“Although value is a weak force in any single year, it becomes a monster over several years. Like gravity, it slowly wears down the opposition.” -Jeremy Grantham
Most of us would love to have the ability to spot bubbles and arrange our portfolios to minimize potential losses.
But what if the bubble did not burst, or had not yet burst, years after you protected yourself from the inevitable bust?
Jeremy Grantham (Trades, Portfolio) has a knack for spotting bubbles and, using a mean reversion strategy, manages money around them. He has been in a protective mode for several years, however, and suffered for lack of a bust.
Who is Grantham?
The 78-year old guru grew up in Doncaster, United Kingdom. He received an economics degree from the University of Sheffield, and in the mid-1960s earned an MBA from the Harvard Business School.
After finishing at Harvard, he told Forbes he became a "crass speculator" and experienced some severe losses; in his words, “I got my head chopped off in a spectacular way.” That was enough to convert him into a die-hard value manager.
His first real job in the industry was at Keystone Funds, which he left to co-found Batterymarch Financial in 1969. With the failure of that partnership, he and two colleagues started Grantham Mayo van Otterloo (GMO) in 1977.
Grantham has become known for his ability to spot bubbles and steering his clients away from them. He correctly anticipated the Japanese stock market bubble of the 1980s, the dot-com crash and the housing crisis that brought markets tumbling down in 2008.
Beyond work, he is an ardent environmentalist. The Guardian newspaper calls Grantham an environmental philanthropist; he and his wife established and funded an organization called The Grantham Foundation for the Protection of the Environment.
What is GMO LLC?
Grantham, Mayo, Van Otterloo & Co. LLC, with offices in North America, Europe and Asia, has a seven-point mission statement; the first point reads, “To deliver superior investment performance and advice to our clients.”
Those clients are mainly institutions, including retirement plans and financial intermediaries, according to its website. It also serves individual investors who have at least $5 million to invest; less affluent investors can buy through Wells Fargo.
The firm’s flagship fund is the GMO Benchmark Free Allocation Fund (GBMFX); Morningstar puts its current worth at $13.8 billion. Firm-wide, GMO reports on its latest Form ADV it has just under $75 billion in regulatory assets under management.
Headquartered in Boston, the firm states in its Form ADV Part 2A it is controlled by active employee-members (the equivalent of partners), and no individual owns more than 25%.
It offers this snapshot of its investing range:
Grantham and GMO’s avoidance of anything that looks like a bubble has cost them clients and assets in the recent past. The Wall Street Journal (as cited in ZeroHedge) reported in early January that GMO had lost $40 billion worth of assets since peaking in June 2014. Grantham and his colleagues have been highly skeptical of the booming American stock market in recent years, and held back.
It had only about 40% of its assets in American (9%) and international stocks (31%) at the end of February, according to Morningstar. This low-risk positioning has delivered low-satisfaction returns; these Journal graphs show how assets have dropped off along with annual returns:
Being a hardcore value investor, particularly one who has made his name by avoiding bubbles, has been tough in recent years. Should the market plunge again, however, he will further cement his legend.
Grantham’s investing philosophy and strategy
The guru became famous because of his ability to foresee the three major bubbles in recent history: the Japanese stock market, the dot-com and the subprime housing market.
Yet, as Institutional Investor magazine reminds us, in the broader sense, this is a mean reversion strategy. In other words, markets go up and markets go down. Careful and thoughtful investors buy when the markets are down and sell when they go up. All true, but easier said than done.
According to Investopedia, “Mean reversion trading looks to capitalize on extreme changes within the pricing of a particular security, based on the assumption that it will revert to its previous state. This theory can be applied to both buying and selling as it allows a trader to profit on unexpected upswings and save at the occurrence of an abnormal low.”
In a bubble, prices go high enough to incentivize many sellers to sell, but are too high for buyers to come into the market. The bubble bursts, and often the market overreacts, forcing the price pendulum to swing too far in the opposite direction—creating a burst or bust.
According to Grantham, “Investment bubbles and high animal spirits do not materialize out of thin air. They need extremely favorable economic fundamentals together with free and easy, cheap credit, and they need it for at least two or three years. Importantly, they also need serial pleasant surprises in such critical variables as global GNP growth.”
Grantham and his colleagues must be voices in the wilderness at times, especially at times when the market keeps climbing and climbing, as it generally has since 2009. They see a bubble in equity asset prices and, consequently, hold cash and securities they consider inexpensive. Hence, the underperformance and flight of clients and assets.
What does all of this mean in concrete terms? Here are some of the positions Grantham initiated or closed out in the first quarter of calendar 2017 (as reported by GuruFocus):
- Sold out of Media General Inc. (MEG, Financial).
- Bought into iShares MSCI South Korea Capped Index Fund (EWY, Financial), while selling out of iShares China Large Cap (FXI, Financial).
- Sold out of Linear Technology Corp. (LLTC, Financial) and InterOil Corp. (IOC, Financial).
- Initiated positions in Mobileye NV (MBLY, Financial) and Mead Johnson Nutrition Co. (MJN, Financial).
- Sold out of St. Jude Medical Inc. (STJ, Financial).
- Initiated positions in Stillwater Mining Co. (SWC, Financial) and Headwaters Inc. (HW, Financial), a building supplies company.
Many clients, and others, are asking Grantham about the current bull market and its future. Will the equity markets continue to go higher, or are we in a bubble that might soon burst?
For 2017, he sees more of the same. In the GMO Quarterly Letter for 1Q 2017, he notes there are three factors that will support U.S. profit margins this year. Strong profit margins should keep the market afloat. Those factors are:
- Oil and resource prices appear to have bottomed out, so there should be a few quarters of year-over-year improvement.
- President Trump likely will not get a full makeover of the tax code, but should be able to announce a "moderate reduction" in corporate taxes later this year.
- Third, removing at least some regulations will raise corporate profits above what would otherwise be expected.
Beyond that, Grantham says a bear market with a dip of 15% to 20% might happen at any time for any number of reasons.
His more acute interest, though, is a possibile return to the levels of profitability, interest rates and pricing that existed before 1997 (prior to the dot-com explosion). Of that possibility, he says, “And for that it seems likely that we will have a longer wait than any value manager would like (including me).”
One of the striking notes about Grantham’s positions is the number of macro views he considers in making his analyses. He traverses not only the economic and political environments, but also brings in statistics, history and, perhaps most importantly, human behavior.
Current holdings
In its 13F filing at the end of first quarter of this year, and as reported by GuruFocus, GMO reported $17.731 billion in managed 13F securities. Its biggest equity holdings were in the technology sector, as shown in this GuruFocus chart:
The top 10 holdings, as reported in the 13F form, were:
- Microsoft Corp. (MSFT) 5%
- Apple Inc. (AAPL) 3.56%
- Oracle Corp. (ORCL) 3.56%
- Johnson & Johnson (JNJ) 3.46%
- UnitedHealth Group Inc. (UNH) 3.26%
- 3M Co. (MMM) 2.54%
- Alphabet Inc. (GOOGL) 2.5%
- Alphabet Inc. (GOOG) 2.43%
- Philip Morris International Inc. (PM) 2.33%
- Cisco Systems Inc. (CSCO) 2.21%
The predominance of technology stocks, which have been responsible for much of the market’s increases in recent years, suggests Grantham does not expect a meltdown soon. In the months and years leading up to previous crashes, he liquidated positions that were expected to suffer badly when the bubbles burst.
Performance
The chart below, which is also shown above, highlights how the returns of its flagship fund, the GMO Benchmark Free Allocation, have taken tumbles since 2009:
As can be seen in this Morningstar table, the Benchmark Free Allocation fund has underperformed the Morningstar Moderate Target Risk and outperformed the category average:
There seems to have been a lot of pain involved in getting a 10-year return that averages less than 6% per year. While there will likely be another burst that makes Grantham look good, will it have been worth the wait for his clients?
Conclusion
I began with this Grantham quotation, “Although value is a weak force in any single year, it becomes a monster over several years. Like gravity, it slowly wears down the opposition.”
No doubt Grantham is right and will be proven right again if or when the current market exuberance breaks down. But for his clients, underperformance year after year becomes a monster, too, grinding down their capital and their willingness to stick around in hopes of a big turnaround at some unknown time in the future.
There are other value investing gurus who are underperforming because of the market’s ongoing strength, but their clients likely sleep better, settling for modest but positive returns most years, rather than proving an intellectual point once a decade.
Disclosure: I do not own stock in any of the companies listed in this article, nor do I expect to buy any in the next 72 hours.
