Most Popular ArticlesJune 2, 2009
Investing based on bubbles
Grantham’s plans for timing his equity exposure belie his true investing style. “Normally,” he said, “we do nothing.” He waits for extreme outliers and then “whacks them.” He will patiently “sit around” and wait for outliers and “silly things.” “I have been blessed by many incomprehensible things. In time they will be less ridiculous and eventually will be normal,” he said.
Outliers are identifiable only in the context of fair value, a core principle of Grantham’s investment philosophy. “Fair value is like gravitation pull; it is not very powerful but is absolutely unrelenting. Everything catches up and eventually reaches fair value.”
“It’s incredibly easy to see the outliers,” he said “but we don’t do much when they are only 10 or 20 percent away from fair value.” He might underweight an asset a little bit, but will hold back his “fire power” until the divergence increases.
For a long time, Grantham was puzzled by an apparent paradox. He acknowledged that the movement to fair value is unreliable over periods as short as one year. So, how can this movement be reliable over many years, which are nothing more than the sum of one year periods?
A powerful analogy resolved the paradox, and showed Grantham how something can be certain in the long run but dangerous in the short run. If you go to Florida in a hurricane and stand on top of a building with a bag of feathers and throw them in the air, some will hit the ground two or three blocks away. But some will go all the way to Maine in eight or nine days.
“Amongst that swirling uncertainty, every feather will hit the ground,” he said. “We are in the feather predicting business. Every bubble will hit the ground and, unlike that analogy, some will bury themselves deep in the ground.”
Grantham said high-quality growth stocks are the only mispriced asset class today. These companies are debt-free, as opposed to companies at the bottom which are burdened with massive debts.
“The only things that matters in life are the bubbles. The rest of the time just show up for work,” he said.
Career risk and the business of investing
During the height of the Tech Bubble, when the market P/E was 31, Grantham asked 1,200 equity professionals: if P/E ratios go back within 10 years to below 17.5, will it guarantee a major bear market? They responded unanimously “Yes.” He then asked how many think such a move will occur. Only seven of those professionals believed it would not come back down. A staggering 99% believed in data guaranteeing a major bear market, but were apparently unwilling to communicate this to their clients.
“Those running the engine rooms knew this, but not their clients. This was a betrayal of trust,” Grantham said. “If those in the engine room squeaked publicly that there was going to be a major bear market, they were through.” He noted that Goldman Sachs’ Abby Cohen was the icon of that group, but she was not alone. The spokespeople of major investment firms were bullish, with almost no exceptions.
“It is not good for business to be bearish. In general, our industry was not bearish, because it understands how to make money,” Grantham said. He called the rationalizing of 35-times earnings “simply splendid.” “You can’t deliver the hard truth and prosper,” he said. Paraphrasing Keynes, Grantham said “if you’re right on your own it’s a bit dangerous, when you are wrong on your own will not receive much mercy.”
His advice, which underlies his investment philosophy, is to look and see what everyone else (brokers, institutions, mutual funds) is doing and do the same, but be quicker and slicker on the draw. “We are not picking winners in beauty contest; we are picking what others will pick.”
Markets move in herds, and Grantham said every single asset class is driven by momentum. “In the long run the economic fundamentals do matter, but the problem for the long-term fundamentalist is that the feathers fall at different rates. The force that drives this, though, is overwhelming and gravitational.”
Sometimes the movement to fair value takes longer than the institutional client’s “3.0 years of patience. That career risk makes that game so difficult to play.”
“There is a lot of career risk in moving assets.” Grantham said endowments, foundations, and pension funds knew market was overpriced and dangerous prior to 2008 and have paid a huge price. “Jeremy Siegel is never right [about stocks for the long run], despite what people hope.” Siegel’s mistake is not recognizing that valuations drive returns. He said “stocks for the long run” was a “very dangerous contribution.”
Markets have a pyramid-like structure. At the bottom are “little stocks” which carry very little career risk. “It is not easy to lose your job picking insurance company stocks,” Grantham said. But once you start betting on oil stocks against insurance stocks your head is on the block. The risks go up as the decisions go to the asset sub-class and asset class levels. “The killer is at the top, when you must decide between equities and cash,” he said. “Then, life expectancy drops quickly.”
Grantham reduced investing to a “battle between career risk and avoiding herding.”
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