This is an interesting time: After spending years in accumulation mode on high quality companies trading at attractive valuations, the market has decided that it has an interest in these names. Over the past year, PepsiCo (PEP), Johnson & Johnson (JNJ) and Procter & Gamble (PG), have all moved higher by at least 20%. While they continue to be great companies, we’re getting closer to a point where market prices imply a level of future growth that is beyond what these companies have achieved in the past decade. Considering that these companies have average revenues somewhere on the order of $70 billion, historic growth rates can become difficult to match, let alone outpace, over time. While not as cheap as they used to be, the alternatives don’t look any better – which leaves an important question for investors like myself (and based on the conversations I’ve had with a few of you in the past, yourselves as well): what to do?
Ben Inker, co-head of asset allocation of GMO, recently added his two cents to the conversation; when asked by Consuelo Mack what one investment he recommended for a long-term portfolio, he said the following:
“Well, we do like the high quality stocks in the US; it’s one group that you can buy and not have to worry too much about what happens to the global economy. I think the expected return through European value stocks are better, or emerging market stocks are better, but there are scenarios where those turn ugly. And the nice thing about the high quality stocks is that they’re priced to do okay, and they should do okay even if we go down one or the other of the difficult paths.”
Looking at GMO’s seven-year asset forecasts from the end of March, we can get a better idea of what's meant by “do okay.” Here are the forecasted annualized real returns through 2020:
|US Large||-1.1% (+/- 6.5)|
|US Small||-2.4% (+/- 7.0)|
|US High Quality||3.7% (+/- 6.0)|
|Int’l Large||2.9% (+/- 6.5)|
|Int’l Small||2.8% (+/- 7.0)|
|Emerging||5.9% (+/- 10.5)|
We got a bit more from Mr. Inker in his fourth quarter letter, “We Have Met They Enemy, And He Is Us:"
“The primary reason that we own quality stocks today is that they look much cheaper than the overall U.S. stock market, but another consideration in their favor is the fact that they are very likely to have more stable cash flows than other companies during a depression or financial crisis. Given that most of the other equities we find attractive today, such as continental European value stocks, would be particularly vulnerable to either depression or crisis, we feel quality is a particularly valuable version of equities to own, and quality makes up a larger percentage of our equity portfolios than its pure forecast would suggest.”
If you’re like me, you’ve had increased difficulty finding places to invest cash in the recent past; to make things even trickier, many names have run up in price over the past few months, and stand much closer to intrinsic value than they did 18 months ago. As a well-respected firm with a solid long-term track record, GMO’s managers are worth listening to. I would think long and hard about what Inker has said in the past few months before making any portfolio changes.
With a solid cash balance on hand (and some portfolio insurance via a stake in Fairfax Financial), I’ve become increasingly focused on position sizing in high quality names like PG, JNJ and PEP, that have slowly crept up towards fair value over the past few quarters. With that said, I see few alternatives – and continue to believe that these names remain among the best choices currently available to long-term focused market participants.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with a handful of equities accounting for the majority of my portfolio (currently two). In the eyes of a businessman, I believe this is adequate diversification.