June marked six years since the formation of our team and the refocusing of GMO’s efforts on quality investing. We are writing to update you on your portfolio, reflect on what has changed over those six years, and share how we’re thinking about quality investing today.
Since mid-2015, the strategy has returned 17.4% net of fees, beating the S&P500 by 2.2% and the MSCI World by 5.7%. The strategy’s performance has had a beta to the markets of around 0.9.
In the early days of the Focused Equity team, we made the decision to increase the role of fundamental vs. quantitative analysis in the way we manage the strategy. Our approach to assessing quality and valuation became more pragmatic, moving from a largely fixed set of quality criteria to a more holistic set of considerations better connected to each company’s specific competitive situations.
These changes played a significant role in determining the portfolio you hold today. The removal of blanket leverage constraints, for example, allowed for the introduction of select Financials into the portfolio. Scrutiny of both sides of the balance sheet gave us the confidence to invest in a handful of essentially conservatively managed financial businesses (e.g., American Express (AXP, Financial) and U.S. Bancorp (USB, Financial)) at moments when the market’s confidence in these storied businesses were at a low ebb. The introduction of a more complete approach to valuation allowed us to better parse long runways for growth resulting, for example, in more exposure to digital advertising (e.g., Alphabet (GOOG, Financial) and Accenture (ACN, Financial)) than would have otherwise been the case. The more forward-looking mindset allowed us to take positions in companies with less data at or shortly after their IPO (e.g., Lyft (LYFT, Financial) or Knorr-Bremse (XTER:KBX, Financial); although the latter, a German rail company, has a hundred years of history as a business).
Overall, we believe that the greater emphasis on fundamentals has enhanced the quality of your portfolio and, we hope, improved prospective returns too. However, with market earnings multiples at ostensibly high levels, some question the prospective returns for equities in general at this point. We understand the starting point but believe that the case for holding the shares in quality businesses remains solid. We wrote two brief pieces in the second quarter outlining our perspective.
In the first, “An Expensive Market Need Not Mean Expensive Stocks: Making Sense of High Multiples,” we noted that the average valuation of your portfolio’s constituents compared to their own valuation history is not especially stretched. Rather, it is the increased weight in higher growth businesses that explains most of the overall market’s higher-than-normal price-to-earnings ratio (as well as a largely temporary hit from Covid-19). Many of those higher growth businesses are also higher quality and we have been happy to include them in the strategy. In these cases, increasing capitalizations say more about their strong fundamental growth over the last few years than a change in valuation.
The second piece, “Quality Investing and Inflation,” reflects other reasons for staying invested. A decided uptick in inflation in recent months may or may not turn out to be transitory. So much the better if it does, but if it doesn’t, we argue that your portfolio of quality stocks ought to fare relatively well; attractively priced quality names have outperformed in inflationary periods in the past, and relatively limited exposure in their cost structures to low-wage employees offers, we believe, some short-term protection. Prevailing bond prices condemn their holders to low real returns today under most plausible scenarios, whereas quality businesses can adapt and as a group we would expect them to be able to continue to compound wealth.
Since year end, your portfolio has returned 15.9% net of fees, ahead of the S&P 500 by 0.7% and the MSCI World by 2.9%. Stock selection dominated relative returns, with significant wins in Financials and the digital businesses mentioned earlier. American Express, U.S. Bancorp, and Wells Fargo (WFC, Financial) benefitted from continued improvement in economic sentiment, while Charles Schwab (SCHW, Financial) has more direct exposure to rising rates from the deployment of its customers’ deposits.
We continue to think of your portfolio as divided into four different baskets. The “tech plus” basket, comprising tech and internet, generated the strongest returns as intimated above. Semiconductor equipment companies, buoyed by chip shortages and strong order books contributed too. We continue to find the semiconductor sector intriguing – for so long viewed as cyclical businesses and therefore treated with suspicion, we suspect that the underlying secular growth trajectory will be the more important driver of returns over time.
Also outperforming was the “back-to-normal” basket of companies, whose share prices have been disturbed by the pandemic. In the first half of the year, we added Safran (XPAR:SAF, Financial), the pre-eminent manufacturer (and more importantly, servicer) of jet engines for narrow-bodied aircraft, which in our view is still underpriced due to the slowdown in aviation. We also initiated a back-to-normal position in Global Payments (GPN, Financial), a key beneficiary of the digitalization of payments. As you may know, we launched an extended version of the back-to-normal portfolio close to the depths of the 2020 sell-off. Initial dollars deployed in what we now call the Quality Cyclicals Strategy1 returned 62.0% net of fees to its anniversary in April this year.
The health basket lagged modestly as a new U.S. administration took charge. However, the quality laggards this year (and for some time before) were Consumer Staples. We made the first purchase in our “classic defensives” basket for some time, buying stock in Constellation Brands (STZ, Financial). Constellation is the owner of the U.S. rights to the premium Mexican beer brands, which we believe are under-distributed and have some years of growth ahead, making the company attractively priced at current levels.
Timing is a hard game to play in the markets. We continue to believe that your portfolio of quality businesses, assessed with an eye to valuation, should remain a core holding at this point. Unlike a bond where the return to maturity is determined at the point of purchase, quality businesses will react to the constantly evolving world by reallocating their capital with purpose, and we endeavour to do so also.
We thank you for the trust you have placed in us to manage your portfolio.
1 Formerly the Cyclical Focus Strategy.
Performance data quoted represents past performance and is not predictive of future performance. Net returns are presented after the deduction of a model advisory fee and incentive fee if applicable. These returns include transaction costs, commissions and withholding taxes on foreign income and capital gains and include the reinvestment of dividends and other income, as applicable. Fees paid by accounts within the composite may be higher or lower than the model fees used. A Global Investment Performance Standards (GIPS®) compliant presentation is available on GMO.com by clicking the GIPS® Compliant Presentation link in the documents section of the strategy page. GIPS® is a registered trademark owned by CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Actual fees are disclosed in Part 2 of GMO's Form ADV and are also available in each strategy's compliant presentation. The above information is based on a representative account selected because it has the least number of restrictions and best represents the implementation of the strategy.
Disclaimer: The views expressed are the views of Anthony Hene, Tom Hancock, Ty Cobb and the GMO Focused Equity team through the period ending July 2021 and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
View original letter with charts here.
