an imminent, harsh correction either.  Looking at the above chart, it just looks like the market is floating around in a range more or less similar to where it has been since the late 1980's.

Known Known
So, here's a known, known.  We know that the market is not cheap, and maybe expensive on a historical basis by certain measures.  But the only thing we can conclude for sure from that is that future returns from a higher price will lead to lower returns.

A guarantee of lower return does not mean that the market has to go down.

For example, I still remember when bond yields went under 6%.  That was nuts to people who started in the business in the 1970's and 1980's.  The U.S. government was constantly devaluing the dollar and overspending.  There was no way that the hockey stick (deficit) can be stopped, so there is no way that a 6% bond yield was going to be sustainable.   When it went under 5%, it was a joke.

If you were a bond investor back then, maybe 6% bond yields were not enough for you.  Then you could have gotten out and stayed in cash.  Would you have done better?  Or maybe you could have been convinced the bond market had to collapse.  So maybe you would have shorted the bond market.  Or maybe you would have bought tons of puts against your long bonds.  Either way, you would probably have gotten a lower return than the 6% (actually, way more than 6% due to the bond rally since then) that was way too low for you.

You can make the same argument at 5%, then 4%, 3% etc...

People have been calling the top of the bond market for as long as I can remember.  (Japanese bond market too!).

So, caution number two:  Just because something is high or low doesn't mean it has to reverse imminently.  Some cycles are very, very long and can last for decades (bond bear market from 1940 to 1982, bull from 1982 and ongoing etc...)

Known Unknowns
Most of us have enough humility to admit that we really have no idea what will happen to the stock market, bond market, economy etc.   But even then, many assume that due to the low interest rates (or high valuation), that bond prices must go down.  Stock prices must go down.

Most admit that they don't know when it will go down, but they are convinced it will go down soon enough to make their decision to be short or stay out a good one  (this is key!).

Unknown Uknowns
But to me, that's sort of the problem.  People assume that just because bond yields are low, that they must necessarily go up.  That stock prices are high, so they must necessarily go down.  Yes, eventually they will.  These things go up and down over time.

But if you really take a good, hard look at the charts above, those things can stay around this level for a long, long time.

Just as bond yields have been lower for a lot longer than anyone has ever expected, the CAPE can stay here for a long time too (as it does seem to follow bond yields to some extent).

If you are short the stock market (either by actually being short, or by having low exposure despite an equity mandate), you are simply betting on a rise in bond yields.  So you are making a bet based on an economic forecast, basically.

What You Think You Know But Just Ain't So
So if you think the market must go down because it's expensive, maybe that just ain't so!  Again, I go back to bonds.  The bond market doesn't care if a bond investor is unhappy with a 3% yield or a 4% yield  (Of course, there are some like Bill Gross that will call interest rates and make money).

Bears will argue that if you own stocks here, then you are basically betting that interest rates won't go up.   Well, not necessarily.  Buffett has been saying rates are way too low and that the bond market is the biggest bubble ever, but has been buying stocks pretty aggressively in recent years anyway.

Conclusion
So anyway, I just wanted to point out that just because bond yields are too low for your taste (stock market CAPE is too high), it doesn't necessarily follow that they must go UP (or CAPE go down).  OK, so maybe they must go up eventually.   But these cycles seem to be so long that it seems a bit silly to try to call the turn.   (And no, that doesn't make me a perma-bull.  Call me a perma-agnostic!  The market will keep going up and down as it always has; there will be plenty of brutal bear markets to come regardless of all of this stuff).

The only thing we know for sure when rates are at 4% rather than 5% is that the returns will (most likely) be lower.  At 2%, we can know for sure that returns will probably not be high.  But we can't know for certain that rates will go up.  And again, more specifically, we can't know for certain that it will go up soon enough for timers to benefit from it.

The Perils of Trying to Time the Market III

I just read an article about a big alternative mutual fund that is facing redemptions due to poor performance last year.  And it got me thinking again about a recurring theme on this blog about the perils of trying to time the markets.

I know it's preaching to the choir here, but it is something I am always thinking about.  And this got me thinking about risk overall.

As I was reading the marketing material and articles about this particular fund, I realized how hard it must be to run a fund with the purpose of earning equity-like returns but with lower volatility and smaller drawdowns.

You Have to Be Right So Many Times
Many of these funds take a completely top-down approach to asset allocation.  For example, they will look at the economic outlook; interest rates, inflation etc.  And then from there, they have to choose investments that will benefit from and get hurt by the trends in this outlook.  They have to choose how much to allocate to each investment/trade, and then they have to time it well.

That's a lot of decisions they have to get right.  For example, just on the outlook itself, how hard is that?  We all know how accurate economic forecasts are.  How many people last year predicted higher interest rates?

What are the odds of getting that right?   So that's decision number one.

And then you have to go and find investment ideas that fit that particular theme (rising rates, higher inflation, for example).  I guess you can just go and find the stocks or investments that are the most leveraged to these particular factors and not care at all about management etc.  Or you can pick the best managed companies in the respective sectors.  Or maybe you want the highest cost producer to maximize operating leverage, or the most levered company for maximum financial leverage.  Or maybe a combination of both.  Or you might want the lowest cost producer (but you may get less bang for the buck if you are right).

Or you can go out and look for the things that will be most hurt by the trends you predict.   See?  This is already getting pretty complicated.

Obviously, you can be wrong about this stuff.  You can get the macro right, but you might pick the wrong stocks.  I remember how people forecast higher gold prices and then bought a bunch of gold stocks and got clobbered.  They got the macro call right (gold prices went up) but got the stock picks wrong (most went down due to higher production cost etc.).

And then you can actually get the macro call right and maybe even pick the right stocks.  But if you are an active manager, you are at risk of getting stopped out of positions that are good at the wrong time.  Even if you make two right decisions,  they might go down far enough to trigger stop losses and push you out before you are proven right.  So you can get two things right and get the timing wrong (investors might flee too forcing you to sell potentially winning positions before they turn) and  lose money.  We all know, the markets can remain irrational for a lot longer than your prime broker or margin clerk will allow you to hold the position.

So think about the many layers of correct calls that an active, top-down alternative manager has to make.  They have to be right on so many levels, it's almost ridiculous.  And they have to keep being right over and over again. (Oh, and as complicated as the above is, think about the fact that they have to think about when to get out.  You can be right on all of the above, and the scenario may unfold exactly as you predict, but then if you don't get out at the right time, you can easily give up all of your gains (as markets reverse etc...)).

Simple
That's why people like Buffett ignore that stuff and just try to focus on the two questions that they think they can answer:

1. Is it a good business?
2. Is it a fair price? 

If it's too hard, you move on.  Munger has said many times that you only need to be right a few times (or less) in your lifetime to do very well. 

Contrast that with these macro-based alternative mutual funds; they have to be right so many times on so many decisions constantly to keep putting up good numbers.  (I contrast these funds with macro hedge funds as macro hedge funds tend not to be so much asset allocators, but very active, highly leveraged traders.   No macro-based alternative mutual fund will ever reproduce the sort of returns that Soros had in the 80's and 90's, for example, as they were very different). 

Risk

These alternative mutual funds sell well after bear markets because people suffered so much that they don't want to experience that sort of pain again.  So they look for people who promise a lower drawdown. 

But anyone who has managed risk professionally knows that you can't really reduce risk in the financial market (OK, well, actually you can by staying away from crappy stocks and not doing stupid things; not overpaying etc.  But bear with me for a second).

Long Term Capital Management was a good example of that.  For many years, they had equity-like returns with lower volatility and low correlation to the overall market.  They were able to hedge out all sorts of risks by taking various long/short positions.  But by eliminating market and interest rate risk, they instead took basis and liquidity risk.  And that's what killed them in the end. 

If you run an options book, for example, you can hedge out all sorts of stuff.  Market makers do this all the time.  They buy IBM calls, for example, and they have to hedge out their delta.  So they short IBM stock against their long calls.  But now they have volatility and theta risk.  So they can short IBM options against it to hedge away their vega (volatility risk) and theta.   Then you might end up with some gamma risk.  You can hedge that out too. 

In more or less efficient markets, the more you hedge away, the lower your returns are going to be (as you are paying the market to take away this or that risk from you). 

So in the end, you might as well just sit on T-bills if you don't want any risk.    That's what happens in a perfectly hedged S&P 500 index portfolio, right?  Buy the index and short futures against it.  Your return will basically be T-bill-like as you are not accepting any risk (well, you are taking futures exchange clearing risk; if a huge counterparty defaults, you can actually lose money even in a centralized futures market without direct counterparties).

So back to alternative portfolios. When people say that they will keep an eye on the economy, interest rates and things like that and promise you that they will use that information to structure the portfolio in such a way to maximize returns and minimize risk, you have to understand that they are not actually reducing risk. 

They are reducing risk in one area and taking risk in another. 

So instead of taking temporary mark-to-market stock market volatility risk, they are taking on macro-forecasting, investment selection, market-timing and other risks. 

The only way they will actually reduce risk is if they own a large, S&P 500 correlated portfolio and then short futures against it.  In that case, your exposure is going to be their portfolio outperformance "alpha".  And judging from how long-only mutual funds usually perform, the expected alpha will most likely be negative anyway.   If the portfolio is not correlated, and the fund uses S&P 500 index futures to reduce market risk, then you have tracking error risk; your portfolio can go down and the S&P 500 index can go up.  You can still lose money. 

In that case, you are better off (if you don't want too much equity risk) allocating, say, 50% to stocks and then just keep the rest in cash.  Sure, your return might be 4%/year (8%/year stock return, 0% on cash), but I bet it would be better than most long/short mutual funds over time, even volatility adjusted.   Why bother with all that other risk?  

So you can't really reduce risk by all of these tactical maneuvers.  You are just trading one risk for another.

All Cash?
Even if you stay in cash, for example, you are replacing one risk with another.  By being 100% in cash, you have eliminated stock market volatility risk.  But then now you are sitting on inflation risk.  If you are an equity investor, there is a risk that the market might not come down to where you like for a long, long time.

I remember reading about a prominent bear that got bearish in 1982.   I think he was calling for a market crash.  The Dow was at 800 in 1982.  And he was right.  The market did crash.   So it was good for him to have stayed out (and short) until then, right?  The problem is, the market crashed from 2,700 or so in 1987.

Staying in cash has some risk too that even if the market tanked and got cheap, would you actually have the courage to get in?  And if you did, would buying in at a 20% or 30% discount (or even 50% off) make up for the time you were out of the market?

Or you can convert your cash to Bitcoins and avoid Fed-and-Congress-destroying-the-dollar risk (which is inflation risk).  I'm sure the technology is incredible.  But then sometimes Bitcoin operations get hacked and the Bitcoins just disappear.  Sure, the Fed can't mess with Bitcoins, but I'd sort of rather have the Fed inflate away the value of my dollars at 2-3%/year.  And if my bank failed, I know I can get some cash back from the FDIC.   The factors that impact the dollar are visible to me to some extent.  If the dollar is devalued, I sort of know why.  I can see the inflation.  I can see the budget deficit.  I can see the Fed balance sheet.

But what about Bitcoin?  If the price of it goes down 50%, what can I look at to help me understand that fluctuation?  As far as I know, there is nothing.  So sure, you are immune from central bank and congressional incompetence, but there are many other factors that I don't understand.

So even for the Bitcoin folks, by getting out of the dollar, they are eliminating one risk but then are accepting another. 

By the way, many view Buffett as sort of timing the market because of the huge amount of cash he keeps on hand.  First of all, we know that $20 billion will be there no matter what; he wants that amount of cash for liquidity (paying out insurance claims etc.).

So when he has $40 billion on the balance sheet sitting there, it's actually just $20 billion that is investable.   With close to $200 billion in shareholders' equity, that's a 10% cash balance; hardly a dramatic market call (plus cash accumulates quickly and sometimes he has to let it build up to get ready to bag an elephant!).  Of course I considered comparing the $20 billion to BRK's equity portfolio, but since we know that Buffett would rather buy whole businesses rather than stocks (and one is not more risky than the other in his eyes) it makes sense to compare it to BRK's shareholders equity.


Buffett's Risk Management

OK, I know most of us are not Warren Buffett, but I just use him as a great example of someone who manages risk in a smart way.  First of all, the difference between Buffett and the rest of the professional investment world is how he defines risk  (This is not just Buffett, of course.  Howard Marks, Seth Klarman and many others view risk differently than the street).  

Buffett does not define risk as beta, volatility, drawdowns or anything like that.  He doesn't care about temporary reduction in the value of something (based on Mr. Market).  He is only concerned with the permanent impairment of value (bankruptcy, for example). 

These two risks are very, very different and one is much easier to manage than the other.  

If one wants to eliminate the risk of temporary reduction in value, then equities is simply the wrong investment vehicle.  Even an investment as rock solid and indestructible as BRK has gone down by 50% a few times in the past.  Any stock you buy can go down 50% or more simply due to the silliness of Mr. Market.

But to try to gauge the risk of permanent impairment is far easier. 

If you asked someone which stock over the next year will or will not go down 30%, the odds that they will be correct will be very low.  I don't think even Buffett would be able to pick stocks that will or won't do that. 

However, if you ask people which companies will still exist in ten years, and will actually be doing more business then than now, it would be far easier.  OK, maybe it won't be so easy.  Who knows where, say, AAPL will be in ten years.  

But however hard that is, it would be far easier than trying to figure out which stocks will not go down 30% in the next twelve months.

So Buffett's risk management is to simply focus on questions he can answer and only think about the long term.  Is it a well-managed company with a good business model?  Is it fairly priced?  It's just two questions, basically, that you need to answer.

Compare that to the top-down macro guy: "What will interest rates do?   We think rates will go up.  If rates go up, will that hurt the economy?  If it hurts the economy, should we own defensive names and short cyclicals?  Should we short highly levered companies and buy cash rich companies?  When should we buy such companies or short such companies?  And when do we cover?  How do we know when we are wrong and when do we have to reassess the scenario and rebalance our portfolio?  When do we admit we are wrong?".   What if we are right and there is a recession?  When do we reverse course and start to cover and go long? etc...  The questions are endless, and most of them have to be answered accurately or else you end up losing money.

With Buffett's approach, you don't care about any of that stuff.  Interest rates go up or down?  Who cares.  The management at these companies that we own are good enough and are financially literate so they will refinance if rates go down and won't borrow more if rates go up.   They are not so overlevered that rising rates will kill them.  What will happen to the stock market?  Who knows.  But we know that we own good companies with good managements so if the stock market goes down, maybe they will repurchase shares or maybe they will find an attractively priced acquisition.   If the stock market rallies, maybe they do a stock for stock deal, or maybe they issue stock to raise capital.

In good times they will do a lot of business.  In bad times they will manage costs and find ways to grow the business (acquisitions on the cheap etc.).  If we own the low cost producer, bad times will hurt us less than others.

So whatever the scenario, you don't care.   Things will work out.

Pzena Commentary
Richard Pzena has talked about the fact that risk of owning equities can be reduced by extending the holding period.   His third quarter commentary updates some figures.

It is an interesting read that most of us understand intuitively, but it's nice to see a study that quantifies this stuff.  Yeah, you might say this is marketing material for a value fund.  True.  But it's still interesting and there is still a lot of truth in it.

Here's the commentary:

Pzena Investment Management Third-Quarter Commentary

And here are some tables from it that are very interesting:

This table is self-explanatory.  Buffett's secret weapon risk management method is simply a long holding period (he has said that his favorite holding period is forever):

While some mutual funds try to dance in and out of markets, hedge or unhedge their equity exposure based on all sorts of things, Buffett simply commits to a long holding period and therefore eliminates all the things most other investors worry about.   As I have said here many times before, more money is usually spent (lost) on trying to avoid temporary losses than the losses they try to avoid (which are usually just temporary anyway!  Their losses are permanent, though).

Hedge Funds
Pzena talks about how hedge funds promise to lower volatility but doesn't even achieve that over time.  Equity volatility can be reduced by extending the holding period, but the volatility incurred by owning a hedge fund is not at all reduced through longer holding periods:






Anyway, I am not all that against hedge funds in general.  When I started in the business, the main hedge funds were Soros, Tiger and Steinhardt (in terms of funds focused mostly on equities).

Today's Funds versus the Legendary Funds of the Past
Not too long ago, Stanley Druckenmiller was ranting about the mediocre hedge funds these days.  He said that you had to be an idiot to be paying 2%/20% to hedge funds with single digit returns or low double digit returns.  In his time, hedge funds were expected to earn 30%+ in good markets and bad markets (well, I forget which figure he used; it might have been 20-30% or 30-40%).   Nowadays, he complained, funds still charge high rates with much lower returns claiming that they have good returns on a risk-adjusted basis.

Well, a lot of this is due to the institutionalization of hedge funds in the past couple of decades.  Back in the 1980's and 1990's, hedge funds were for wealthy individuals and maybe European institutions.  If you had a drink with a hedge fund money raiser, they would have told you that you need to put up 30-40%/year returns (or promise to do so) to have any chance of raising capital. This figure may be lower for fixed income arbitrage and other strategies, though.

But since then, U.S. institutions like pension funds started investing heavily in hedge funds and they actually wanted lower volatility and most importantly, I think, non-correlation to conventional asset classes (basically the S&P 500 index).

Presentations were usually filled with tables showing how a 10% or 20% allocation to hedge funds can increase the Sharpe ratio of traditional pension fund returns.

So I think a lot of this low vol / low return stuff comes out of that.  Plus, I guess many managers realized it's much more fun to earn 10%/year with $10 billion AUM (and earn $200 million/year just in management fees) than to try to shoot for 40-50% returns with $500 million.  If they can get to $20 billion AUM, they can earn $400 million just on management fees.  And if you get 20% incentive fee on a 10% return, that's another $400 million/year.

How many percent return do you need to make $800 million/year on an AUM of $500 million?

And how do you get to $20 billion AUM?  You need the big institutional money; pensions and insurance companies etc.  And how do you get that?  By reducing volatility!

And by the way, in defense of the younger, new generation of hedge fund managers, we have to remember that a lot of those old legends put up those impressive return figures in the 1980's and 1990's (well, Soros and probably Steinhardt did very well in the flat 1970's too).  The younger generation had to perform in a market that so far has been pretty flattish since 2000; that's like 15 years of nothing in the market!

Anyway, I do like some of the hedge funds I talk about here, especially the equity focused guys, activists etc.  And of course Oaktree too.

Conclusion
Wow, this is another one of those meandering stream of consciousness-type posts.  What I wanted to say, basically, is the same as what I always say here.

But I realized there is another way of putting the risk of market timing.

When someone tells you that they will earn equity-like returns with lower volatility and low correlation to the stock market, and they say they are going to do it mainly in the stock market, I think it's a good time to run.

You can't really earn high returns with lower volatility without taking some other risk to compensate.  When someone offers you something like that and they say you will have lower stock market risk (and returns are still going to be high), you have to think hard about what kind of risk they are going to take instead.  Most of the time, they are just reducing one risk to take another kind of risk.

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!