Episode #486: Ben Inker & Tom Hancock, GMO – The Value and Quality Opportunity
Guest: Ben Inker is co-head of GMO’s Asset Allocation team, a member of the GMO Board of Directors and a partner of the firm.
Tom Hancock is the head of Focused Equity team and a portfolio manager for GMO’s Quality Strategies.
Date Recorded: 6/11/2023 | Run-Time: 58:59
Summary: In today’s episode, Ben and Tom give their take on the markets so far in 2023. They both share why they think quality and value stocks are attractive today. We dig into both factors and get specifics on their set up looking forward. We also touch on growth traps, Japan stocks, the opportunity set in emerging markets, and what companies are at risk to be disrupted by AI.
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Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
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Meb:
Welcome my friends, we got such a fun episode for you today. Our returning guest is GMO’s Ben Inker, and we also told him to bring a friend. Today he brought Tom Hancock. Ben is the co-head of GMO’s asset allocation team, and Tom is the head of focused equity team and also a portfolio manager for GMO’s Quality Strategies. In today’s episode, Ben and Tom give their take on the market so far in 2023. They share why they think quality and value stocks are attractive. We dig into both factors and get specifics on their setup looking forward. We also touch on growth traps, Japan stocks, the opportunity set in emerging markets, and what companies are at risk to be disrupted by Ai.
Before we get to the episode, be sure to go to Apple, Spotify, or wherever you listen to the show and leave us a review. We love to read them. We have 849 reviews on Apple and 74 on Spotify, so let’s get them in. We love to read them. Please enjoy this episode with GMO’s Ben Inker and Tom Hancock.
Meb:
Ben and Tom, welcome to show.
Ben:
Hey Meb, thanks for having us.
Tom:
Yeah, how’s it going?
Meb:
Ben, last time we had you on, it’s 2019. I think you kind of jinxed it. Everything went to shit right after, man. It’s like all of a sudden the pandemic, we had a meme stock mania. Why don’t you walk us forward how the last couple years was like for you guys since the last time we were able to break bread?
Ben:
Wow. Yeah, 2019 feels like a very long time ago. And as you say, we had a pandemic which changed the world for a while. And certainly from an investment standpoint, plenty of investors thought it had changed the world in a number of ways, some of which seemed to involve a somewhat more aggressive disregard of the importance of company fundamentals than we had seen in even previous bubbles. In the TMT bubble. You had plenty of peoples who were making assumptions about how the world was going to be in 10 years and extraordinary growth, but nobody was saying, “I am buying this stock and I don’t actually care what happens to the company.” So that was new. With meme stocks, we’ve had the rise of the zero-day option, which to me is a fascinating change in that it is, I would say, the most aggressively speculative instrument yet devised. I can’t imagine a particular investment reason why you would say, “Ooh, I really want to have this contingent exposure over the next couple of hours that will then disappear.”
One of the problems with writing stuff down is once you have written it down, it tends to exist for a while, possibly forever. I think it was in early 2021, I was writing about the absurdity of the rise of short-dated options, which were options that were going to expire in the next two weeks, and I was making the claim then, “Well, you can’t possibly think there is going to be a change to the underlying fundamentals of the companies you’re dealing with over the next two weeks unless it’s over an earnings announcement or something.” So that is about as speculative as anything could ever get. But again, two week options seem positively tamed today.
So we had 2020 and 2021 where the world seemed to be changing. We had 2022 where it felt like the world was changing back and interest rates got up off the floor and started moving to historically normal levels. Equity markets did pretty poorly, value did well versus growth. And then of course we had 2023 where as well as value had done versus growth in 2022, it is manfully trying to give it all back this year associated with… Well, at this point I guess you say it is associated with the excitement over AI. Given how much of this predated the near term excitement over AI, I don’t think that’s quite fair, but it’s always nice to have an easy narrative.
And I will say AI is different from meme stocks because it’s a thing and it is going to change the world probably in ways that are harder to predict than a lot of people investing on the back of it assume. But yeah, relative to where the world was in 2019, a lot’s gone on. I would say as my team looks at the world, there’s a fair bit of similarity though. Value stocks look quite cheap versus the overall market. The non-US markets look pretty cheap versus US stocks. One profound difference is interest rates are a good deal higher and cash rates are a lot higher where it’s much harder to say in 2019 we talked about TINA market, there is no alternative. Today there are alternatives to equities. I’m not sure any of them are as exciting as equities are. So where one wants excitement and I guess there’s probably still excitement somehow in crypto, but equities are the place to be.
Meb:
If you’re having a coffee or beer and you’re saying, “Here’s my guess why 2023 is looking like it is,” what’s y’all’s thoughts?
Tom:
The AI thing feels very, very early bubble. It is a classic. There’s a real thing here that’s going to change how we do stuff like the internet in 1998. And I don’t think the market’s very good at figuring out who the ultimate winners of that are, but we know a lot of money’s going to be spent. We know who some of the company’s involved in. So that aspect of a bubble, if you want to call that, my beer copy guesses that has some legs to it.
Ben:
With regard to the market more broadly, it’s hard for me to point to something in history that this looks a lot like. Jeremy Grantham, our firm’s founder has been on the record saying, “Hey, this is year three of the presidential cycle. Bad things don’t happen in year three, so maybe this is a timeout from things reverting back down.” The one thing we were just talking about, actually we had a worldview team meeting in my group, that the worldview group, our job is to try to make some sense of the macroeconomic situation. The one thing that does feel pretty clear is there does seem to be a disconnect. The stock market does not seem to be at all pricing in a recession. And other markets are pricing in the idea that a recession is going to happen.
Now, from my standpoint, I don’t care too much because most recessions don’t really matter at the end of the day. Stock markets usually fall associated with recessions, but most recessions don’t leave a lasting mark on the economy or the markets. So if the market goes down because there’s a recession, it’s going to come back up. Periodically, if you get a depression, that’s a very different beast, but depressions don’t happen very often. Even something short of a depression like the global financial crisis leaves substantial scars. So a downturn creates the potential of something that would create a lasting problem, but sooner or later we’re going to get another recession. My guess is it is relatively sooner, but it’s not at all clear that that’s going to be an event that’s all that horrible economically.
Tom:
It’s interesting because by the market, you’re thinking about the US market. It is much less cyclical market than it ever has been. It’s really all about secular growth. So you have to think a recession bad for it because people are depressed and less willing to pay high multiples. But really whether Tesla or NVIDIA are great investments determine… It’s based on things that have nothing to do with the cycle. We sort of saw that around the Silicon Valley Bank period where there’s sort of panic and people rotated into what they saw with safety. And a lot of what they saw with safety is high multiple secular growth companies, which is it’s not Coke necessarily.
Ben:
Yeah. That is absolutely true, Tom. On the other hand, parts of market that were as secular growth have now grown to the point where they are inevitably more cyclically exposed, right? An Alphabet or a Meta, they are such a big piece of the overall advertising universe that if advertising falls in a recession, it’s going to hit them in a way that maybe it didn’t in the GFC.
Tom:
Yeah, that’s right. Their fundamentals were able to totally grow through that and of course they can’t this time. But also I think rightly or wrongly, the market isn’t really pricing Meta and Alphabet these days off their ad revenues over the next 12 months.
Meb:
I was thinking about calling this episode of Two Value and Quality Guys Walk into a Bar. And for a lot of people listening, this is a very real focus for me right now because obviously the value guy in me has not bought tickets yet for the game tonight, but it’s struggles with the quality guy saying this is the only time Nuggets have been there. I grew up going to a bunch of the Dan Issel games and struggled through a long time of Nuggets basketball. So I’m trying to err on the side of quality too. So they’re waging their war but they’re not exactly the same thing.
But as we talk about these two topics today, I thought it might be important for you guys to give a little overview of what that means. GMO had a great piece on talking about the different types of how you define value this year, this January, and other times how you would’ve done, there’s a huge difference. And value and quality maybe, I don’t know, would you guys call them siblings or cousins? They often sort of overlap more than other factors. But okay, get back to you guys. Give us a little definitional guidance on how you think about these words that a lot of people use but mean a lot of different things.
Tom:
The thing I think about them in common is a style of investing where you’re based on the fundamentals of a company and sort of imagining you’re going to hold for the very long time and not forever, versus what do other people think about the stock. Now, both as we think about value and quality, it’s not that we hate growth and don’t incorporate growth into. It’s just a matter of what the right price is to pay, assuming you’re going to get the growth, not assume that someone else is going to want it at a higher price.
GMO back in the early days when Jeremy and Dick Mao and Eijk van Otterloo started the firm, it had value in quality then. I think over the years we came to appreciate more the fact that you shouldn’t be penny-wise and pound-foolish and not pay up for quality that is going to be worth it down the road. The analogy I sometimes like is you buy the house in the town with the better schools and the more expensive price, you’re pretty likely to get that back when you sell it in 10 years. Where if you buy the marginal far out condo, that’s the riskier investment even if it’s a lower price. But yeah, they’re very much aligned.
Oh, I liked your tickets, sports tickets. One of my regrets in life is I grew up in Stores, Connecticut. My dad taught at the University of Connecticut, followed their basketball as a kid. Always were lousy. They finally made the final four and I didn’t pay up for tickets and I wish I had.
Meb:
Shame on you.
Tom:
I didn’t go actually partly because I was afraid they’d lose and then I’d feel really bad. So it had that aspect to it too.
Ben:
So if I can add a little bit of nuance from a top-down perspective of how I think about value and quality, the way I think about quality companies, quality companies are the companies whose businesses are farthest from getting into potential financial trouble. And so the interesting thing about quality companies is if the reason why equities give you an equity risk premium is because equities do really badly in a depression type event. And a depression type event is the worst circumstance on earth to be losing money.
The funny thing about quality is well, quality is therefore less equity-like than other equities, right? It’s going to do less badly in the circumstance where you hope and pray not to have equity exposure. And so to my mind as a kind of, I don’t know, top down looking guy, the weird thing to me about quality is if there is any group of stocks on earth that has a good fundamental reason to underperform, it’s quality. And that is because they’re less risky, they are less fundamentally risky. And so you could easily imagine the market price is them up higher. In order to give a decent return, no matter how wonderful the underlying asset is, it needs to be priced at a level which will give you that return.
So you could imagine investors care so much about the survivability of these companies that they bid them up too much, and they simply haven’t. Quality as near as we can tell as we look back through time has at least kept up with the market and probably actually has outperformed, which is weird. That is the market gets it wrong. Value is different. Value, these are not companies which are guaranteed to do less badly in a really bad economic event. But the other thing about value is it is a more kind of short term malleable group in that it is in general acquires from other parts of the market those companies that have been doing badly lately.
So one of the things that definitely impacted different definitions of value to the start this year is the extent to which growth type companies wound up in the value universe and different definitions of value gave you different amounts of those growthy type companies. So if there was a single bias I was going to have to my equity portfolios under every circumstance, if I was just going to do one thing for the next 100 years, I’d have a quality bias because it’s less risky. And unless the world changes, it’s not going to underperform. I like value today because it’s trading at a really big discount and I think when it’s trading at a really big discount it is going to outperform. But in 2005, value was stupidly overpriced.
Tom:
I think even with it, the quality style to flip that around slightly, it’s also pretty important to pay attention to valuation. I think a lot of quality-focused managers will buy quality at any price and then they’ll tell you stories about how quality is defensive. And yeah, generally it is but not at any price. And if you’re hurt, time horizon is infinite, maybe your entry price doesn’t matter as much. But if it’s not, it does. And you saw that last year… Most really in the tech bubble, but last year was kind of an echo of that too where there a lot of great companies that are just at unreasonable valuation. So just because you buy quality doesn’t mean you’ll get that safety. But we found that the trade-off for quality at a reasonable price is a pretty effective way to have your cake and eat it too to Ben’s point about the unreasonably high return of high quality stocks.
Meb:
I love when there’s like a market quirk, I don’t want to say inefficiency, but there’s something where you kind of scratch your head and say, “This is weird that this is kind of the way it exists.” Tom, you had a piece recently in the GMO quarterly letter where you were talking about quality spectrum and the backwardation of risk. The example you gave was sort of talking about junk bonds. Maybe you just talk a little bit about that, walk us through it.
Tom:
That phrase backwardation of risk, which is kind of a, I guess, bastardization of what people normally use by, backwardation finance is kind of a shout-out to a former GMO or who maybe was a malapropism on their part. So fixed income markets kind of work the way you expect where you get a higher yield for more risk. Equity markets, to Ben’s point, have historically been the opposite in that we talked a little bit about high quality companies that give you safety, and if anything, better return. And the flip side of that is the more speculative junk companies that mentioned meme stocks earlier, but I think lottery ticket like companies that don’t have any earnings, any one of them might be due fantastically well, but if you look at a basket of them, they’ve been pretty consistently been underperformers and they’ve been underperformers at a higher level of risk. So you get lower risk, higher return at the high quality end. Higher risk, lower return at the low quality end. It seems backwards.
When you see something like that and you’re scratching your head, you definitely have to ask yourself why. The best explanation we have kind of boils down to career risk, which is something we think of a lot generally at GMO, which is that a lot of money is of course managed by professional money managers. Professional money managers have a little bit different motivations. They want to win more often than they lose, maybe putting aside the magnitude. They want to win when markets are going up, that’s when flows are coming to their asset class into equities and so forth. So quality, while it does has won over time, often wins kind of at the times when people are depressed and doesn’t help you that much. And it’s not most of the times. You only see it over the long term through the virtues of compounding or protection on the downside. So maybe its arithmetic average return isn’t higher, but the compounded return is. So there’s definitely a slow and steady wins the race that we’ve seen in equity markets here.
Ben:
The interesting thing is you actually see the same pattern within the high yield market. So the basic pattern, you get paid more for taking the risk associated with high yield than you would in treasury bonds. Sure, that is true. But if you look at high yield bonds, you’ve got a fairly heterogeneous group. You’ve got the BBs at one end, the highest rated low rated bonds, which default at about 1.5% per year. And then you’ve got the CCCs, the junkiest junk bonds that default on average at about 15% per year, but with huge cyclicality to that. So in boom times they’re still not really defaulting, whereas in really bad times, maybe 30 to 50% of them might default.
The weird thing that is very similar to what we see with quality stocks, BB bonds have outperformed CCC bonds despite the fact that CCC bonds are twice as volatile. I think it comes down to some of what Tom was saying about the career risk aspect and people getting focused on the wrong things. One of the things about CCC bonds is they yield a lot more and people get fixated on the yield. But they default a lot more, so net of the expected defaults, it isn’t so great. But even where you’ve got markets that kind of make sense and high yield makes sense in that it is the highest returning piece of the fixed income market on average, you still see some stupid stuff going on under the surface and there’s something very analogous to what happens in equities.
And again, I still don’t really understand why it happens. I suppose arguments you could make, Tom points out, well slow and steady is not very exciting. It’s also the case that if you’ve got a group of stocks that let’s say you are absolutely sure we’re going to destroy the market, do much, much less badly than the market in a depression, and a depression happens once every a hundred years. So it’s still material because hey, if the stock market goes down 80% in a depression and you go down 60, man, that’s a lot of outperformance, right? The market has to double to make it back to where you are. Well, the rest of the time you would be sitting there owning a group of stocks that was going to underperform and you have to be cool with that.
So I mean there is some subtlety here. There’s also the kind of maybe the excitement thing. I would say there’s another piece of this. Tom talked about how in the quality portfolio they are willing to pay up for growth where there are growth opportunities. And actually, the place where you should be more interested in paying up for growth opportunities is within that quality universe. The weird thing… Not the weird thing, but the thing that people tend not to appreciate about growth is not all growth is worth paying for. The growth that is exciting, the growth that really accretes to shareholders is the growth that is associated with a really high return on capital. When the company by reinvesting their own retained earnings can earn a much higher return than you can by investing in the stock market, that’s cool, that’s accretive. Not every company that is growing can achieve that. In fact, not all that many do achieve that.
But one of the things about the group of stocks we call quality is that they are almost definitionally a group of stocks with a really good return on capital. And where you have a good return on capital and growth opportunities, man, that’s where it makes sense to be willing to pay in above market multiple. And one of the problems with growth in the longer run is some of these growth companies that growth is not actually accretive, it is not useful to shareholders because it just came because the company was investing a ton of money without a particularly high return on capital.
Meb:
One of you had a quote, I assume it’s Tom, because I can’t remember in my show notes, but it says, “While a glancing punch can knock a junk company to the mat, quality companies absorb body blows like Rocky Balboa and come back for more.” One of the things that you guys differentiate in some of the research on the quality side is quality doesn’t necessarily mean low vol. It doesn’t necessarily mean low beta. So when you say quality, what do you mean? Do you mean just consistency of earnings? Do you mean doing it where there’s not super leveraged? What is the kind of general elements of quality in y’all’s mind?
Tom:
Yeah, a good question to ask since I doubt any manager comes in and says to you on your podcast, “Well what we really focus on are low quality companies.” Everybody says what they invest in is high quality.
Meb:
Not specifically, but they may say it in other ways.
Tom:
They might say something like deep value. So Ben really hit the nail on the head for what we think about it is return on capital, companies that can reinvest a dollar and incrementally higher return are the companies that should trade at a premium. One of the ways that GMO got into quality investing is coming from this deeper value orientation is, where should we be paying more of a premium than we have been historically? And that’s kind of the core concept to us, predictably, sustainably reinvesting at a high rate of return.
So we’ve talked earlier about quality companies being less risky. It’s not the converse that less risky companies are quality. Utility-like companies that have sort of regulated constrained returns or just no growth opportunities to invest in aren’t particularly high quality. You also have to be, in our minds, very cognizant about leverage. To the point about the body blow, a sure way to weaken your business ,and you can take a strong business and trade into a weak business, is just to add lots of leverage. So in a way, that sort of feeds into the ability to earn high rates of return sort of in different environments though with that being the key concept.
Another thing just to contrast other metrics of quality is dividends and rising dividends are great sign of financial strength, it tends to be correlated with quality. But plenty of great companies that have great investment opportunities aren’t paying a dividend because they have things to invest in internally and they certainly think that’s valid for early stage growth companies and don’t think that’s necessarily a negative. What’s a negative is if you don’t pay a dividend because your empire building and just like to grow for growth’s sake.
Meb:
I want to kind of slowly move over to the value side in a second, but as we look at the quality universe today, I don’t know if I’ve seen it, maybe you have, is the quality universe trading at as far as valuations and not paying up? Are they reasonable prices today? Are they cheap? Are they expensive? Do you guys kind of even quantify it the same way you do on other areas?
Tom:
We do do forecasting and Ben can talk on about that. I’d say bottom up, actually a little bit expensive in aggregate. So I wouldn’t particularly recommend quality as a factor right now. I think I made the point earlier about valuing quality. I think there are a lot of great opportunities there, but the overall landscape is a little bit dicey.
Ben:
I think the slight difficulty for our forecasting methodology in dealing with quality is it’s a group whose characteristics can change. So the nice thing about value is values always value and growth is always growth. Quality can be more value or more growthy. And that makes it a little bit tricky to figure out, “Well is it okay that it is trading at a 10% PE premium?” Well if it’s growthy, that’s probably fine. If it’s a value or a less growthy group, that would be a sign of expensiveness.
So on the face of it, on our asset allocation kind of seven year forecast data, quality looks to be priced about normal versus the market, which is a level at which we’re certainly comfortable with it, right? It’s a group that has modestly outperformed with less risk and it’s priced pretty similarly to how it has been historically. That is okay, that should be fine to own. The US stock market in general looks pretty expensive relative to the rest of the world and relative to history, so it’s hard for us to get super excited about that. But quality itself looks fine. And again, I do think the inefficiency associated with quality, we haven’t seen anything else quite like it in that you get to have your cake and eat it. It is a group that has outperformed with lower fundamental risk and that’s weird and good. It’s good weird.
Meb:
I figured we might as well talk about value now. It’s something we’ve kind of chatted about on the podcast quite a bit, but you guys had a really interesting piece that I don’t know if I’ve seen before where you were starting to stratify the different parts of value, meaning I think it was quintiles maybe of value, but you can get more specific, but talking about shallow and deep value. And by the way, listeners, every time I read this piece, I don’t know why I cannot get a movie that would not be made today by the way, but Shallow Hal, which is old Jack Black, Gwyneth Paltrow movie, which would certainly not get made today. Absolutely not. So if you don’t know what it is, look it up. Don’t watch it. I don’t even think I ever saw it. It is probably a terrible low rated movie, but that always pops up my head when I was reading your piece, Ben. I don’t know if that was intentional, but all right, let’s talk about shallow and deep value.
Ben:
When we’re talking about value, the default way most people think about it is halves of the market. So there’s the value half of the market and the growth half of the market. But within that half, there can be substantial differences. And just as when I was talking about the high yield market, BB bonds and CCC are really quite different. When we break the market up into finer pieces than just halves, occasionally something interesting pops out of that. And right now there is something weird going on within the US stock market in particular, which is what we refer to as deep value, which would be the cheapest 20% of the market looks really cheap. It looks cheaper than it has been 98% of the time through history relative to the market. So value is always trading at a discount to the market by definition. But sometimes that discount is big. Relative to history, sometimes it’s small. Right now for the cheapest 20% of the market, they’re trading at the second percentile. So cheaper than they’ve been 98% of the time.
Now, if we look at the rest of value, which if the cheapest 20% is deep value, I am calling the next 30% shallow value. The next 30% of the market is trading more expensive relative to the market than it almost ever has. So that next 30% right now is trading at an absolutely tiny discount to the market, and it is more expensive than it has been 98% of the time. So it’s as expensive versus its history as deep value is cheap versus its history. So that causes us to say, “Hey, you don’t just want to be looking at the cheap half of the market because the cheap half of the market contains two very different groups of stocks. And we think if you’re going to be buying value today, you really want to be buying the deep value stocks, that cheapest 20%, because they are priced much cheaper than they normally are and the rest of value is much less attractive than that group and substantially less attractive than normal.”
Now that pattern doesn’t quite exist in the rest of the world. The deep value stocks are really cheap everywhere. They’re really cheap in Europe, they’re cheap in Japan, they’re cheap in EM. But the rest of value is fine in the rest of the world. It’s only the US where we’ve really got this thing where there’s this cheap 20% tier of the market which is stunningly cheap and everything else is a lot less appealing from a valuation perspective.
Meb:
What was the other 2% of time when these stocks were cheaper? Is it like within the last two years? Or was it some random point in like 1932 or something?
Ben:
Well, to be clear, I don’t have good data on this back to 1932. I can bring it back to 1970. So it was cheaper than this relative to the market for a few months in 2000, at the height of the TMT. And it was cheaper than this for a couple of months in the fall of 2020, in kind of the height of COVID, whatever the heck that was. But otherwise, it’s cheaper than at any other point we have decent history to look at the valuations.
Tom:
You were asking before about the definition of quality. The definition of value is not… It means a lot of different things coming out of different people’s mouths. And at GMO when we talk about value, there is often a component of it that’s quality and return on capital oriented. So we’re when we say deep value, I said earlier deep value is a euphemism for monk junk. That was more how other people use deep value. Our deep value actually has a reasonable amount of quality in it. So these are not like sectorally declining going out of business companies we’re talking about. There’s actually some reasonable overlap with the quality strategy holdings.
Meb:
One of the things that listeners, when I talk to them talk about value, say, “Ah value, I don’t want to get stuck in a value trap. This thing’s cheap for a reason. It’s going to underperform, it’s going to disappoint,” blah blah blah. You guys have done a fun series on the phrase, which I don’t think I’ve seen before, called growth traps. You guys want to give us a quick overview of what that general methodology and insight was?
Ben:
So we came into this by trying to come up with a decent definition of what a value trap is. I think everybody… Well, not everybody, but probably just about everybody who listens to your podcast has an idea of what a value trap is, right? It’s a company that looked cheap but turns out not to be cheap because the fundamentals wind up deteriorating a lot relative to what expectations were. So you bought this company and then the bottom fell out of the fundamentals.
So we came up with this quantitative definition of something that is a value trap in a given year. And so we were looking for companies within the value universe that not just disappointed in a given year but where beyond the problems of this year, the market is also saying, “Hey, we think the future has deteriorated materially as well.” So we came up with this quantitative definition and we could say, “Yeah, actually almost a-third of the value universe winds up being a value trap in a given year.” And this group stinks. They underperform the rest of value by about 15% per year. So you do not want to own these guys if you could avoid them.
We came up with a couple of interesting findings once we had this definition of what a value trap was. One of them was, “Okay, what is the likelihood of being a value trap given that you were a value trap in the prior year?” So you’ve got a company, they disappointed this year, they were a value trap. Does that mean you should sell them out of your value portfolio or not? And it turns out whether you were a value trap in the prior year, has no bearing on whether you were going to be a value trap this year. So one of the difficulties for value managers is yes, it would be great to avoid these stocks because they underperformed by 15% a year relative to the rest of value, but it’s not that easy to predict who they’re going to be. And the problem of being a value manager is, man, it would be great if you could figure out who these guys were going to be. And we haven’t figured out an easy way to do that, although there are some things we do that we think can help.
But the other thing we were able to do with this quantitative definition is value stocks are not the only kind of companies that disappoint. And so we could look at stocks in the growth universe that had that same pattern where they disappointed in the course of a given year and their future growth prospects fell as well. The thing about that group is that group does even worse. So I said those value traps underperformed the rest of value by about 15% per year. Those growth traps, those disappointing growth companies underperformed the rest of the growth universe by almost 23% per year. And it turns out they are at least as big a piece of the growth universe as value traps are of the value universe.
So the thing on behalf of value managers everywhere that seems a little bit unfair is every perspective client, and frankly all of our current clients, when they come in, one of the initial questions is, “All right, how are you guys going to avoid value traps? Because we know value traps are horrible.” I would like it to be the case that when investors are speaking to their growth managers, they start asking them, “Well, how are you going to avoid these growth traps? Because growth companies that disappoint are death in your portfolio.” So these growth traps are a really nasty piece of the overall universe. And actually one of the fun things… Fun. You’ve got to be the right kind of nerd.
Meb:
This is fun to our listeners. I mean, you don’t listen to The Meb Faber Show podcast unless you get hot and heavy for quant factor insights and macro. I mean, you’re talking to our people, Ben.
Ben:
All right, well then for the quant factor nerds-
Meb:
And my mom. My mom listens to every episode too. So shout out, mom.
Ben:
The interesting thing, 2022 was a horrible year for growth stocks relative to the market, the worst year since 2001. I’d say the common narrative is, well, interest rates went up. And when interest rates went up, people just knocked down the valuation premium they’re going to have on growth companies.
But something else happened last year as well. An almost record high percentage of the growth universe turned out to be growth traps. And that’s funny because that normally happens in recessions. The only time where a higher percentage of the growth universe wound up disappointing in that way was in the global financial crisis back in 2008, 2009. But last year, over 70% of growth companies wound up disappointing not just on 2022 but on forecast for what was going to be happening in 2023. I think part of what was going on was 2022 was a surprising year in a number of ways, but one of the ways it was surprising is how quickly the economy got back to something more normal, a normal pattern where people were buying less goods and more services and going out to restaurants and doing more travel and all of that stuff. And the companies that had been the biggest beneficiaries of stay at home and do everything on a screen wound up being disappointing.
And two differing extents. I think Apple computer last year wound up disappointing on revenues by maybe 4% and their future revenues came down by about 4%, whereas some of the high-flyers saw much bigger disappointments. But 2022 was actually a record bad year of growth traps.
Tom:
And to your point earlier, I think the disappointments were most damaging when it was revealed that what growth they’re having came at very high levels of capital being deployed. So it wasn’t just that the growth wasn’t happening, it was that money was being lit on fire to get what was kind of temporary growth, but not a permanent thing. You show your age, by the way, Ben, to refer to Apple computer.
Ben:
Oh.
Meb:
I thought you guys were going to say making it rain with all this stock-based compensation, which the tech world in particular has been particularly fond of over the last five years. Is there any way to try to identify these traps ahead of time, you guys think? Does momentum screening help at all? Is it sort of they give up any warning lights before they take a big dirt nap?
Ben:
There’s definitely nothing foolproof. There are a number of signals we have seen that tend to be associated with kind of future fundamental problems. But honestly, momentum itself is in general a good thing. A stock that is exhibiting strong momentum is generally one that is more likely than the average stock to have a positive surprise rather than a negative surprise.
The difficulty, the tricky thing about momentum is when they have that negative surprise, bad stuff can happen. So NVIDIA would be a great example. A company that had positive momentum going into an earnings announcement, which turned out to be an incredible earnings announcement and the stock went up a bunch. Imagine what would’ve happened to NVIDIA if they had come out with a negative surprise after that momentum. That would’ve really stunk. But on the other hand, is it a shock that NVIDIA where investors were saying, “Hey, good things are happening. Good things are happening, I want to buy this stock,” is it a surprise that it wound up with surprisingly good numbers? I suppose some definitional way, a surprise has to be surprising. But on average, good momentum is associated with positive surprises, not negative surprises.
Tom:
I mean, I would focus, not to sound like a broken record, but a focus on return on capital or companies that have gotten their growth with relatively little investment. Not so much that those companies… And NVIDIA would be one of those companies. Not so much those companies can’t surprise dramatically in either way, but I feel like for those companies, time is your friend. If something bad happens and the growth is broken, it’s much more likely to come back the year after that rather than start some downward death cycle, at least for the longer term investment where I’d focus mostly on that. From a factor point of view, the best thing I’ve ever seen predicting future growth is just high multiples and that predicts fundamental growth. It doesn’t help you very much for picking stocks though, because that’s basically predicting the growth that everybody else knows is already there and is already priced.
Meb:
As you guys look around the world today, we’ve talked about some of the opportunities, but feel free to go anywhere. We mentioned a little bit about global equities. You guys could talk about tips, commodities, REITs, cap bonds, anything you want that’s like, “Hey, I think these are some really interesting opportunities or this is something that is particularly worrisome.” Obviously, the deep value is a core great place to start here. But anything else that’s kind of stands out is particularly worth mentioning?
Tom:
One area I’d kind of highlight… Sorry, more from the bottom up, but you mentioned NVIDIA, we talked about AI. These are big trends, unclear how much you’re paying for NVIDIA. Maybe you’re overpaying. But this is kind of a uniquely nice area to invest in, is you don’t have to buy NVIDIA. You can buy a lot of the stuff in the supply chain that’s going to benefit from exactly that same capital investment. You don’t really have the same downside risk if you’re buying the equipment stocks that are built to make the chips that go into all the GPUs, that go into all the data centers. I’m thinking about the Lam Researchers, KLA type companies. It feels like there’s a lot. And there are other sectors actually where it feels the same thing. People, to your earlier point about maybe superficiality, buy the headline stock and not the picks and shovel enabler that is equally important, just not as glamorous or as much of a household name. So that’s the kind of stuff I’m excited about.
Ben:
From the more top-down interesting stuff coming out of our forecasting work, I’d say one group we have been quite excited about is Japan, particularly smaller caps in Japan and smaller cap value in Japan. And as we see it, Japan’s got a few lovely things going for it. One of them is the yen is really cheap. The yen’s currently at almost 140 to the dollar. That makes Japan a really cheap place to do things. So Japan has this nice fundamental circumstance where it’s actually a pretty cheap place to be creating goods and services relative to almost everywhere else around the world. It’s also a place where from kind of a fundamental quality characteristic, we have seen a real uptick in their return on capital. It’s not the last couple of years, it’s actually been going on for about… Not 20 years, maybe about 12 or 15 years that we’ve seen this sustained uptrend in their return on capital that we think is sustainable.
Whenever you’re talking about Japan, honestly what I find is that investors tend to go to sleep or they pull out their smartphone and start sending emails because everybody knows Japan is where capital goes to die. But right now it’s trading. The stocks are trading cheap. They’re not just trading cheap on Booker sales, but they’re trading pretty cheap on a PE basis. These companies have on average no net debt, they have net cash on their balance sheets, they’re trading quite cheap. A lot of these companies have really interesting niches. Tom was talking about parts of the semiconductor supply chain that are… Hey, they’re in this position of, “Well, it doesn’t matter who wins. You’re going to need something by these guys.” Well, a lot of the little niche pieces of a lot of tech supply chains run through Japan.
So it’s a really interesting place and it’s a place where the government is also on your side in that it is trying to push companies to be more shareholder-friendly. So I think it’s really interesting. We have been definitely investing there. It’s one place where I think active engagement with the companies is really quite useful because there are plenty of companies that are not really doing very good things with their retained earnings. Tom talked about companies who are setting money on fire. I would say in Japan it’s less that they were setting money on fire, but some of them were kind of flushing it down the toilet.
Talking about emerging markets because we do like emerging markets, we think they’re really quite cheap. But we come up against the, “Yeah, but you’ve been saying that for a while. These guys have been a nightmare for the last decade. What could possibly change?” Well, things that could change, the last 10 years were a nightmare for EM. As you pointed out, the 10 years prior were amazing for EM, right? They were up several hundred percent over that decade, outperformed the S&P by over I think 300% in that period. And people thought that was the height of the BRICs mania where people were saying, “Well, this is where the growth is” and you got to invest where the growth is.
Now, that argument was wrong at the time because it turns out investing in countries that are experiencing fast growth is a lousy way to invest from a stock market perspective. And a lot of it comes down to what Tom was talking about. The easiest way to grow fast as a country is to invest a ton. And if you are investing a ton, the return on that investment may not be all that hot. So China has grown faster over the last decade than anybody else. It hasn’t been a great decade to invest in China. A lot of it was because the return on capital in China stunk. They invested way too much. And they grew because if you don’t have a negative return on capital, you will grow when you invest. But as a shareholder, the two things that matter are the valuations and the return on capital. And they came in with expensive valuations. In 2012 emerging was trading at a premium to the developed world. Their currencies were also stunningly overvalued after that period of good underlying fundamental performance.
Today, now if we look over the past year, their fundamental performance has not been good. They have not really grown much on a per share basis. Even China, which grew a lot on a per head basis, GDP per capita did very well, earnings per share did not. So it was legitimately a horrible decade for EM from a fundamental perspective. Things that give me hope are, well, 10 years ago these currencies were stupidly overpriced and that made EM a very expensive place to do anything. Today, they are generally underpriced. 10 years ago, EM stocks were trading in general at a premium to the developed world. Today they are trading at half the valuation of the rest of the world. The thing with regard to Russia, from an external investment standpoint, man, any money you put in Russia, well you have flushed down the toilet or set on fire or something bad with, and that stinks. Now that is kind of the worst case scenario as an investor.
Tom:
Russia is a pretty small part of emerging markets even before the plumbing episodes it might have had. I mean, emerging markets these days, it’s China. And then if you look at indices, it’s Korea and Taiwan, which from an economic development sophistication point of view really aren’t the same thing as like a Russia. But they’re in Asia and China’s uncomfortably close to them. For a lot like Latin America, the economies are dominated by commodities and China’s the biggest customer. So there’s that linkage. But from an investing point of view, I think we and others would tend to more think about the individual companies. And then the China risk is a huge thing. That’s further risk that keeps me up at night most. And it’s not just because we do some investing in China or Taiwan. It’s like I have Apple. Apples, all their chips are made in Taiwan. Or for that matter, just like the Nikes and Starbucks of the world, which we don’t hold but have held in the past. It’s a huge market for them.
So that’s sort of geographic decoupling and the breakdown between east and west is probably the thing that would, again, keep me upmost at night. But like to Ben’s earlier point, at least emerging markets interest people, like Japan, you’re not even going to get a debate on. They’ll just walk out of the room or fall asleep.
Meb:
Yeah. What’s a question you guys would ask each other that might be interesting for the podcast listeners?
Ben:
Well, I will start out with a question that I was asking Tom and his team. We do a lot of valuation work, and that valuation work tends to assume a certain amount of stability in how the world works. It’s not that things can’t change, but the potential of discontinuous change is really a thing. And kind of the question of AI and less about who are going to be the companies that are the real wonderful beneficiaries. It’s hard for me running kind of broad portfolios to think, “Oh, I’m going to hold the real winner.” It’s, “Who are the companies that are really at risk of being profoundly disrupted by AI?” Which is a question that I was just asking Tom and his team. And they were pointing me at a bunch of different things. I’d say on that one, we don’t have perfect answers. There are a few companies that seem to be in the crosshairs, but that’s a question… Since they are looking more in more detail at companies, it’s certainly a question I was asking them last week.
Tom:
It’s interesting because it’s a lot easier to point to winners than it is to a massive [inaudible 00:53:21] set of losers from AI. So I guess that sounds bullish other than the fact that everybody’s talking about it. And the prices are all up. They always counter that at least GMO, we’re going to turn to. I mean, to turn that around, you sort of framed it a little bit as potty and value, but a lot of what we do is a little bit more I would focus on bottom up and stocks, and Ben and his team are focused on asset classes and looking at things through the broad sweep of history. So what I’m always worried about, basically missing the forest because I’m looking at too many trees. And that would be the forest of equity markets generally, or even maybe more so, other asset classes because I really do only think about stocks and it’s a bigger world than that.
Meb:
How do you guys deal with the complexities of surviving in this very real kind of career risk?
Ben:
I’ve got a lot of experience both being on investment committees and even more talking to investment committees. One thing I have almost never convinced any investment committee to do, whether I’ve served on it or not, have them do some post-mortems around the companies they have fired. Because people are very worried about, “How do I make sure I am hiring good managers?” And obviously, hiring good managers is very important. If you are going to outperform, it’s got to be because you’ve fired good managers.
But in round numbers, all managers that are fired are fired after a period of bad performance. So the question I think people should be asking when they are thinking about firing a manager is, “Well, did this manager underperform for bad reasons or okay reasons? And am I prepared to keep an eye on this manager and how they do over the next three years?” Because one of the things we’ve seen, and there’s been some academic work on this, in general, managers after they have been fired have a tendency to outperform. My guess is that’s pretty true even when they’re being fired by some of the smartest investors around. There’s just, you come up with excuses to fire people who have been underperforming. And you come up with excuses why the really strong performance from those managers who have done better than you thought they should have is due to their brilliance, not their style getting into a bubble.
Tom:
I think for probably 90% of the listeners having a fairly static allocation and rebalancing to it is kind of the way to go. And probably not rebalancing too quickly because momentum is a thing, but on some schedule. If you go back to 2009, Jeremy Grantham wrote a piece called Reinvesting When Terrified, and it was sort of at the bottom of the crisis. And the easy read was, stocks are down a lot, you should buy despite the fact you’re terrified. If you actually read it, a lot of it was about having a battle plan and sort of planning in ahead. “If stocks or whatever asset class moves X amount, here’s how much I’ll move in response to that” and sort of setting the rules for yourself in advance before whatever emotional thing happens around the event. I found that to be very helpful for us in managing portfolios. And I think it would be helpful for listeners to sort of imagine some scenarios and lay them out, not just act on the here and now.
Ben:
Yeah, I think that that’s great advice. One of the things we try to do on my team, whenever we’re contemplating a new investment, we try to come up with what we call a pre-mortem. If we look back and this turns out to have been a mistake, why do we think it might have been a mistake? What are the things should be looking out for that is a sign that this thesis is not playing out? Because we don’t want to knee jerk sell EM just because it’s gone down. But if we had specific things, we were buying EM because we were hoping X was going to happen or Y was going to happen, and we see that, well, they failed to happen, in that case, all right, well at least you shouldn’t own it for the reason you owned it then. But having that battle plan and having an idea of how this thing might go wrong is a great idea whenever you’re getting into an investment.
Tom:
Maybe. Maybe it’s because we’re at a value firm, but often our problem is not reallocating to our winners and keeping riding them off and it’s not being willing to sell our losers when the thesis has changed. So I very much echo those sentiments.
Meb:
Gentlemen, this has been a blast. We had a great time, covered a lot. We’d love to have you back here soon after this massive value run and quality outperformance we’re going to have over the next year. So hopefully sooner than later. We’ll use that as the template for when it happens and we can take a giant victory lap. So hopefully 2023, not 2028. Gentlemen, Ben, Tom, thanks so much for joining us today.
Tom:
It’s been our pleasure. Thanks, Jim.
Ben:
Thanks for having us.
Meb:
Listeners, if you enjoyed this episode, check out the link in the show notes for your episode from last March with GMO-founder Jeremy Grantham.
Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us a feedback at feedback@themebfabershow.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.
