Regression to the
Mean?
I met Jeremy Grantham
of GMO fame on several occasions many years ago and I had a working
relationship with Dick Mayo, the M in GMO. Thus, it was a pleasure to read
Jeremy’s autobiography written with the help of Edward Chancellor. Grantham is
a value investor’s value investor and as such numerous times in his career
he was out of step with a raging bull market, hence the title “Permabear." In
the interest of full disclosure, I would characterize myself as a value
investor.
Grantham was born in
Yorkshire, England in 1938, just at the onset of the war that would kill his
father. His background was middle class and he attended Sheffield University, a
far cry from the Oxbridge of the elite. However, the future Nobel Laureate John
Hicks read one of his papers. Nevertheless, by the dint of his efforts and
natural intelligence he ended up at Harvard Business School and ultimately into
investment management.
He broke off from
Keystone, a prominent mutual fund manager in the early 1970’s to form
Batterymarch Financial where he was a pioneer in the nascent index fund
industry. He left them to form his own firm, and Dick Mayo soon joined him. The
mid-1970’s was a heyday for value managers as the once exalted nifty fifty
cratered and practically everything else moved higher. Simply put, value was
having the sale of the century.
Like most value
managers, Grantham believes that stock valuations and profit margins are mean
reverting. Simply put, when the market’s price/earnings ratio gets down to
around 7 or 8, the market as a whole is a buy and when the ratio is well into
the 20’s on normalized earnings, the market is a sell. Grantham backed up his
investment analysis with serious quantitative research that covered
international markets as well.
The dot.com boom of
the late 1990’s tested Grantham like no other. Valuations went to the sky from
1998 to early 2000 leaving GMO’s performance in the dust. Nearly half of its
assets when out the door. Here Grantham is very astute in talking about
business risk and career risk. Being bearish in a bull market brings with it
enormous risks to investment managers and their principals. Trust me, as a
sell-side equity strategist at Salomon Brothers I felt the brunt of career
risk. Nevertheless,
Grantham stuck to his guns and was buying REIT stocks that were yielding up to
9% at the time. I had the same instinct at the time and built a personal
portfolio holding a basket of REITs. I later became the REIT analyst at Lehman
Brothers. In early 2000 the dot.com boom crashed and burned, but unlike in the
mid-1970’s the overall stocks market did not get really cheap.
In the early 2000’s
GMO recovered dramatically, but by mid-decade Grantham blew the whistle on the
unsustainable housing boom. Yet again he was early, but dead right. Although
stocks suffered from a vicious bear market in 2008-2009, the averages only stayed
cheap for a few short months by Grantham’s reckoning.
As I write this
Grantham is again calling out what he perceives to be the outlandish valuation
of the U.S. stock market. Profit margins are at an all-time high and the
cyclically adjusted price/earnings ratio is just a touch away from its 2000
peak. What’s going on? Perhaps, the economy has changed so much that it is now
dominated by a few highly profitable tech monopolies that are skewing aggregate
profit margins. Furthermore, the emphasis has shifted from tangible capital to
intangible capital. That was true until last year when the tech behemoths
started to massively spend on data centers to support artificial intelligence.
The big question is whether or not those investments will be sufficiently
profitable to support today’s valuations.
Grantham, through his
foundation, is a very active environmentalist. He almost went to jail in
opposition to the Keystone XL pipeline. He rightly worries about climate change
and chemical pollution. In his private life he attacks the major oil companies,
but my guess is that as a value manager he holds the stock in those very same
companies. In his environmental hat he applauds the decline in population
growth, but as a money manager, he realizes that might have negative
consequences for future profit growth.
To sum up, Jeremy
Grantham is quite the character. and it comes through in his book. For those
readers interested in the stock market, its contrarian take is well worth the
read and if you are of value bent, like me, it will gird you for the market
that lies ahead.
