Thursday, February 26, 2009 4 comments ++[ CLICK TO COMMENT ]++

Jeremy Grantham 4th Quarter 2008 commentary (Part 2)

Thanks to GuruFocus for pointing me to Jeremy Grantham's latest two-part commentary (4Q 2008). I can't remember if I covered part I before but I believe I did, so I'll just go over part II. Jeremy Grantham, for those not familiar, is a macro-oriented value strategist for GMO funds. I find his writing hilarious at times so it's always a fun read. I wish I had read his stuff 3 years ago (I dismissed him back then because he seemed like an extreme permabear--a big mistake on my part :( ).

Jeremy Grantham is one of the best macro thinkers out there (another great macro thinker is Marc Faber.) Unlike many other macro thinkers, he is very unique and comes up with insightful ideas. Most people, including me at times, cover the beaten down ideas of global trade, economic growth, bear market cycles, and so on. Grantham, in contrast, comes up with ideas that I haven't seen anywhere else. It is a sign of a great thinker!

Overall, he says that the high-probability investment ideas are gone and we are stuck with low probability ones. For example, the markets have historically overshot on the downside but whether the stock market falls another 15% is a low probability call. He says he has started to study, for the first time, the major busts (in the past he has concentrated on studying bubbles.) There is some really insightful stuff about value traps so if you don't have time, check out the first section.

(source: Obama and the Teflon Men, and Other Short Stories. Part 2. By Jeremy Grantham. GMO Quarterly Letter - February 2009)

(Underline within quotes are from original author. Bold within quotes are mine. Quoted text is messed up but I don't feel like fixing them up.)

The Year of the Value Trap

Grantham spends a section discussing his theory of value traps and why so many value investors fell into them. Being a fan of Bill Miller, I feel like some of Grantham's words describe Miller. I don't know if everyone would agree with Grantham's thinking but it's interesting.

I don't know how to cover Grantham's thoughts witout extensively quoting him but let me see if I can capture his words.

Since time immemorial, the most successful value
investors have been the bravest. The greatest advantage
of value investing has always been that when your cheap
stock goes down in price, it gets even cheaper and more
attractive. This is the complete opposite of momentum
stocks, which lose their momentum rating as they decline
and hence become unattractive.
But averaging down
in value stocks can take lots of nerve and considerable
ability in convincing anxious clients of the soundness of
the strategy. For at least 60 years, those value investors
who managed these problems and bought more of the
stocks that had tumbled the most emerged with both the
strongest performance and the most business success.


Outsiders could view this as a return to bravery, but it
was also a return to risk. The cheapest price-to-book
stocks are those deemed by the market to have the
least desirable assets. And Mr. Market is not always
a complete ass. Because these companies are so often
obviously undesirable and are seen as such by clients,
they represent a career or business risk to the manager
who owns them.
This career risk is usually reflected in an
extra discount that will deliver an extra return for bearing
the career risk. This “career risk” return is in addition
to the discount for buying lower quality companies with
more fundamental risk.
Problems arise when this pattern
of over-discounting and handsome recovery has taken
place dependably for several cycles in a row. It begins
to look like the natural, even inevitable, nature of things
rather than merely the most usual outcome. The growth
in the number of quantitative investors exaggerated this
tendency because quants model the last 10 or 20 years (or
even 40) without really requiring a full understanding of
the very long-term pattern and why it behaves the way
that it does. And none of us modeled data that included
the last great value trap: the Great Crash of 1929.

In mild economic setbacks, even the wounded value
stocks recover fully. In substantial setbacks, a very small
number fail, but not nearly enough to offset the large
discounts. Only in the really severe economic setbacks
do enough casualties occur to bring home a truth: priceto-
book (P/B) and price-to-earnings (P/E) are risk factors.

Buying them and averaging down routinely has an element
of picking up not nickels in front of the steamroller – that
would belittle the substantial returns – but, say, $1000
bills in front of the steamroller. Because of the extra
discounts for career risk in the long run (at least for those
who are not dead), the strategy will probably still pay off
even if the rare, severe fundamental crises are included.
But investors should be aware that the fundamental part
of the risk premium is justified by the pain of these outlier
events and is absolutely not a free lunch.

Jeremy Grantham is essentialy arguing that the classic value investing strategy of buying cheap assets is not free. I think some would disagree with that but many who followed that in the last few years will agree that it hasn't been a free lunch.

He points out that there is substancial risk in buying seemingly undervalued assets. It just so happens that very few faced a serious value trap since the last big one, at least according to what Grantham implies, was during the Great Depression.

The whole notion of a value trap scares the hell out of me. I have been thinking a lot about that for months. I think value investors, but more importantly contrarians of various stripes, should be really careful that the businesses they are investing in are not value traps. People have always talked about value traps--I even keep referring to them--but the value traps Grantham is referring to are the very serious once in a century type traps. You will also see below that many value stocks were a disaster during the Great Depression and, in fact, you would have been better off owning growth stocks such as Coca-Cola.

The value problems of the last two years were particularly
bad because of the outperformance that value stocks had
between 2002 and 2007. They won for five years in a row,
so that by mid 2007 the value/growth spread was about
as unfavorable as possible for value stocks in the U.S. ...

To put a measure on how awful the value trap was
during this time, please see the Fall 2007 edition of
the Outstanding Investor Digest. This publication
concentrates on a dozen or so of the top value investors
and is readable, interesting, and chock-full of insight.
However, that particular issue is a heartbreaker as one
after another of these superior investors put forward the
case that – down 30% to 50% – AIG, Lehman, Wachovia,
Fannie Mae, etc., were ridiculously underpriced, and
represented enormous long-term franchise value that the
nervous market was missing.

Unless you were a value investor that didn't invest in financials, a lot of value investors lost a fortune on financials. The unfortunate thing is that, unlike the momentum investors who made a killing owning many of these names in the prior 5 years (and hence had huge gains before that,) value investors tended to start investing after these stocks had been cut by a third or more, and they lost everything.

The following point is very important. Grantham points out how value stocks did poorly during the early stages of the Great Depression:

It has long been my view that the pricing of value stocks
has a folk memory of the Great Depression when many
cheap companies went bust and the expensive Coca-
Colas survived the best.
Remember, you cannot regress
from bankruptcy. Using proprietary research data, we
examined one fixed time slot: October 1929 to June 1932.
With no rebalancing, the data showed a massive “value”
wipeout in which high P/E stocks declined far less than
low P/E stocks.

When I say Grantham is often insightful, you can see what I mean. After all, how many people knew that high P/E stocks did better than low P/E during the 1929 to 1932 crash? I certainly didn't.

None of this is to say that one should avoid stocks with low valuations; rather, what it implies is that a lot value stocks can be major value traps and will end up bankrupt during severe recessions/depression.

Near Term Outlook

Whether 2009 will see a snapback for
value is an important question, and not one that we can
answer clearly. On the one hand, value stocks are now at
least much cheaper on a relative basis than they were a
year ago. On the other hand, they can get a lot cheaper,
and they face the worst economy since 1938. I would give
them at best a 50/50 bet this year. (“Thank you very much
for such useful advice!”)


I share similar views as Grantham. I think the market can drop a lot more but it is difficult to say whether it will.

Time to Research Busts

We at GMO have another problem: almost all of our
work has been aimed at the study of bubbles or upside
outlier events. Until eight minutes ago, the study of a real
bust seemed, in comparison, academic. Now, however,
we have thrown ourselves into studying the reverse. This
very morning – true story – I unpacked The Panic of 1819,
a new book by Murray Rothbard. As I write this at our
large and untidy breakfast table, I can see the recently read
The Forgotten Man by Amity Shlaes. It is a book about
the plight of working men and FDR’s erratic experiments
with stimulus programs in the Great Depression. At
GMO, we are now in full-court press mode, studying
the patterns of economic and market lows and looking
for predictive clues (with luck, see next quarter’s Letter).
But this is a relatively new effort after spending 12 years
studying bubbles. Ah, well. Of course, this is all written
assuming that we are indeed heading to extremes of

Grantham is a professional and far more knowledgeable so his reading material is way beyond me. I'm just a newbie but I'm also doing a similar thing by reading books like The Anatomy of the Bear.

Given the massive destruction in wealth, I suspect we will see further declines, or a prolonged, mild, bear market. As I have said before, don't spend all your capital with the assumption that the bull market will start soon. It could, but if it doesn't, you would be stuck owning assets that may get much cheaper.

The Lack of Ethics

Grantham has a section on the weak ethics exhibited by those in the investment world. I'll just quote his words about Madoff:

Certain European private banks, for example, charged
a substantial fee for investing their clients’ money with
Fairfi eld Greenwich Group, who, in turn, charged a lot
to invest with Madoff, who actually did the “work!” At
least Madoff had the decency to waive his fee. Settling
for the principal was enough.
You could call this a fund
of funds of funds of Ponzi.

LOL ;)

Perhaps the investment industry never had ethics but it certainly has very little these days. When this is all said and done, it would not surprise me if investment bankers, portfolio advisors, hedge fund managers, et al, were looked up unfavourably by the public.

Bullish on High Quality US Stocks

But our biggest bet
recently has been on quality stocks in the U.S. – a bet on
the great franchise companies. Our U.S. Quality Strategy
became more than 90% of our U.S. equity money in our
Global Balanced Asset Allocation Strategy. And 50% of
the quality stream was injected into our venerable U.S.
Core Strategy. This was the fi rst important override of our
U.S. quant model in its 29-year history!

As I have referenced before, Grantham expects, over the next 7 years, high quality US stocks to outperform small-cap, mid-cap, low quality, and various other asset types (the only ones that beat high quality US on his forecast model are emerging markets.)

More Opportunity in Asset Allocation

Asset allocation is simply much easier
than adding alpha to a fund, since there is more to sink
your teeth into. Counter-intuitively, asset classes are
more inefficiently priced than stocks.
There is a large and
relatively effi cient arbitrage between stocks, and the career
risk of picking one stock versus another is quite modest.
In contrast, when picking one asset class against another,
it is painfully clear when mistakes have been made. This
immense career risk makes it likely that there will always
be great ineffi ciencies, for investors are reluctant to move
money across asset boundaries. Consequently, there is
great advantage to be had in getting out of the way of
the freight train, rather than attempting to prove your
discipline by facing it down. The advantage is in both
higher return and lower risk.

Grantham says that it is easier to outperform by switching between assets, than if you just switched between stocks. I think this applies more to institutional investors than small investors. The problem for small investors is that we generally don't have enough knowledge about non-popular asset classes (like emerging market bonds, timber, foreign stocks, etc) and the cost is very high. For instance, I have been looking at buying some junk bonds and it's really tough to get a good price.

In any case, ignoring some specific debt (loans/bonds/etc) (such as mortgage bonds or select corporate bonds,) I suspect that stocks are more attractive than the rest. I don't think we need to concern ourselves with asset allocation right now, even if we were able to invest in other assets easily.

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4 Response to Jeremy Grantham 4th Quarter 2008 commentary (Part 2)

February 27, 2009 at 1:40 AM

I have given up following your blog and ramblings for a while, but on a lark I decided to check in and see whether you've gotten yourself out of the investment wilderness and befuddlement.s Having read your latest piece, I would say you appears still to be searching for the holy grail.s Gods knows why -- as there is no investment holy grail.
I'll give you a hint:s so-called value trap only exist if one doesn't have portfolio risk management.s But. ahh...swe have gone thru that ad nauseum already, haven't we -- that pesky "trader mentality."
Btw, YMM still appears to be struggling.s The latest bomb in his portfolio appears to be UNH and other assorted HMO healh insurance companies that he seems so confident about.s On the bright side, he'ssoutperforming Chris Davis's New York Venture fund -- which appears to have the distinction of riding AIG all the down to, let me check the latest.....53 cents a share.
Something else for a thought:s sometimes one's quality of life can improve a lot if one just STOPS paying attention to investing.s You have a couple bucks, put it in a bank.s Sure, it barely earns interest, but there are other more interesting things in life, I'd presume.
Continue to wish you good luck in life and, if you insist, in investing
Checking out again,

February 27, 2009 at 5:15 PM

I read several reports that some of the worst damage to the Harvard endowment was done by (supposed) hedges gone horribly wrong. "Risk control" ssounds fine, but what if you are controlling for the wrong thing?
All the big banks, including Lehman, believed they had their risk "controlled" sas well, look where they are now.

February 27, 2009 at 7:34 PM

I haven't read any details about the Harvard fund but our local Canadian fund, Caisse de Depot, the largest in Canada, lost around 25% (a huge sum for a fund that is supposed to be conservative and not 100% in stocks) partly on, supposedly, bad currency hedges. The made some money on the hedges before but the loss last year was massive.
My newbie opinion is that a lot of these people using so-called hedges are actually making macro bets. I suspect they don't even realize that; either that or they are somewhat incompetent.
The thing is, some of these blow ups aren't even due to Black-Swan-type events. The currency drops 30%, basically back to what it was one or two years ago, and these companies post massive losses. What sort of lame hedging is that?

February 27, 2009 at 7:38 PM

Going back to Syncrho, my criticism has always been that he will have a hard time figuring out when to come back into the market. I have no idea what he actually does but I suspect he is totally out of the market or mostly market-neutral right now.

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