Jeremy Grantham “has almost never been this dire”

Jeremy Grantham heads one of the best quantitative, value-oriented firms out there, Grantham Mayo and Van Otterloo (referred to as GMO for short). In his quarterly letter (www.gmo.com, you have to register to read their letters, but it’s worth it and I’ve never received a bit of unsolicited email from them), Grantham puts forward the same message he’s been delivering for some time: the market is grossly over-valued.

Grantham has been preaching this for some time, but his record in being right, though almost always early, is excellent. Heeding his words back in the late 1990’s would have saved you a lot of heart-ache if you were invested in the tech and telecom bubble.

Grantham’s theme in the past focused on a reversion to the mean of corporate profit margins. In this letter, he doesn’t spend much time on that subject, but he does take private equity, corporate tax rates, global financial markets, subprime mortgages, etc. to task. He simply sees too much risk taking out there and predicts it will end poorly.

I’ll just quote Grantham here because he says it best, “To conclude, I have been trying to come up with a simple statement that would capture how serious the situation is for the overstretched, overleveraged financial system, and this is it: In 5 years I expect that at least one major “bank” (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.”

Wow, that’s quite a prediction!

He goes on to say, “I have often been too bearish about the U.S. equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck.”

He’s not mincing words there, either.

What’s his suggested solution? In a word, “anti-risk.” He doesn’t take much time explaining what that means, but I think I can guess. Some investements will do a lot better than others if or when risk becomes a four-letter-word again. That may include shorting the market, buying commodities or gold, buying Treasury securities, or finding business managers who can benefit greatly in a market situation characterized by a lot of risk aversion.

In this last category, I’d put companies like Berkshire Hathaway, Leucadia and Fairfax Financial, companies that have a lot of cash on hand or are short the market and are waiting for a risk averse market to put their money to work. In the interest of full disclosure, I own positions in all three of these companies both personally and for clients.

A more risk averse market like we are facing usually scares people to death. In contrast, I see such situations as golden opportunities to buy when blood is running in the streets. In addition, I’ve purchased securities that I believe will do well even if the market does fair poorly.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The problem with deep value investing

If you’ve read much about investing, you may have heard that value investing beats growth investing over the long run. Numerous studies have shown this in detail. Basically, buying low price to fundamental stocks beats buying high-flying, glamour stocks. But, that’s not the whole story.

I was reminded of this, recently, when I was reading David Swensen’s book, Pioneering Portfolio Management. Swensen has been managing Yale’s endowment for almost two decades and has been generating great returns, so what he has to say should be taken quite seriously.

Swensen warns against just being a deep value investor. What he says is that deep value investing does great until the proverbial 100 year flood comes along. At that time, low price to fundamental stocks get crushed because they tend to be lower-quality, fundamentally riskier businesses.

Deep value investing works like this: poorly performing companies have very poorly performing stocks. People who buy these stocks at super-depressed prices (deep value investors) get great returns as long as the 100 year flood doesn’t hit. In other words, they get great returns for bearing the risk of a flood as long as this isn’t the year a flood comes. This makes value investors’ records look extraordinary–until the flood.

When the flood hits, such portfolios get wiped out! Jeremy Grantham’s (of GMO) research on how these investments did during the Great Depression is revealing. From 1929 to 1933, high price to book stocks (higher-quality, growth-oriented stocks) declined 84.3%. In contrast, low price to book stocks (lower-quality, value-oriented stocks) declined 93%. This may not sound like a big difference because they both did terribly, but an 84.3% loss requires 640% growth to get back to break-even whereas a 93% loss requires 1,430% growth to get back to break-even. Put differently, that’s a 9.7% annualized return for 20 years for the growth stocks versus a 14.2% return for 20 years for value stocks! When the flood comes, you don’t want to be in deep value stocks.

Does this mean that value-investing isn’t the way to go? Not at all. It just means that buying something simply because it is statistically cheap doesn’t mean it will do well in all situations. Just because it has done well doesn’t mean that it will continue to do well. Unless 100 year floods are a thing of the past or you can predict them with great accuarcy, you probably want to make sure your portfolio isn’t filled with deep value stocks.

When evaluating investment managers, this method of investing issue becomes critically important. Looking at someone’s 10 or even 20 year record isn’t enough. You have to know more about the process they use. If Investor A has earned 18% returns by investing in deep value stocks, and Investor B has earned 15% returns by buying good companies below fair value, you may actually want to go with Investor B. That is, unless you know how to predict 100 year floods…

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.