Friday, January 23, 2015

Cowen Group, Inc. (COWN)

I was always curious about COWN; it did an interesting merger with Ramius, an alternative asset management company run by some stars from the 1980's.  I have taken a look at it a few times over the years but never really thought much of it.  I don't know what I think of it now, but I thought I'd make a post about it as I am taking a closer look.

First of all, to me, COWN the boutique broker-dealer/investment bank has always been a small company that specialized in health-care and technology; nothing special.   I don't think it has been making any money (or not much) since the 1999/2000 bubble crash.  After that, the industry sort of just seemed to shift away from these little guys and to the bigger banks.

The first time I really noticed it as something I should look at more seriously was when it showed up on Leucadia's (LUK) 13-F back in May 2011.    Many of us respect Cumming and Steinberg as great investors so obviously, anything they take a stake in is interesting to me (but of course, I would never blindly buy anything just because someone I like does).

So here is the curious holdings history of COWN at LUK:

                     COWN         #shares owned          
                     price             by LUK                       BPS    P/B        TBPS    P/TBS
3/31/2011     $4.01            1,000,000                    $5.95   0.67       $5.42     0.74
6/30/2012     $2.66            2,000,000                    $4.45   0.60       $4.23     0.63
3/31/2013     $3.09            3,000,000                    $4.40   0.70       $4.03     0.77
9/30/2013     $3.44               0                            

*shares are rounded to the nearest million.  It's pretty close, though.

Yes, it's a pretty small position for LUK.  The other stock they've owned for a long time is INTL FCStone (INTL).  We can see that after the LUK/JEF merger, they completely sold out of COWN.  This can be because they are a direct competitor to JEF.  Or maybe they (Handler, who took over from Cumming/Steinberg) just don't like COWN.  INTL also is being sold down.  

I used to follow INTL until their merger with FCStone.  I personally hated that merger because I am not a fan of the commodity futures brokerage business.  I didn't like JEF's purchase of Bache's commodities business either.   I've never worked in that industry, but it has always sort of seemed like a low-margin, low-return business.  And then every few years you have these spectacular blowups. Refco had a blowup, MF Global lost a ton on unauthorized, hidden trades (this was in 2008 and not the Corzine blowup of 2011) and there were some others.  All it takes is one bad unauthorized trade and *poof*.  I hate that.  You may argue that this is the case with any financial company.  Yes, to some extent.  But in futures, it seems much easier to blow up.  (But importantly, thanks to central clearing, those blowups rarely lead to systemic problems).

Anyway, that business sort of turned me off to INTL.  If I take a close look at it again, maybe I'll make a post about it.

If someone were to ask why LUK owned COWN, Cumming / Steinberg would have probably said, "Because we like the people and it's cheap".  I think that's exactly what they answered when someone asked about INTL at an annual meeting a few years ago.

So, Cumming / Steinberg probably like the people at COWN.  It can't be just because it was cheap; there were plenty of cheap financial stocks back in 2011.

But there is another connection.  Ramius, the alternative asset manager that merged with COWN had a stake in Linkem before LUK got involved.  So there is probably a relationship there.  All of these guys (the LUK folks and COWN folks) go way back.

COWN Management
Some of the older people will recognize these names, but the younger folks may not have ever heard of them.  Peter Cohen is sort of the original Jamie Dimon (Sandy protege).  He was a rising star, young, "boy wonder" back in the 1980's.  Thomas Strauss, of course, will make many Buffett-heads cringe as he was the President and Vice Chairman of Salomon at the time of the scandal.
       Peter A. Cohen.    Age 67. Mr. Cohen serves as Chairman of the Company's Board of Directors and Chief Executive Officer of Cowen Group and serves as a member of the Management and Operating Committees of Cowen Group since November 2009. Mr. Cohen is a founding principal of the entity that owned the Ramius business prior to the combination of Ramius and Cowen Holdings, Inc., or Cowen Holdings, in November 2009. From November 1992 to May 1994, Mr. Cohen was Vice Chairman and a director of Republic New York Corporation, as well as a member of its Executive Management Committee. Mr. Cohen was also Chairman of Republic's subsidiary, Republic New York Securities Corporation. Mr. Cohen was Chairman of the Board and Chief Executive Officer of Shearson Lehman Brothers from 1983 to 1990. Over his career, Mr. Cohen has served on a number of corporate, industry and philanthropic boards, including the New York Stock Exchange, The Federal Reserve International Capital Markets Advisory Committee, The Depository Trust Company, The American Express Company, Olivetti SpA, Telecom Italia SpA, Kroll, Inc. and L-3 Communications. He is presently a Trustee of Mount Sinai Medical Center, Vice Chairman of the Board of Directors of Scientific Games Corporation, a member of the Board of Directors of Chart Acquisition Corp. and a director of Safe Auto Insurance. Mr. Cohen provides the Board with extensive experience as a senior leader of large and diverse financial institutions, and, as Chief Executive Officer, he will be able to provide in-depth knowledge of the Company's business and affairs, management's perspective on those matters and an avenue of communication between the Board and senior management.

        Thomas W. Strauss.    Age 71. Mr. Strauss is Vice Chairman of Cowen Group, Inc. and is the Chairman of Ramius LLC. Mr. Strauss was appointed a director of Cowen Group in December 2011. Mr. Strauss previously served as Chief Executive Officer and President of Ramius Alternative Investments since February 8, 2010 and serves as a member of the Management and Operating Committees of Cowen Group. Mr. Strauss previously served as Chief Executive Officer and President of Ramius Alternative Solutions. Mr. Strauss is a founding principal of Ramius. From 1963 to 1991, Mr. Strauss was with Salomon Brothers Inc. where he was admitted as a General Partner in 1972 and was appointed to the Executive Committee in 1981. In 1986, he became President of Salomon Brothers and a Vice Chairman and member of the Board of Directors of Salomon Inc., the holding company of Salomon Brothers and Phibro Energy, Inc. In 1993, Mr. Strauss became Co-Chairman of Granite Capital International Group. Mr. Strauss is a former member of the Board of Governors of the American Stock Exchange, the Chicago Mercantile Exchange, the Public Securities Association, the Securities Industry Association, the Federal Reserve International Capital Markets Advisory Committee and the U.S. Japan Business-Council. He is a past President of the Association of Primary Dealers in U.S. Government Securities. Mr. Strauss currently serves on the Board of Trustees of the U.S.-Japan Foundation and is a member of the Board of Trustees and Executive Committee of Mount Sinai Medical Center and Mount Sinai-NYU Health System. Mr. Strauss provides the Board with extensive experience in both investment banking and asset management.

I don't have any particular opinion about these guys as they were pretty much before my time.  I only know how they have been portrayed in the media.

So why bother looking at this?   It is nominally cheap.  As of September 2014, BPS was $4.74/share and tangible BPS was $4.33/share.  It's now trading at $4.44/share which is 0.94x BPS and 1.03x TBPS.  That's not that cheap compared to when LUK owned it.

But there is a near-term catalyst that makes this valuation much cheaper.  Due to previous losses, they have a large deferred tax asset that is not reflected in book value because of the valuation allowance (as they weren't profitable enough to be able to say they can use it).

From the 3Q14 10-Q:
Due to recent and current positive operating results and, because the losses from 2011 are rolled off from the three-year rolling analysis, the Company anticipates to be in a three-year cumulative income position later in 2014. As a result of this development and other positive factors as indicated above, it is possible that the Company could release a large part of the Company’s valuation allowance in the fourth quarter of 2014, which would have a material and favorable effect on Net income and Stockholders’ equity. At September 30, 2014, the Company’s valuation allowance was $137.4 million, of which $135.2 million is related to the Company’s US operations. 
$135.2 million amounts to around $1.20/share.  If this DTA is added to the above BPS and TBPS, we get $5.94/share and $5.53/share respectively.  That makes the valuation 0.75x BPS and 0.8x TBPS.   COWN starts to look cheap again.

Of course, this assumes that COWN didn't lose money in the 4Q of 2014.  We don't know that yet.  And we don't know how much of the valuation allowance will actually be released in 4Q2014.

But if the turnaround is for real at COWN, then we can assume that the DTA will eventually be realized.

BPS History
Any time we look at something against book value, we have to see how BPS has changed over time.  It's not cheap if a company can't or hasn't grown BPS at a reasonable rate over time (or paid out dividends etc.).

Ramius and COWN merged back in 2009, so let's look at BPS and TBPS since then.  Some of the figures may be off by a penny or two since I rounded when making the BPS/TBPS calculations.

                                 BPS             TBPS
Dec 2009                 $6.34            $5.75
Dec 2010                 $5.95            $5.42
Dec 2011                 $4.45            $4.23
Dec 2012                 $4.40            $4.03
Dec 2013                 $4.41            $3.99
Sep 2014                 $4.74            $4.33

So, that's not so exciting.   BPS has been going down since the merger.  How can this be when the market has done really well, generally, since the bottom of the crisis?

OK, so COWN was probably in much worse shape and not positioned for the post-crisis world (I don't think COWN ever even recovered from the other bear market in 2000-2002; it seemed like they were just waiting around for the next bubble to come to bail them out).

But there is hope. COWN is a little complicated because they consolidate some of the funds that Ramius manages.  So we have to look at the economic income (which ignores the consolidated funds and other things).

In general, Economic Income (Loss) is a pre-tax measure that (i) eliminates the impact of consolidation for consolidated funds and (ii) excludes certain other acquisition-related and/or reorganization expenses (See Note 2). In addition, Economic Income (Loss) revenues include investment income that represents the income the Company has earned in investing its own capital, including realized and unrealized gains and losses, interest and dividends, net of associated investment related expenses. For US GAAP purposes, these items are included in each of their respective line items. Economic Income (Loss) revenues also include management fees, incentive income and investment income earned through the Company's investment as a general partner in certain real estate entities and the Company's investment in the activist business. For US GAAP purposes, all of these items are recorded in other income (loss). In addition, Economic Income (Loss) expenses are reduced by reimbursement from affiliates, which for US GAAP purposes is presented gross as part of revenue. 
Here is the economic income of the two businesses (alternative investments (Ramius) and broker-dealer (the old Cowen)) since 2009:

(in $millions)
                    Alternative     Broker-dealer
2009           -25.7                -16.3
2010            31.8                -67.4
2011            10.2                -81.7
2012            18.5                -36.1
2013            10.1                  -3.6
2014*            7.9                 17.4

*2014 is for the first nine months

So it looks like they are really turning around the broker-dealer business.  If this trend in improvement continues, that can really help the stock.  All they need to do is not lose so much money on the broker-dealer side and do well with Ramius.

They have a presentation on the website from November 2014, so let's look at that for a second.

Here are some slides:

What is interesting here is that not only do they have a broker-dealer business and an alternative asset management business; they invest a lot of their own capital into their alternative strategies.  This is different than most other listed alternative asset management companies.    Others do invest in their own funds/strategies, but it usually isn't a large part of their value (OAK, BX etc).

I think it's obvious that the merger in 2009 was driven by the needs of both sides.   Both of them were hit hard during the crisis.

This model sort of reminds me of the old Salomon model.  Salomon made a lot of money trading for itself back in the 1980's, and I think a lot of their ability to take risk came from the steady stream of revenues from their client businesses.

This is why I wondered if Long-Term Capital Management (LTCM) would do as well on its own when they split from Salomon.  For example, if you belong to an organization with a stream of $10 million per day coming in, you can take a lot more risk than if you had zero coming in every day.  With a $10 million per day revenue stream to support risk taking, you can take VAR up to $10 million and you wouldn't lose money even on the bad days ($10 million loss offset by $10 million revenue on that day).  If you include the revenue stream in the VAR, for example, you really shift the curve to the right and really minimize that nasty tail on the left side.

I think this is a big part of why Salomon was able to take such big risks back then, and this may be one of the reasons LTCM couldn't survive when they had one of their outlier days/weeks/months; there was nothing there to offset it or smooth it out.  And this too, by the way, is why JPM and GS are better off 'diversified' than not.

Anyway, moving on.  These are the different strategies that Ramius runs.  And yes, that Starboard is the "put some damn salt in the water when you boil pasta and don't give out so much friggin' bread!" Starboard.  They were spun off so COWN only owns a minority stake.  This could be a good thing or a bad thing depending on what you think of Starboard (I know there is a wide range of opinions!).

AUM growth has been good since 2009.

I am generally not a big fan of managed futures and global macro.  But who cares what I think...

And here is how they are turning around the broker-dealer business:

It is sort of stunning that they have 110% of COWN's book value invested in their proprietary trading strategies.  This could be a good thing for people who want alternative exposure.  But it can be scary; what happens in the next bear market?   If the next bear market causes the broker-dealer business to go back to losing money, it can get scary.

Here is the breakdown of how the capital is invested (by strategy):

Historical Returns
So check out this chart.  It shows how COWN's (and Ramius pre-merger) own invested capital performed since 1999.  It seems like they did fine in the 1999-2002 bear market but got killed in the financial crisis.

Since 1999 (or from the end of 1998), their gross return has been 15.4%/year.  That's not bad at all.

But let's look at it in the different time periods.   From 1998 to the top in 2007, the return was +24.6%/year.   And then they lost -23.7% in 2008.  That's not bad at all, but if this sort of loss happens in a broker-dealer and the b/d business also loses money, things can get pretty ugly pretty quickly.

Since the low in 2008, they earned +10%/year.    So there is something going on that is making it harder for alternative strategies to make money. Or they prudently scaled back their risk due to being part of a broker-dealer.  We don't know how the mix has changed over time so we can't really say.  It's not the stock market, though, because that has done really well since 2008.

Mutual Funds
Ramius runs some mutual funds too with some of these alternative strategies.  There is a website with some interesting information:

Ramius Mutual Funds website

They run four alternative investment mutual funds:

Ramius Hedged Alpha Fund  (RDRIX/RDRAX)
State Street/Ramius Managed Futures Strategy Fund  (RTSRX/RTSIX)
Ramius Strategic Volatility Fund  (RVOAX/RVOIX)
Ramius Event Driven Equity Fund  (REDIX/REDAX)

You can see for yourself at the website, but the performance is not so great.  The Strategic Volatility Fund can't be considered anything other than a total disaster.  True, most of these funds are still new so it will take time to see if they perform well.

The Ramius Event Driven Fund is run by Andrew Cohen, Peter Cohen's son.  The blurb on that fund actually looks interesting but I have no idea if Andrew Cohen has actual experience managing money and if he has a proven track record.

I wouldn't recommend any of the above funds, mostly because I am unfamiliar with the managers and I don't think some of the strategies make any sense.

I actually don't know much about Ramius and COWN.   It is an interesting play for sure if you like this sort of thing (proprietary trading / alternative investments).  But I don't know enough about them and their funds for me to be comfortable.  For alternative asset management, I would prefer the other big names (BX, OAK etc.) and for broker-dealers, I would much prefer GS and LUK.  But that's mostly because of the familiarity I have with those organizations; I have been following them for years.

To date, I have heard very little about Ramius (other than Starboard which has been in the public eye a bit lately) and I never thought much of the old Cowen.  I don't mean it was a bad company,  I just mean that I had no interest in small, boutique investment banks in general; the world seemed to have moved away from that model.

I also have no view, particularly, on the management of COWN (Cohen, Strauss) even though I used to read and hear a lot about them early on in my career.

One big concern for me is how COWN would do in a bear market.  If you get a combination of losses in proprietary / alternative strategies and the broker-dealer business, it might not be a situation I would want to sit through.

Also, Cohen/Strauss and the other old Ramius owners initially owned a bunch of COWN, but it looks like they sold that down in the past few years.  It seems clear that the merger was basically an exit strategy for the Ramius owners.

This is from the 2010 proxy:

Executive Officers and Directors
Amount and
Nature of
Percent of
Peter A. Cohen(1)(2)
Stephen Kotler
Jules B. Kroll
David M. Malcolm(3)
Jerome S. Markowitz(4)
Jack H. Nusbaum
L. Thomas Richards, M.D. 
Edoardo Spezzotti(5)
John E. Toffolon, Jr.(6)
Charles W.B. Wardell, III
Joseph R. Wright
Morgan B. Stark(1)(7)
Thomas W. Strauss(1)(8)
Stephen A. Lasota(9)
Christopher A. White(10)
All directors and named executive officers as a group (15 persons)

...and this is the 2014 proxy:
Amount and
Nature of
Percent of
Executive Officers and Directors:
Peter A. Cohen
Katherine Elizabeth Dietze
Steven Kotler
Jerome S. Markowitz
Jack H. Nusbaum
Joseph R. Wright
Jeffrey M. Solomon
Thomas W. Strauss
John Holmes
Stephen A. Lasota
Owen S. Littman
All directors and named executive officers as a group (11 persons)

It's true that these guys aren't so young anymore, so I can see selling down.  Also,  it might be safer to just own the Ramius funds instead of owning stock in COWN.  If things hit the fan, you may take big marks against you but funds generally don't go bust.  But this can't be said of broker-dealers.  (One of the ironies here is that Ramius had some assets stuck in the London prime brokerage of Lehman when they went under).

This combination of broker-dealer + alternative asset manager + capital invested in alternative strategies can be very interesting when things are going well, but if things go back to where they were (when the b/d was losing money),  and we get a bear market, things might get ugly.

Also, from a valuation viewpoint, ideally, if the broker-dealer business does OK, and the proprietary investments work out like it has historically, then you get the alternative asset management business for free.  A sum of the parts analysis might add a value using some sort of percentage of fee-earning AUM, but I have never really liked that approach since the fee structures differ between firms.

It's hard to put a value on the asset management business if the earnings are not separated out.  For example, other alternative managers are typically valued based on fee-related earnings and incentive fees.  In the case of COWN, I don't know what the fee-related earnings is; if you deduct expenses from management fees, it is negative, but some costs might be offsets to incentive income and bonuses from proprietary trading (strategies done in-house but not for any fund).

So, in any case, you can add some value based on AUM, but I haven't done it here.  (Also, if you deduct investment income from economic income of the alternative investments segment, it's negative every year.  This suggests that the asset management business is not adding value (or there are costs included that are not related to the asset management business)).

If it was clear that fee-related earnings are consistently positive, then that also would add to the stability of COWN; a stable, positive fee-related earnings would help stabilize potential volatility on the balance sheet.

But to date, this hasn't been the case.

In any case, this is an interesting investment.  If someone has more familiarity with the people and funds here (as Cumming/Steinberg presumably did), it's an interesting idea.  But for me, I don't have the comfort level but I'll keep an eye on it.

Thursday, January 15, 2015

Dimon is Right!!

Dimon sounded a bit frustrated on the 4Q 2014 conference call the other day and it is totally understandable.  Yes, JPM and other banks made some mistakes, but it's really strange how regulators are jumping on JPM.  Just like they jumped on Goldman Sachs too, when they were one of the better operators (Fabulous Fab notwithstanding).

Bass Ackwards
The regulators seem to equate size with risk, but I don't think so at all.  The biggest problem that we learned from the financial crisis is not so much the size and complexity of the banks, but the size and complexity of the alphabet soup of regulators!    Simplifying that would go much further in reducing systemic risk.

Size ≠  Risk  (Regulatory Complexity = Risk!)
If we think back to the financial crisis, Citigroup was the only large bank to get into trouble.  The big failures, remember, were Bear Stearns (not even the biggest investment bank and not integrated; it was not too big or too complex at all), Lehman (same, this was not a global bank but an independent investment bank), AIG (this was not even a bank or an investment bank!  And I don't know that complexity had anything to do with it.  Bad trades were put on, basically, in two divisions).   Of course there was Countrywide, IndyMac, Wamu and some others.   (By the way, during the S&L crisis in the late 80's, the absence of size didn't seem to help much.  Sometimes it's more complex to deal with 1,000 small problems than, say, one big one).

I remember when a reporter for the Economist wrote that the beating up of banks and investment banks after the crisis is like when a fight breaks out in a bar.  Some people don't go find the guy that started it and punch him, but just punch the guy sitting next to him because he never liked him (and it was a good time to punch him).  That's sort of what it feels like.

Also, I'm not going to bother to Google it and post it here, but U.S. banks aren't even that concentrated (large relative to economy) compared to most other large banks in the rest of the world.  The deposit share of the large U.S. banks are much smaller than, say, Japanese, German and other banks around the world.  Are those banks riskier?  (well, if the answer is yes, it's for different reasons!).

So I don't agree that size = risk.  JPM, in fact, was (as Dimon keeps saying) the strong haven during the storm of the financial crisis.  They got through the crisis without losing money in a single quarter, and they had to buy some of the failing institutions to help bail the system out.

This is hardly proof that size = risk.

In fact, when the crap hit the fan, Goldman Sachs and others rushed to find a partner that had stable deposits (banks) so as to stabilize themselves.

What does that mean?  Are independent investment banks safer than universal banks? The real life stress test of the financial crisis seems to have proven that the integrated model might be sturdier.

Break Up JPM?
And the idea of breaking up JPM is an interesting one.  Honestly, I looked at that idea too a few times in the past and thought about making it a post here, but didn't because I didn't see it as a good idea.

First of all, JPM has done really well over the years due to the many different revenue/earnings streams it has.  The volatility of the investment bank can be smoothed out by the stable consumer business.

And too, a quick back-of-the-napkin look showed that it's not really all that interesting.

This is very crude and I'm sure Goldman and others have a better analysis, but here's my simple look at the idea of a split:

Value-Enhancement From a Split
I don't know what all the different parts would trade at, but the main things that are viewed as undervalued are the Investment Bank (actually, not the whole investment bank as GS is cheap, but the advisory business which seem to trade at high multiples (Greenhill, Evercore etc...) and Asset Management.

So assuming JPM trades at 10x P/E, this is what the market is implying these divisions are worth:

                                          Net income              Value@ 10x  
Asset Management             $2.2 billion              $22 billion
Advisory                             $320 million            $3.2 billion
Total                                                                    $25.2 billion

For the investment bank, you could use the $6.6 billion investment banking fees, but that includes underwriting and that actually takes capital and size to do.  Evercore and Greenhill are valued highly because they don't need balance sheet and distribution; they just advise on mergers etc.

That's why I used the advisory fees earned by the investment bank of $1.6 billion and used a 20% profit margin to get $320 million net income.  20% happens to be the net margin for the whole investment bank for JPM, but that's a lot higher than the margins at Evercore and Greenhill so I'm being generous.

So how would the market value these independent entities?  Well, asset management used to trade at a 20x P/E; I think it's lower now (Blackrock is at 16-17x) , but let's use 20x to be generous.  Also, boutique advisory firms used to go for 30x.

So using the above net income figures and new valuation, here's what they would be worth on their own:

Asset Management:  $2.2 billion x 20x =     $44.0 billion
Advisory:                  $320 million x 30x =     $9.6 billion 
Total:                                                             $53.6 billion 

So the financial alchemy from this split would increase the value of JPM by $28.4 billion!   Yay!  Right?  But wait a second.  JPM has 3.7 billion shares outstanding and it closed at $55 or so today.   That's a $200 billion market cap.   That's a nice 13% pop!    13%?  Yup.  Just 13%.  All that work, risk, hassle for a one-time 13% pop.

Oh, and don't forget, synergies from this integrated model is $6-7 billion according to JPM's 2014 Investor Day presentation.  This synergy can come from all over the place, not just between these two entities and the bank.  But since Asset Management probably gets a lot of assets from JPM the bank, a lot of it might be from there.

If a split makes these companies independent, then that $6-7 billion might go away. Yes, maybe not.  We don't know where those synergies are.  But let's say it goes away.  What is that $6-7 billion in net profit worth to shareholders?  Let's just use the lower 10x that JPM trades at.

That's a possible $60-70 billion decrease in value due to un-synergies!  

So yeah, you might be giving up $60-70 billion value (at a cheap 10x) for an instantly gratifying one-time gain of $28.4 billion today.   Is this really a good idea?  Hmm...

Splitting the Whole Investment Bank Itself
OK, so you may be wondering, wouldn't the bank itself be worth more without the investment bank?  Maybe.  But here, in the above scenario we are just ripping out the good businesses; Asset management and Advisory.

But yes, if the whole investment bank is holding down the valuation of JPM, we can look at it the other way.  Take away the whole investment bank and put a 12x multiple on the bank (and leave the investment bank at 10x,  12x is where Wells Fargo is trading).

Well, the banking businesses had net earnings of $11.8 billion.  I'm looking at Consumer and Community Banking and Commercial Banking.  If the multiple on that goes from 10x to 12x, that's an enhancement of $23.6 billion in total value, similar to the above splitting off of the high value pieces.

And the same argument about synergies may apply.

Oh yeah, it's not that simple.  There is a cost to being big and integrated (and diversified, stabler and more Gibraltar-like).  There is that extra capital for the bigger, more complex banks (how about lower taxes for entities that have to deal with unnecessarily complicated multiple regulators?!  Banks seem to have to play a game of Twister to keep everyone happy.  It's a miracle they are still in business!).

So here's a snip from the 2014 Investor Day:

The net income contribution assumes 50% overhead ratio and 38% tax rate.  Cost of equity is 12% based on some CAPM model they used (5-year average).

But check it out.  They only need $3 - 6 billion in gross synergies to be SVA positive (Shareholder value added) on incremental capital requirement.   By the way, that equates to $1-2 billion in additional net income.

So looking at the G-SIB requirement of 2.5% (JPM falls under the 2.5% bucket), let's see how much additional capital they need to hold.  Risk-weighted assets at year-end was $1.6 trillion.   2.5% of that is $40 billion.    So JPM needs to hold $40 billion more in equity capital than others, just because they are big, sturdy, safe, diversified and rock-solid.

Assuming a 12% cost of equity capital, JPM needs to earn at least $4.8 billion in incremental net profits to justify being a Systemically Stable Important bank (remember, they were a stabilizing force during the crisis; how about negative capital requirement for that?!).  As shown above, the synergistic effects of the current integrated model is $6-7 billion.   So already, they are earning enough to more than offset that added capital requirements for their current model.

And from there, if further capital is required, as it says in the above slide, they only need another $3-6 billion (in gross synergies), or $1-2 billion on a net income equivalent basis.

But you will notice that they already earn $6 - 7 billion extra from the current model versus the $4.8 billion needed to make up for the 2.5% G-SIB, so they are already earning enough to make up for another 50-100 bps in capital.

I'm sure, though, that JPM will keep refining pricing and products so that they will more than make up for further capital requirements.

OK, so this was quick and crude so you can nitpick this and that.  I know there are other businesses within JPM that earn high ROE's, but I don't know about tearing them apart and then slapping high multiples on them.  If you do that, then you have this huge corporate piece left over.

For me, the idea of a spin-off or split to enhance value was mostly about splitting off the asset management business.  That's where the multiples differential seems to be the highest.  And the advisory business too.

But ripping the whole investment bank away probably wouldn't change the value much as Goldman Sachs, Morgan Stanley and others are not valued any higher than JPM.  It might make the lone bank trade higher (12x vs. 10x), though.  Plus, the fact that the two independent pieces would not be able to smooth each other out would suggest higher earnings volatility, lower balance sheet stability and lower credit rating, so it might be value destructive.

But I don't know.

What I do know, though, is that it seems like:
  1. Splitting up JPM might enhance value on a one-time basis, but the loss in synergies might lose more value in the end. 
  2. Splitting up JPM to escape G-SIB and other capital measures is interesting, but the above analysis shows that maybe the synergies more than offset the onerous, additional capital requirements necessary to maintain their model. 
So I think the "break up JPM!" crowd is wrong.  It may not enhance value.  I think much of JPM asset management AUM comes from the bank and investment bank.  On it's own, they don't have any of the distribution infrastructure like Fidelity and other independent fund companies.  To build this out would probably take a lot of time and money.  

Too, the advisory business on it's own would have to work harder to get business.  Oh yeah, and think about how JPM got the Shake Shack IPO partly because JPM was their banker!  That's synergy right there, right?  (OK, SHAK is not an advisory client, but an underwriting client)

And for regulators, I think they're wrong! It's not the banks and financial institutions that are too complicated.  It's the regulations and regulators!!  Simplify that alphabet soup of regulatory entities and stop making the banks play a game of Twister trying to satisfy this and that rule from all different directions!  

As usual, things are just bass ackwards, and I can see why Dimon is so frustrated these days.

Tuesday, January 13, 2015

Market Timers vs. Macro Hedge Funds

OK, so this is another post that follows a discussion in the comments section (of previous posts).  I think it's pretty important so I thought I'd expand on a comment I made and turn it into a post.

Halo Effect
No, not the book.  But the same idea.  I think some of these top-down, market-timing mutual funds in the past have benefited from a sort of halo effect.  For example, people read about how Soros made billions betting against the Bank of England.  They read about how some hedge fund wizard made a killing shorting Japanese stocks.  They read about a trader that had a massive position in index puts on the day of the crash.  They read about how someone piled into subprime default swaps and made a killing during the crisis.

So they see all these people making tons of money while other, "normal" mom and pops lose their shirts in a nasty bear market.

And then they see these funds that promise to watch out for these macro factors and structure the portfolio accordingly, promising them that they won't get crushed in the next bear market (never mind that there is a cost to that; a cost/risk that is not at first evident).

Most individual investors don't have access to hedge funds, so these market-timing funds sort of fill that need to have an 'alternative' to the usual equity funds.

The more volatile the markets, the higher returns that the big hedge funds show, the better relative performance these market-timing funds put up in the short term, the more popular these funds get.

Market Timing Funds Have to Be Right All the Time
But there is a big difference between the big hedge funds and the market timing mutual funds.  The market timing mutual funds, for the most part, have to be right just about all the time for them to do well.  If they miss one bear market, their performance is in the tank.  If they miss one rally, that can also destroy their performance.  Once you do that, it gets exponentially harder to try to make it back.

For example, you can take some of the great traders from the past.  Say, George Soros or Stanley Druckenmiller.  I can't prove this or know for sure, but I am pretty certain that if they had a mandate to hold an equity portfolio and then hedge it according to their market views over the past 30 years or so, they would not have gotten anywhere near keeping pace with the S&P 500 index.  No way.  Druckenmiller himself has said that he has predicted 15 of the last 3 bear markets (or something like that; I don't remember the numbers but you get the point!).

Difference Between Market Timing Funds and Macro Hedge Funds
Contrary to popular belief, most of the high returns generated by macro hedge funds are not from timing the stock market.   Yes, some have made tons of money shorting stocks on Black Monday (Soros was actually on the wrong side of that, famously having sold the low tick on Tuesday), shorting the Nikkei crash in 1990-1992 etc.

But most of the money, I would guess, in macro hedge funds were made in fixed income and currencies.  Back in the 1980's and 1990's, there were a lot of strong and persistent trends, macro imbalances with sudden corrections and other things that allowed hedge funds to make tons of money.  And these funds put these trades on with massive leverage; leverage that can't be replicated in the usual equity mutual fund format.

So they can be wrong about the stock market for years and still make tons of money (also, if they are bearish and short, they don't stay short for very long when the market goes against them).

However, market timing funds don't have alternative sources of income.  They live and die, basically, by being right about the U.S. stock market.  And they have to be right year in and year out.  It's just impossible to do that.  Not even Soros can do that.

A lot of macro hedge funds take massive bets, but they do so in many markets around the world.  If they have no opinion about the U.S. stock market, they can still go long something else somewhere in the world.  Like Buffett looks for the easy questions to answer, macro hedge fund traders do the same thing; they look for the easier questions to answer.  They don't have to know where the stock market will go.

One of the big macro funds today has a bunch of non-correlated trades on.  So they can be wrong about the stock market or interest rates, or even both and still make money because they have different trades on with uncorrelated factors.

If you are a market timing fund, you have to be right about the stock market.  If you are right, that's great.  If you are wrong, that's it.  It's hard to make it back.

This is not to say, of course, that all macro hedge funds are good.  It is very hard to make money in global macro hedge funds and there are plenty of failures there too.

I am only trying to illustrate the difference between market timing mutual funds and the global macro hedge funds.  Some market timing mutual funds talk about going into various asset classes and flexibility to go anywhere, but it seems like they are still mostly driven by being right or wrong about U.S. stocks.

OK, so here goes one of my analogies that might just confuse the issue.  But anyway, it goes back to Rumsfeld's known knowns, known unknowns and unknown unknowns.   By the way, I am not a fan (or unfan) of Rumsfeld; it's just a convenient expression.

Buffett is known as a great stock picker.  He has done well for more than 50 years.   But if you look at Wall Street analysts, they do no better than random.  Why is this?  The usual interpretation is that Wall Street analysts are just incompetent.  But I beg to differ.  Many Wall Street analysts are very smart.  Yes, I've met some really, truly dumb ones.  But most of them are normal, highly intelligent, hard working people.

So why are they so wrong all the time?  Well, they're not wrong all the time.  They are just no better than random.

But again, just like asking Soros to hedge and unhedge a portfolio over the years, if you ask Buffett to look at a list of the S&P 500 stocks and pick the ones that will outperform over the next year or even five years and then pick the ones that will underperform, I bet he will do no better than random.


Because for most stocks, his opinion would be "I don't know".  Most stocks would go into his "too hard pile".  If we force him to choose, buy, sell or hold, he will choose.  But he will have no conviction.   And he will probably do no better than random.

The key here is that in order for him to do well, he doesn't have to have an opinion on most stocks!  He only has to have conviction on the ones he understands well and has a strong opinion about.  He can ignore the rest.

Wall Street can't do that.  Analysts, in aggregate, can't say, "no opinion".  They have to say, buy, sell, or hold.   Not to mention that they have to guess the next quarter's EPS etc.  I don't know if Buffett would be any better at guessing EPS on a quarter to quarter basis than Wall Street analysts.

Again, it doesn't matter because he doesn't have to do that to do well!  But Wall Street does.  This is why Buffett is not often wrong while Wall Street is very often wrong.    In fact, Buffett has been wrong about all sorts of things but it hasn't hurt his performance because he knows what he doesn't know (he predicted a housing recovery that never came, higher interest rates that hasn't come yet etc.)

Back to Market Timing Mutual Funds
Similarly, market timing mutual funds, like Wall Street analysts, have to have an opinion all the time. They have to be long, flat or short.   They can't really say, "I don't know" and just stay flat, as that is their only source of profits.  Yes, some funds have flexibility to go elsewhere, but for all practical purposes, other assets will usually only be a small part of an equity mutual fund.

Macro hedge funds can afford to say I don't know about the U.S. market and choose to do something elsewhere.  They can put on massive, leveraged bets on things they have conviction about and don't have to have a view on the U.S. stock market at all.  They can just go out and find something they do have conviction about.

Fallacy of Overvalued Markets
When you look at these long term charts, it's really easy to fall into the trap of saying, "gee, look how expensive the market was in 1929, 1962, 1972, 1987, 1997, 1999 etc...  We should have shorted the market at these levels!".

Yes, expensive markets are often followed by corrections.  Sometimes corrections are meaningful, like in 1929, 1999 and 2008.  Sometimes they are not, like 1987.

But this is sort of like the guns and bank robbers fallacy.  All bank robbers have guns, but not all gun owners are bank robbers.  Many large corrections and bear markets are preceded by overvalued markets, but not all overvalued markets are followed by bear markets or corrections.

Here, check this out:

CAPE 10 (inverse): 1909 - 1992

Again, Excel couldn't handle the length of data so I chopped it off at 1909.  If you go back further, the chart is even more convincing as CAPE10 (inverse) was under 5 in 1901.

If you saw this in December 1992 when the CAPE10 yield fell under 5% for the first time since the late 1960's, it would have been perfectly reasonable to assume that the market is very overvalued, even more so than right before Black Monday.  I didn't do it, but you can put an average on here and then standard deviation bands around the 100-year average, and it would have told you that the market was really, really outlier expensive in late 1992.  Look what happened to the market in that past after it got below 5% CAPE yield; 1929, 1937, mid 1960's etc.

It is a visually compelling argument.  It's hard to argue that the market is not overvalued at this point.  I just picked a 5% yield because it corresponds to a 20x P/E ratio that usually makes people think the market is expensive.

But check this out.

Where was the Dow and S&P 500 index back then?

                        December 1992                   Now          Chg       per year
DJIA                3301                                    17613         5.3x       +7.9%
S&P 500            436                                      2023         4,6x       +7.2%

And this 7-8%/year return since then, when the market was just about as overvalued as ever is excluding dividends.  That's just the change in the index level.  Throw in dividends and it's probably close to 10%/year.  From an expensive market!

And then check this out:

CAPE 10 (inverse):  1992 - 2014

If 5% earnings yield was silly expensive and you held to that 'standard' which has proven itself over 100+ years in the stock market, you would have basically been out of the market (or even short) for just about the whole period since 1992.  You may have gotten in during the financial crisis, but then you would have gotten out again pretty soon after that.

It's crazy, isn't it?   Now you see why a lot of people have been saying that the market is overvalued for more than 20 years!

This is why it's so dangerous to make investment decisions based on this stuff.  And again, this is why Buffett is such a great investor; he ignores it.  Well, I'm sure he sees the graphs and charts and goes, whoa...  But he doesn't let this stuff distract him from doing what he knows what to do.  And he isn't tricked by these charts into thinking that he can guess where the market will go in the future.

As great as any argument sounds, you still really can't know what is going to happen to the stock market going forward.

You can look at these charts and go, wow, returns are going to be lower going forward.  I've seen those tables that show stock market return based on the P/E ratio of the market on the initiation date.  Yes, higher P/E's mean lower prospective returns.

But what I haven't yet seen is a table that shows, for example, that when a P/E is 25x, that, say, there is a 30% probability of a 30% correction within the next three years such that if we get long at the bottom of such bear market, our total return from this timing strategy will be Y%.  This could be a table.  Maybe there is a 50% chance of a correction of 30% or more within the next five years after such a valuation, and if this happened, and we were able to go 100% long at the bottom of that bear market, our prospective return would Y% etc...

All of these possible scenarios have to be calculated, including the probability that there won't be any correction greater than 20% within the next five years.  And if the sum of all the expected returns in all those scenarios is higher than the prospective, buy-and-hold expected return, then you can say maybe it's a good idea to try to time the market.  But then again, we all know how these complicated calculations with layers and layers of assumptions go.

But anyone who has traded (and/or studied) equity derivatives knows, there is a cost to such opportunism and it can be calculated.  For example, in the old days, there used to be interesting-sounding options like "down-and-in" options, or "lookback" options, and other trigger or barrier type options.  These options were designed for buy-the-dippers.  For example, you can create  a call option that becomes effective when the market goes down 10%, and the strike price becomes the stock market level 10% lower than when you put on the trade.  Of course, you would have to pay a call option premium to the seller for them to take that risk, and for them to effectively 'trade' for you.  If the market didn't go down 10% within the time period of the call option, it expires worthless and you lose your premium.

The theoretical value of these options can be calculated, incorporating the probability of the movements in the market, trading costs etc.  And this theoretical cost would effectively be the opportunity cost of waiting for the market to come to your level.  This has to be compared to the buy-and-hold, fully invested return.   If, say, interest rates were 8% and the expected return in the stock market is (unlikely in this scenario) 1%, and the knock-in option is worth 3%, then maybe it's a good idea to sit it out; you are getting paid 8% to wait, and out of that you pay 3% for an opportunity to get in lower, so you are earning 5% already; much better than the 1% you would get by investing fully now.   Again, unlikely scenario, but I just did that to illustrate the thought process that would go into something like this.

Even simple hedges have their costs.  You can buy put options to hedge against stock market risk, but those premiums can add up over time.  And especially in this lower return environment, it's going to be hard to make money with low return stocks when you dish out a bunch of money on put premiums.

But again, if you can precisely calculate the odds, maybe some sort of hedging structure makes sense.

But  you never really hear anything like that.  Usually, it's something much simpler, like, "the market is overvalued because the P/E ratio is as high as it's been in 100 years, therefore the market must go down soon so we will buy puts, short futures and buy gold", or something like that.

So anyway, market timing mutual funds and macro hedge funds are very, very different animals. They are not even close in terms of what they do and how they make money.  Even the best traders of all time, I don't think, could time in and out of the markets if his sole mandate was to hold a U.S. equity portfolio and then hedge / unhedge according to his market views.  No way.  In fact, many of the great macro hedge fund traders have lost tons of money trying to short the U.S. market.  But they make it up elsewhere in other massive, leveraged trades so it's not an issue for them.  Each trade is like a single poker hand; one bad hand or bad beat is not going to ruin their year; and macro hedge fund traders typically make many, many trades a year (as opposed to market timing funds that make very few decisions; if they are bearish due to market valuations, they will stay bearish etc.)

If a market timing mutual fund gets the timing wrong, it's just going to be a total disaster.

Just as there is no way that even Warren Buffett can predict which stocks will go up and down in the future (out of, say, a list of the 2000 Russell stocks), even the best macro hedge fund traders couldn't time in and out of the markets consistently.

And the key is that neither Buffett nor macro hedge funds have to do that.  Just like Buffett has to only find the questions he knows he can answer (just buy the stocks that he thinks will go up and then ignore the rest), macro hedge funds can take massive bets when they see an opportunity and can throw the direction of the U.S. stock market in the "don't know" bucket and leave it there for years if need be.

But just like analysts have to have an opinion on every single stock they cover (even if they personally may be indifferent and have no strong opinion either way most of the time), market timing funds have to always have an opinion on the market, and if they are wrong, they are dead.

It is impossible for market timers to get it right consistently all the time just as it is impossible for analysts to be right on every opinion they have on every single stock they cover.

But unfortunately, those people are in a game they can't win.  Buffett and macro hedge fund traders have the luxury to only pick their shots when they have conviction.

Having said that, not all macro hedge funds are good.  Most are probably no good.  And having said what I said about analysts, they do have a role to play in the financial markets.  It's not always critical for them to be right or wrong on stocks; they do act as a conduit between companies and investors.  And they have sort of a high level 'reporter' role in keeping a professional eye on companies and report on various developments.   Many analysts are valued not necessarily for being right or wrong, but for their deep knowledge about companies and industries that can be helpful to investors.

And no, I am not arguing that the markets will stay expensive forever.  I am just trying to point out that it is not so easy as saying "the market is expensive, let's get short!".

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 (

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.

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.