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The Science of Hitting
The Science of Hitting
Articles (447) 

Stocks Run Higher, What to Do? Some Thoughts from GMO

April 23, 2013 | About:

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:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 3.8/5 (20 votes)


Marcolanaro - 4 years ago    Report SPAM
Hi Science,

as always, great article! I completely agree with you on Fairfax as portfolio insurance, do not agree on JNJ, PG, PEP, dont'you think that they would suffer in a crisis or depression hitting Europe? Wouldn't be betterto wait with cash in hand for greater european opportunities?
The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Glad you enjoyed the article! I think they would, but not particularly significantly; I have plenty of cash set aside to buy more if they get cheap (would need to drop 15%+ by my calculations), and will capitalize on the opportunity if it arises. With that said, I will not liquidate my entire position today due to (A) material tax bill, and (B) lack of alternative that justifies the move; pretty much, yes and no to what you've asked - but more no from my view. Thanks for the comment!

20punches - 4 years ago    Report SPAM
Great article, Science. I've been really fortunate to learn from your articles, so thanks for sharing.

On another note, will you attend the Berkshire shareholder meeting next week?
AlbertaSunwapta - 4 years ago    Report SPAM
Hmmm, I'd really have to question the idea of Fairfax being a suitable hedge for an equity portfolio. In a market decline what would you expect FFH to do?
The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

I will be attending; shoot me a message.

Thanks for the kind words!


"In a market decline what would you expect FFH to do?"

I have no idea what the stock would do - but I know the intrinsic value of the business would hold up quite well; if there's deflation, intrinsic value would increase substantially. That's what I mean when I call it a hedge - and understand how some would disagree with that definition; if you're a long term investor, I think that is the appropriate way to look at FFH, rather than to guess where the stock would go.

Thanks for the comment!

Jake75 - 4 years ago    Report SPAM

In 2008 FFH share price rose 36% while intrinsic value rose 21% (according to 2012 shareholder letter). According to PW, FFH remains fully hedged (like 2008). Should we see another pull back in equity markets, FFH should fare well.
SeaBud premium member - 4 years ago
I think it is inarguable that P&G/JNJ and the like are priced well beyond the potential growth they are likely to see. In my mind this is pure market miscalculation, such as when the market calculated continued double digit growth for technology companies ad infinitum. In this case, due to limited alternatives for income production, these stocks have been bid up beyond intrinsic value and potential growth. To be fair, they are not as mispriced as bonds.

Are there alternatives? I think so but you must accept some risk. Multiple European stocks have dividends and growth potential (Volkswagen, Tesco, Santador, France Telecom etc) while technology and telecom in the US may fit the bill (Intel, Microsoft both offer much better value from a growth perspective to my mind and since I work in these industries I am fairly comfortable with their continued existence if not spectacular growth).

I sold all my JNJ as the P/E rose over 21 as I can't justify buying or holding overpriced assets.

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