Online Extra: Q&A with GMO's Jeremy Grantham
Investment strategist Jeremy Grantham makes most other stock market bears look tame. The co-founder of Boston-based money-management outfit Grantham, Mayo, Van Otterloo (GMO) thinks U.S. stocks will be flat for the next seven years. Yet, he's not your typical naysayer. First, he's bullish on other types of arguably riskier investments, such as emerging-markets stocks. Second, he has an excellent track record as an institutional money manager for the last 25 years, running some $23 billion.
Grantham designs quantitative investment models for the company's 53 different products, which collectively have beaten their benchmarks by 2.4 percentage points per year. BusinessWeek Staff Editor Lewis Braham caught up with Grantham recently at his Boston office and discussed his investing style. Following are edited excerpts from their conversation:
Q: What would you say distinguishes GMO from other quantitative investment shops?
A:We're looking for systematic ways of beating the market, but we're determined to be pragmatic. In other words, we see the [market] model as our servants and not the other way around. I have always thought a great potential weakness of quants is you believe in the model so much that you march off a cliff in disciplined ranks to prove how confident you are in it. Managers who actually pick stocks stop at the edge of the cliff and say "this doesn't look right."
Q: What's the key to your investment philosophy?
A: We put so much weight on the idea that assets will revert to their historical mean valuation. We've looked at the price history of every asset class -- stocks, bonds, currencies, commodities -- and we have not found any that didnet revert.... The length of time to revert usually takes about seven years. So we make all of our predictions for that time period.
Q: Could you tell me a little bit about the process you use for analyzing the Standard & Poor's 500?
A: The S&P 500 is obviously the bedrock on which much of our analysis stands. So we check almost every aspect of what would constitute a serious way of valuing it. What we attempt to do is fix its long-term, trend-line value. So one of the inputs is simply the price series of the S&P, adjusted for inflation going back for 100 years. And we establish what that trend is, and how far away it is from trend.
Then we start to cross-check that by asking questions like: What do we think makes a rational long-term return? What do we think, therefore, makes a rational earnings yield or the inverse of the price-to-earnings ratio? We believe, as do most academics, that in the long run, if you sell for 10 p-e, other things being even, you will return 10% per year after inflation, or 10% "real." If you sell at 20 times earnings, you will return 5% real.
Q: What do you think is the an appropriate valuation for the S&P 500 today?
A: If profit margins stay at their current 6% level, which is above average, we believe a 17.5 p-e is justified. The average p-e coming into the 20th century was about 12. The average for the whole century was 14. But we think the trend line value in the next few years has reached 17.5. The p-e is higher because it's generally perceived that the stock market is a safer place than it used to be.
As a result, investors are willing to pay more and receive a lower earnings yield. You don't need to be bribed so much to take the risk of owning stocks.... The problem is today, we actually trade at a 26.3 trailing p-e, only a 3.8% yield. At a 17.5 p-e, the S&P 500 would be valued at 770 today. It's currently over 1,100, more than 40% overvalued.
Q: What about the spike in productivity that began in the 1990s? Couldn't it justify higher profits and p-es?
A: Productivity has very little to do with profits. Imagine what would happen...if you lay a lot of cable, and it turns out to have five times the carrying capacity than before. It's wonderful for productivity, and devastating for profits.
Q: So how do you explain the rise in earnings growth in the 90's?
A: In the late 1920s and the late 1990s you had two wonderful little surges in technological progress. And that spurred up a great hornet's nest of venture-capital investment and speculation, which is very good for business. And that is typical of technology. It goes in these little spurts.
America...tends to move a little more aggressively, take a little more risk than foreigners, make a little more overinvestments, and therefore, when the good times end, it tends to pay a little higher price. But while it's rolling, it tends to be pretty nice for economic growth and profitability. And one of the things that happens is that pleasant surprise: [A] series of above-average growth interacts with the stock market to create steadily rising stock prices.
Q: And that lowers a company's cost to raise capital?
A: Precisely. If a company is selling its shares at 150 times earnings, it has an incredibly low cost of capital. It can raise money very, very cheaply. And therefore what happens in these stock market booms is that they interact with the economy. They allow massive increases in capital spending because you can raise capital so cheaply.
This becomes a vicious cycle. So in Japan 10 years ago and here in the 90s, you have this capital spending boom fueled by incredibly high stock prices. And that, of course, interacts with the economy, creating yet more pleasant surprises, and yet higher stock prices, and yet more capital spending. Until you create a very serious glut of capital spending: In Japan perhaps as much as 25% of their whole capital base became redundant, and in America let's assume 10% or 15%.
Q: So what happens now?
A: Well, then companies have to write off the excess as a loss. So now, we're in the down cycle. Capital spending is falling below trend, and that impacts profit margins. And then you get into a series of unpleasant surprises: The stock market tends to do poorly, and so the cost of capital goes up, and capital spending falls and so on.
Q: How long do you think that will last?
A: My great belief is that the only things that really matter in the stock market are the great bull cycles and bear cycles -- not the interim bull markets, [but] the real humdingers, the ones ending in 1929, 1965 and 2000. They're the ones that really count. And the bear markets that follow those kind of real McCoy bull markets or bubbles, if you prefer it, tend to be very long.
The first one in the 20th century lasted for 10 years, 1910 to 1920. The second one lasted from 1929 to 1944. And the third one lasted from 1965 to 1982, 17 years. And in between you had mega-bull markets where you made 10 times your money as we did from 1982 to 2000. So this bear cycle won't play itself out overnight.
Q: What do you mean?
A: I think that there'll be at least one economic recovery and probably two before the low point in this stock cycle is reached. There are certain powerful short-term forces like inventory correction, which will kick the gross domestic product up. And every strategist will tell you that before every economic recovery there is a stock market recovery. So the stock market will kick up, and it has done quite a lot.
But then we'll run into the longer-term problems such as the tremendous capital spending and debt buildups of the 1990s. Corporate debt now runs at six times earnings for U.S. stocks. That's the highest level in more than 40 years.
Q: Is there any case to be made that the risk premium investors expect from stocks relative to bonds has declined to the point where we can justify much higher valuations?
A: We accept the higher valuation of a 17.5 p-e S&P 500. The earnings yield on 17.5 is only 5.7% real return, much lower than the delivered return in the past. And we think that the bond market returns between 3% and 3.5% in real terms, and the proof of that would be 3.5% in the inflation-protected bond today in the U.S. government. So the S&P only has a risk premium of 2.2 percentage points over bonds. The premium used to be six or seven. So it's come way down as a testimonial to how much confidence people now have in stocks.
Q: What's the risk premium with a 26.3 p-e as opposed to your 17.5 prediction?
A: Well, right now if you have a seven-year horizon, you are making a lot more money in bonds than stocks. So there's no premium. If you assume that the p-e will end up at 17.5, then, of course, you're getting approximately nothing out of the stock market and approximately 3.5% real out of the inflation-protected bond. Or 5.7% after inflation, which averages 2.2% per year. But if the p-e did not shift, then you get the earnings yield on 26.3, which is 3.8%. That's 3.8% compared to the 3.5% for a bond that has almost no risk at all. Stocks just aren't worth the extra risk.
Q: Why do you like emerging market stocks?
A: The total return on emerging markets is, in real terms, very handsome. On the seven-year forecast, it's 9.4% real or 11.6% after inflation. That's because the p-es are so low, 12.9 on average. Moreover, the countries' markets are so inefficient we've been able to add an extra five percentage points per year over our benchmark for the last eight years. So you start with a much higher return and much higher confidence that over a five-year horizon, you'll add considerable value, which makes a pretty attractive package.
Q: How long is the historical record of emerging markets?
A: The good data only goes back about 20 years or so. So we don't have the data confidence that we have in the S&P 500. So the critical number there is a terminal p-e of 15. So what we are saying there is we can't say much meaningful about the 20 years of history. Eight years ago indeed emerging markets sold at a premium p-e to the S&P 500. But what we are saying is in a semi-rational world, which is what we live in, even though they grow faster, moderately faster, the markets of the emerging world, because they are riskier, deserve a lower p-e and thus higher returns.
Q: What emerging countries are you bullish on right now?
A: We are bullish on Russia, Thailand, Brazil, Philippines and Indonesia. Their stocks all have one thing in common always, and that is they're cheap. And some markets like Russia's have the added bonus that their political and economic system is moving along better than the consensus believes. Their political system is settling down, and their corporations are becoming much less crooked.
Q: What about timber?
A: Timber is my favorite asset class. Since 1910 stumpage prices have grown at 3% above inflation. After inflation, the S&P 500's earnings grew only 1.4% and its share price 2.2% during the same period. Moreover, the price of wood has gone up during each of the three great stock bear markets. So it's a great diversifier. And you can see that these were not one-year bear markets as I pointed out early, 10 to 17 years long.
Q: And real estate investment trusts. You like those as well, right?
A: At the top of the market in 2000, REITs were more than cheap. I referred to them as the great no brainer of this cycle. They yielded 9.1% on Mar. 31, 2000, while the S&P's p-e was 33, the highest by far it had ever been in history. And the yield on the S&P was only 1.1%. REITs were also trading at a 25% discount to their underlying real estate, which was selling at replacement cost.
Since we had this incredible imbalance, from that day until this the REITs have outperformed the S&P by about 60 percentage points. And at the end of that time period, they still yield 7%, and that still looks cheap compared to the S&P's 1.4% yield and 26 p-e.
Q: And government bonds. You're predicting 5.1%?
A: We thought bonds were really very attractive a couple of years ago. They've done well. You know interest rates have come down. And the nominal bonds, the regular bonds, we think are close to fair value now. So they are priced to return about 3% after inflation, not exciting, but not particularly dangerous.
What we do like in contrast to that is two flavors of fixed income. One of them is inflation-indexed bonds, which still yield 3.5% real. A 3.5% real yield protected against everything -- no credit-quality or inflation problems -- is simply not bad. And we also like emerging market debt, which is much riskier. But it has a much higher return with a premium yield of about seven percentage points over Treasuries, enough return to justify buying it.
Q: You want to comment on international small-cap value stocks. Is there any difference there between that and U.S. small cap value?
A: The foreign small-cap sector is substantially cheaper, and it has the added benefit that foreign currencies, which are not factored into our stock predictions, are cheap relative to the U.S. dollar. So in addition to the 7.7% per year expected return, international small-caps are likely to pick up an additional 1% to 2% a year from the rise of other currencies against the dollar.
And I'm thinking we can add a couple of percentage points return through our stock picking. So we're talking about double-digit return potential if you can pick the countries and the stocks.