Thursday, June 19, 2014

Is Coke Undermanaged?!

OK, now that's a silly idea.  Coke (KO) is one of the most respected companies and known to be very well managed.   It is an excellent company for sure.

One great thing about running a blog is that I can just think out loud here and sometimes someone pulls on a thread and gets me thinking about other things (or corrects my mistakes).

After posting about a possible (or impossible) BUD/KO merger, someone commented that the operating margins can't be compared because BUD and KO operate under different models.  KO lets the bottlers do the heavy lifting and KO only makes the syrup.  This is increasingly less so due to the non-carbonated drinks they sell.  They also took over the bottling operations in the U.S.  But OK, that only accounts for 20% of global volume so it is still mostly a syrup selling operation; a very high margin and lucrative business.

But as I pointed out in the comment section, that makes the BUD/KO merger argument even stronger.  If KO has the better operating model, then how come BUD has an operating margin of 32.5% versus KO's 21.8%?    That makes no sense at all.

And as I went about my usual daily routines, I kept thinking about it and couldn't get over the fact that KO has been run so long by insiders, on how insiders tend to respect 'sacred cows' and respect tradition (in other words, it's been a tradition for 100 years to do it that way, so let's keep doing it that way).

Also, if you went up in the organization, that means you have a lot of subordinates that you helped promote over the years.  It's really hard to give a hard-working underling a department to run and then later take it away saying that we don't need it anymore.  The more likely scenario is, well, it doesn't cost us so much and we can still make our numbers so let's keep that department going.   It's probably also hard to give people nice offices over many years and then suddenly say, hey, no more offices!  We are all going to work in cubicles now.

I keep going back to that comment by the new Sony CEO that said they will never stop producing televisions because the engineers in that division are very proud of their work.  Is it any wonder what is happening there?  I've seen a lot of that when I worked in a big company too.

At KO, it's probably not so much product lines, but activities.  They probably spend a ton of money on all sorts of events with questionable returns.  I don't know (but I'm sure it will take a couple of days for 3G-type people to figure out).

It's Return on Capital, Stupid.  Not Margins!
And as I was thinking about this stuff all of the sudden I slapped my forehead and said to myself, geez, it's not the margins!  Well, margins do matter and the higher the better.  But the KO model was meant to be an asset-light model; let the bottlers build the bottling factories.  Let them do the capital intensive part and we'll just keep producing Super Bowl commercials.

So when this occurred to me, I rushed back to my desk to look at the return on capital figures for the relevant companies.

Operating Margins
So first of all, here are the operating margins for the businesses we are talking about.  Oh, and I also added Dr. Pepper Snapple Group (DPS) because they are in a similar business to KO but they are integrated, meaning they bottle their own drinks instead of relying on bottlers.   DPS is way smaller than KO so may not be a fair comp, but still, it would be an interesting benchmark.  Actually, the advantage should be to KO; size/scale benefit etc.

Here are the operating margins:

KO       21.8%
DPS     17.4%
BUD    32.5%
PEP     14.6%

So here it looks like KO is doing well against DPS and PEP.  But PEP is attached to a snack business which might have slightly different economics.  But the margin is a lot lower than BUD, who bottle and deliver their own drinks.

Return on Capital
But as I said, it may be the capital that matters, so let's look at some return on capital figures.  For capital, I will use the total of long-term debt and total equity.  I will look at operating earnings against this and call that return on capital.  Also, I won't use average equity or anything like that; I just use whatever is on the balance sheet at the end of the year.

So this is not text-book correct, but should give sort of an indication.

              Operating earnings /
              (LT debt + Total Equity)
KO*            24.2%
DPS            21.9%
BUD           14.5%
PEP            19.9%

For KO, I deducted the $10 billion or so of equity investments on the balance sheet as the equity income from those investments (bottlers) don't show up in the operating income line.  I also use total equity as minority interest is not deducted before the operating income line.

But here, the first thing you notice already is that KO's return on capital is better than DPS and PEP, but not that much better.  I thought it would have been a much bigger gap given the advantageous  business model.

And then you say, "aha!", look how awful BUD is!  But then we have to remember that BUD was created by a giant merger (and more mergers in the past) so there is a lot of goodwill on the balance sheet.

So I decided to take a look at return on tangible capital.  Here, I will only deduct goodwill, and not other intangible assets as goodwill is the pure premium paid on acquisitions, and intangibles were identifiable (but not tangible) assets that were put on the balance sheet.  I don't want to get into if the intangible valuation is fair or not.  Plus, if I deduct those intangibles, DPS capital would be negative so would destroy the elegance of my argument so let's just keep that in.

Return on Tangible Capital
So deducting goodwill from the above definition of total capital, the return on tangible capital (ROTC) becomes:

KO               34.2%
DPS             58.2%
BUD            52.7%
PEP             30.2%

I was a little surprised by this result too.  KO's return on capital is good, but look at DPS and BUD.  And KO's is not much higher than PEP's ROTC given it's supposed asset-lightness.  My image is that the soda business is much more lucrative than the snack business (growth problem aside), so it was surprising to me that KO and PEP were so close here.

Greenblatt Return on Capital
And for fun, as one more layer of return on capital comparisons, I decided to use Greenblatt's Magic Formula return on capital as it does exclude all intangibles.  I will again use operating earnings on top and for the denominator I will use net current assets plus net PPE.  Let's call that NCAPPE.  

Using that I get:

                Operating earnings
                 / NCAPPE
KO              55.4%
DPS            82.9%
BUD           67.2%
PEP            42.3%

Again, this was surprising.  Both DPS and BUD beat KO on this measure.  So what happened to the asset-lightness?    Is KO pissing away the benefit of the operating model with unnecessary spending?

Here is a table that summarizes the above stuff:

Again, I deducted the equity method holdings for KO from the capital.  Net current assets was negative for BUD, so that's why it's zero there.

I don't think anyone can look at KO and think it's poorly managed.  And there is a question as to whether everything has to be super-optimized for super-efficient, super-returns-on-capital.

But it was interesting to go through this exercise and realize that KO is not that way out in terms of performance as I thought it was.  And again, it shows partly how incredible the 3G guys are.

If Heinz, which was considered pretty well-run (people wondered what more 3G can do after years of restructuring there) can improve so much and they can get so much value out of it, imagine what they can do at KO.  From these figures, you can see that there is a lot of room for improvement.

So while Buffett has denied Berkshire Hathaway and 3G taking KO private, that doesn't mean that Buffett doesn't want some more value extracted from KO.

And KO is so big they will need some sort of vehicle to do that with, and what better vehicle is there than BUD?

Although it is more likely that BUD acquires SABMiller, PEP and even DPS (too small?), a deal with KO would be very interesting.

Some of the pieces of the puzzle are lined up already.

  • Buffett loves what 3G is doing; he would probably love to see their work on some of Buffett's holdings 
  • KO has not been a great performer recently.  It has done well, though, but not supergreat
  • Like Ackman owning Allergan (I just threw that in there for fun; not comparing Buffett to Ackman), Buffett already owns a big stake in KO so BUD would already have some votes for a deal (and a potential supporter on the board in Howard)
  • Buffett has owned BUD in the past and probably likes the business.  We know he loves the management already, so he would gladly take all stock and maybe even buy more BUD stock or preferreds if needed to get a deal done.  Buffett would love something big to put a big chunk of capital to work. 
  • Unlike an LBO, a BUD/KO merger would have the benefits of synergies.  I know, we hate that word, but there would be a lot of synergies here, including procurement.  Someone pointed out that KO doesn't do it's own bottling, but if BUD and PEP can do a procurement deal, surely KO bottlers can do a procurement deal with BUD, so the same benefits may be realized either way. 
  • etc... 
So there are a lot of things when you think about it that makes a lot of sense here.  And yes, there are things that may be difficult.  Can you imagine the uproar of a foreign firm buying Coke?  The size of the deal alone makes it look impossible. 

But again, what's the fun if we don't dream big?! 

Tuesday, June 17, 2014

Big Dream: Anheuser-Busch InBev (BUD) / Coca-Cola (KO) Merger

This morning KO's stock price popped up on a comment by David Winters that Buffett and 3G are planning to take KO private.  He said that there are indications that something is going on, including press reports in Brazil regarding something related to 3G, KO and Buffett.

Now, I don't want to speculate on mergers and that's not what this blog is about, but it can be fun sometimes to do so.  I would usually ignore this sort of noise in the market.  Oh, and Becky Quick from CNBC called Buffett and he immediately said there's no chance 3G/BRK will take KO private.  It is way too big being bigger than the Heinz deal ($180 billion versus $23 billion for the HNZ deal).

But something has been nagging me for a while now and it was reinforced after reading the very interesting book, Dream Big: How the Brazilian Trio behind 3G Capital - Jorge Paulo Lemann, Marcel Telles and Beto Sicupira - acquired Anheuser-Busch, Burger King and Heinz.

It's really a great book that tells the story of the rise of the folks at 3G.  All business success stories are very similar but what I kept going back to is how these guys started out small and kept building things up.  They tend not to buy something to sell, but to build up.  Each acquisition turns into sort of a platform for growth and further deals. And they also give a lot of freedom to employees to take risk and grow as long as they do so prudently.  Their acquisition of BUD was seen as a long shot but it eventually happened.  It was a "big dream" that was realized.

What will they do next with BUD?  I don't think they are in it to maintain the status quo.  That's why I thought they would bid for Pepsi's snack business, for example.   I also wonder about Burger King (BKW) too.  You know 3G is in it for the long haul, so they are not going to be content sitting on it; they will make it grow and at some point down the line there will probably be some deals there too once they finish modernizing their restaurants (they already finished franchising out all the restaurants).

OK, back to BUD.

A few years ago, BUD had some agreement with Pepsi on some procurement deal so they can save costs on procurement as they share many common inputs.  Of course, this should make Pepsi too a target of a potential deal for BUD  (And in South America, beer companies also frequently sell the sodas too).

This procurement deal suggests that there would probably be some significant synergies in BUD selling sodas.  Imagine the synergies in procuring aluminum cans, and maybe even media/advertising.

And look at these figures comparing BUD and KO:

                                      BUD                    KO
Gross margin:                59%                     61%
SGA % sales:                 27%                    37%
EBIT margin:              33%                    22%

BUD's SGA includes stuff that may not technically be SGA; I just took whatever came in between gross margin and operating earnings.  In KO's case, I just took SGA as reported in the 10-K and there are other things in between SGA and operating earnings.  Also, there are probably a lot of differences in accounting standards that make a direct comparison difficult.

But in any case, this is just a quick look to see if KO might benefit from Zero-Based Budgeting (or whatever it was called).

And sure enough, as high margin and amazing KO looks, BUD is even better.

KO is very highly regarded and well-managed, but I can imagine that over the years with such a lucrative, high-margin operation, maybe there is a lot of waste that has built up over the years.  And maybe KO insiders are too generous to cut wasteful spending  (lifers sometimes have too many friends they don't want to offend).

So, maybe there could be some significant synergies between the tie-up between these two.  Getting KO operating margins up to BUD levels would increase operating earnings by 50%; that alone can pay for the premium that BUD would have to offer (presumably in a lot-of-stock / maybe-some-cash offering).

And then think of the obvious synergies of selling liquids in cans and bottles to similar retailers and other points of sale (restaurants/bars).

If what is in the above book is all true (and there is no reason to believe otherwise), this can create some huge value.

As a sanity check, here are the respective market caps and enterprise values of each:

                                             KO                BUD                       combined
Market Cap:                        $180 bn          $180 bn                  $360 bn
Enterprise Value                 $198 bn          $218 bn                  $416 bn

Yeah, that would be a huge deal.  Ridiculous, actually.  But this is a blog so I can imagine and fantasize about whatever I want!

But you know, I bet that somewhere within BUD is a spreadsheet that has all of this pro-forma-ed out on what a combined operation would look like and what synergies and costs-savings can be achieved and what the value-added would be.

Who knows, maybe it's on Brito's laptop, or maybe it's just some low-level financial analyst/intern doing it as an exercise at the suggestion of a mid-level boss.  But either way, the spreadsheet is there somewhere at BUD.  To be fair, the same one would exist for PEP, SAB Miller and every other big company that might make sense (or might not make sense).

Even a combined market cap of $360 billion (of course more if you include a takeover premium) is still way lower than the $560 billion market cap of Apple!  It's a different world.

So Buffett might have said "absolutely no chance of that" to a Berkshire Hathaway / 3G deal for KO, but he didn't say "absolutely no chance" of a BUD/KO deal, right?  And Buffett may participate too; he can buy BUD common or preferreds to help fund the deal.    So in a sense, it would still be a Buffett/3G deal, and Buffett's denial would still be true (maybe that's why he needed Quick to clarify the question to make sure that he is only denying that BRK will take KO private with 3G).

Both Buffett and Munger think Muhtar Kent is a great CEO and they seem to love him, but it's also true that Buffett really loves the guys at 3G and is impressed with what they are doing at Heinz.  HNZ too was regarded as pretty well run.  So who knows?  Maybe Buffett would really support a BUD/KO deal!

Also, BUD may have trouble doing more large beer deals due to anti-trust issues, so BUD/KO might make a lot of sense.

Wednesday, June 11, 2014

What To Do in this Market II: Gotham Funds

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

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

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

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

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

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

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

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

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

OK.  So we all get that. 

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

So here's the punch line: 

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

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

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

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

Here's the website:  

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

The Funds
And these are the funds that they offer: 

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

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

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

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

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

The S&P 500 total return isn't listed with these figures, so here are the year-to-date and one year returns of these funds versus the S&P 500 index  (the figures below are as of June 10, 2014):
                                                            YTD                           1 Year                        
Gotham Enhanced Return                  +10.5%                      +34.4%
Gotham Absolute Return                    +6.4%                        +21.5%
Gotham Neutral                                  +7.4%                          n.a.
S&P 500 Index                                  +5.5%                       +18.7%

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

And I wouldn't really advocate that at all. 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

So why is this relevant to this post?

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

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

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

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

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

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


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

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

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

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