Understanding Valuation Metrics
Viewed by some as a diagnostician of bubbles and various valuation metrics, Grantham acknowledges that any measurement, even the Shiller CAPE ratio upon which he relies extensively, has its own limitations.
Some metrics have become almost worthless, he says. “Book value once approximated replacement cost,” he recalls.
Today, thanks to mergers, acquisitions, buybacks and other cases of financial engineering, book value has become “hopelessly polluted.” Furthermore, in an information economy dominated by service companies, many intangible or hard-to-value assets with earnings power bear little connection to numbers on balance sheets.
Defining value today is a lot more challenging than it was when Grantham was a young hotshot in the 1970s. In his view, it is easier to say what value isn’t.
Used the wrong way, many popular yardsticks can become value traps. Some cheap stocks have justifiably low P/E ratios because they have the least desirable future stream of earnings. Equities sporting high yields often signal that the market is scared of owning them. And low price-to-book ratios frequently indicate investors are voting on which company has the “dopiest” assets.
Just because a company looks cheap according to these metrics doesn’t mean it represents “serious value.” Grantham’s belief is that “if an investment is risky to your career, the more return you are going to need.”
When one looks at two companies within the same industry or even two countries in the same geographic region, pricing rarely gets far out of line. It’s when one compares two separate asset classes that the huge gaps in value may appear.
The idea that asset allocation trumped stock selection helped prompt Grantham to leave stock selection in 2000 and become the firm’s chief equity strategist.
Diversification Still Works
Financial advisors don’t need Grantham to remind them that global diversification has been a tough sell over the last eight years. Many advisors look to GMO’s seven-year forecasts for various asset classes, as this is where GMO has enjoyed an excellent track record.
It should be noted that GMO’s seven-year real return forecasts square more closely with the value investors whose wrath Grantham has incurred lately than with his recent commentaries. GMO expects U.S. large caps to return a negative 4.0% after inflation while U.S. small caps will give investors a negative 3.1%.
Emerging markets are the only equity asset class expected to offer a positive real return of 3.4%. In the bond market, emerging market debt is the only asset class with a positive projected return. Because GMO historically has been a value shop, Grantham concedes these forecasts have a conservative bias.
Since the bull market began in 2009, the MSCI EAFE Index ex-Japan has trailed the S&P 500 by 100%. For an extended period during the lost decade, the S&P underperformed that index by 80%. In early 2016, the Shiller PE for emerging markets stood at 10, cheaper than it was at the bottom of the financial crisis.
“The odds of that [emerging market versus the S&P 500] not winning is negligible,” Grantham says. “At the extreme, strange things can happen, but they don’t stay there very long. Whether the S&P is going to stay high is another question, but it cannot return as much as emerging can.”
It should be noted many other shrewd market observers like Mark Hulbert and managers within GMO itself have written that leadership may be about to transition from growth to value. Were that to materialize, financial markets might once again exhibit some of their pre-1995 characteristics. According to GMO’s Neil Constable and Rick Friedman, the stars are starting to align for value stocks, which could be “very well-positioned to benefit from a rising-rate environment.”
They may well be right. But as Grantham points out, nothing is cheap these days. That includes value stocks.