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On January 26, 2021, CFA Society Chicago’s Distinguished Speaker Series held a webinar entitled “Value:  If Not Now, When?”  Jeremy Heer, CFA, served as moderator and the keynote speaker was Ben Inker,

CFA, head of asset allocation at GMO. The conversation initiated with Inker talking about the investment process and forecasting methods at GMO.

Inker noted he and his team work from first principles where risk and return are measured to determine what can be the right compensation and then drive the estimate of fair value. One such principle is that cash flows should be sufficient for the risk being taken and should be used to determine a fair price. Additionally, part of GMO’s process contemplates a 7-year return period — what return should one receive for getting 1/7th of the way back from the initial investment each year. Inker suggested that most of the return should be coming back from the cash flows that the asset produces. Some styles or investments may revert more quickly, currencies may happen more slowly, but sooner or later one must realize return over the 7-year period.

Heer asked if there was any difference in this process due to regime changing – what would happen in the middle of an investment if the world changes? Inker noted that several things can happen. Riskiness of an asset can change. The question may be, how much extra return should one be paid for the additional risk being taken? One example might be the risk of equities compared to bonds. In the last 10-15 years, rate of return on risk-free cash has fallen lower and lower. The lower it is, the higher the value can be on risky assets. In addition, markets recently have done a poor job of estimating future risk-free rates.

Inker then noted that GMO conducts scenario analysis in their work. Their scenarios generally focus on “mean-reversion” and “partial mean-reversion.” A partial mean-reversion scenario has some yield-curve reversion characteristics, but not back to the same historical reversion level. One such partial mean-reversion concept is that interest rates have fallen and will never get back to levels seen since World War II. GMO’s portfolios are evaluated on both full and partial mean-reversion, so that if either scenario turns out to be true then the investment returns are good. GMO is not looking to bet on one singular scenario.  It’s helpful to build a portfolio that will be robust in several scenarios.

Heer then steered the conversation to how these positions are taken. Inker noted they are trying to build a portfolio that makes sense given the forecast in their scenarios and that the amount of risk taken is commensurate with the return. GMO then looks to put the first dollars into the best assets and subsequently looks at relative rankings to determine how much to invest in next-best assets.

The discussion then took a turn to highlight “career risk” in the investment profession. Inker noted that there is a risk to investment professionals that applies to any arrangement with an agency issue, such as portfolio managers investing on behalf of their clients. Portfolio Managers must answer for their performance, and it’s important to understand how clients determine positive performance. Inker suggested that Portfolio managers should be aware of what they would do in absence of a client compared to what they do acting in the midst of the client monitoring. Heer chimed in with an example, university endowments get measured against a peer group—any time they do something different than peers they create career risk. The career risk question is, how much are you willing to do better or worse than your peer group?  Outperforming is great, but you’re likely not going to be fired if you’re performing similarly to peers. It means that investment managers will be in the position of holding assets that they might not hold otherwise, because they’re afraid of what might happen if they underperform their peer group. In this situation, investment managers end up still being in reasonable range of benchmarks even if they might own what they consider to be undesirable assets. Another career risk scenario is when portfolio managers have difficulty changing the direction of what they have been known to do well. In the case of GMO, clients may hire them because they are good one thing, even if GMO might feel it’s better to walk in a different direction. Or if a portfolio manager has been hired to make bets, then staying too close to the benchmark can lead to a client noting that the portfolio manager is not doing what they were hired to do.

Next, Inker and Heer discussed the 7-year concept for investing that GMO started in mid 1990’s. Given that there are many completed forecasts are now available, Inker noted that on average they systematically have been slightly underforecasting—GMO has been a little under on average but stayed close to overall positive results.

Heer then asked what GMO might be excited about now?  Inker noted that there is a strong opportunity for value investing. The spread between value and growth is nearly as wide as ever, some of the highest spreads since late 1990’s at end of internet bubble.  There are also particularly good opportunities outside of the US securities market. Worldwide valuations are a lot lower and more attractive, so there is an opportunity to outflank a traditional portfolio by diversifying globally. That said, there is still upward movement in just about everything. Valuations look expensive compared to history. The opportunity to make money in traditional assets may not be great, but ability to differentiate seems very good.

Heer then asked Inker to comment on the recent trend in SPACs. Inker noted the investment community will be talking about his recent SPAC era for a long time and that it’s a fascinating innovation. He noted these vehicles are well-designed to make money for those who make them and invest in them, but they also may not be well-designed for those who look to trade in the resulting public companies. Interestingly, there were more SPACs created in 2020 than in all previous history, and Inker noted that they allow companies to go public much more quickly. Inker paid a special note to how attractive this speed to market feature has been for autonomous vehicle companies.

Heer then asked about GameStop. Inker noted GameStop has a profound difference compared to internet bubble. Back in the late 1990’s, investors may have disagreed on the concepts, but they overwhelmingly thought the companies had the opportunity to change the world. But with GameStop, many realized fundamentals are not even close to being good, and the weirdest component is that activity on the runup may not have been within the rules.  Inker provided an analogy to Tesla – the company might not have sales revenue today, but the valuation reflects belief in the company. But with GameStop, the concept was more about “owning the shorts,” “us versus them,” and that people were out to win the game. Inker concluded his remarks by saying that it is a unique situation that will likely turn out poorly for anyone who bought in near the top.

Value indexes are dominated by energy and financial stocks.  Are these stocks expected to outperform?

Inker noted at times the Indices have problems. One difference recently is that the COVID crisis was not a crisis of the financial system. The problem has been that financial stocks are always a big component of a value index. Energy stocks have not been as big a portion of the index lately because they have lower capitalizations.

There is 5 Trillion of cash on the sidelines, and the US continues with deficit spending. Does this mean investors should stick with long duration assets?

Inker noted if it’s possible for interest rate to stay at these levels, then overall valuation around the world isn’t crazy. The US valuations may be a little more crazy than other markets. There is some crazy stuff going on, such as GameStop and Tesla, but the market may not be crazy overall. There are many exceptional growth companies, but most companies only stay in that category for 3 – 5 years. People may overestimate the actual duration of growth. If you believe that interest rates are going to stay low or go lower, then you want to have a long duration way of betting on that.

Can you speculate on what may be the catalyst to bring the S&P back to a normal valuation?

Inker noted he doesn’t do well at predicting catalysts. In addition, at important turning points, it can be hard to know what the catalyst was. For the internet bubble, we still may not be sure what the bubble was. The 1929 and 1987 market downturns may be similar – we may not be sure what single item to point to as a catalyst. But we could point to a few potential catalysts. One might be interest rates moving back to normal levels, likely through inflation. Inker noted the amount of speculative fervor going on today is not normal. This fervor could die out to a more normal level, and in turn the lack of activity will have an influence and that may not be positive.

What are your thoughts on ESG investing?

He noted ESG has complicated issues. An average Emerging Markets (EM) company scores worse perhaps due to focus on goods production tendencies and that leads to concepts counter to optimal ESG. ESG is a statement about quality of the investment being made. He noted it does make sense to pay a premium for high quality business. If an asset is trading at a discount then they can be great investments. His group looks to have emerging market holdings trade at a lower PE ratio than the developed world because of its lower quality.  He noted that investors should be paid for taking the governance risk. ESG definitely matters; it’s a kind of “quality” measure.

Is there a positive outlook for timber today?

Inker noted that this today is more of a private equity type of business. It’s done well over the last 25 years, but a lot of that has been bidding down the rate of return of forest as an asset. It can still be an interesting asset due to tax features, but the pricing has gone up a lot.

Can growth stocks can mean-revert, such as large cap technology companies, without taking down the entire market?

Inker noted that the growth style indices have much less diversification than people realize. For example, Apple is a huge piece of some indexes. So, if such a large asset were to go down in price, the rest of index is not going to easily make up for this. Apple has grown for long periods of time and at paces that are much more than any other growth stocks could dream of. They also are basically monopolists and exposed to active antitrust rulings. The US has thought about antitrust historically in terms of consumer harm.  In general, these valuations aren’t stupid. They may be expensive — for example Apple is now trading at 39x earnings—but it’s also possible that it can grow enough to justify its valuation. Purchasing in a growth index or S&P 500 exposes you to this risk. Heer also asked if it is possible that breaking tech firms up into pieces could be a fix and increase the value of their component parts? Inker noted one issue is that these large technology companies have access to information and a customer base that no one else can match. Overall, that may not be net positive to economy or society.  It is a risk that you should understand if you purchase into them.

There is more and more passive money moving into financial markets; is this money driving returns?

Inker noted there is way too much stock-specific trading going on to have this all be driven by routine passive investments. Passive is becoming a lower level of activity. The more the market is passive, the better it is for active investors.  Passive investors desire liquidity, but only a small part of the market is passive. The more passive investing, the more mispricing that evolves in the market.

What are your thoughts on Bitcoin and other cryptocurrencies?

He noted that it’s important to recognize that this is not an investment in a common sense.  Holding these assets is not helping anyone, and the investments have no cash flows. Bitcoin has the potential to be a speculative winner. Inker noted that bitcoin needs value more than gold for example. Gold has some other properties and things that you can do with it. Bitcoin has no other use except to hope that someone else decides it has value. That sometimes proves to be a failure because it has not proven to have frictionless transactions.  It’s very hard to put an intrinsic value on it. It is much more a speculation.

Overall, this was a very helpful session to give more insights into the investment thoughts of Inker and GMO, and to get additional perspectives on investment strategies.

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