The transcript from this week’s, MiB: Ben Inker, GMO, is below.
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BARRY RITHOLTZ, HOST, MASTERS IN BUSINESS: This week on the podcast, I have an extra special guest. His name is Ben Inker and he is the head of asset allocation at famed hedge fund GMO located up in Boston. They manage about $60 billion.
Inker is Jeremy Grantham’s right-hand man, and we had a fascinating and nuanced conversation about all things value related. I was especially intrigued about his take on why we are measuring intangibles from companies and whether that’s intellectual property or various other assets they hold that make them less capital-intensive, and therefore, potentially more valuable was intriguing. They’ve done some fascinating research that really is very interesting.
He explains how and why value has underperformed, what he thinks is going to happen going forward. We go over a handful of different sectors of the economy, of the world, and talked about specific stocks.
If you are at all interested in either value or asset allocation or anything along those lines, you’ll find this to be an absolutely fascinating conversation. So with no further ado, my sit down with GMO’s Ben Inker.
VOICEOVER: This is Masters in Business with Barry Ritholtz on Bloomberg Radio.
RITHOLTZ: My special guest this week is Ben Inker, he is GMO’s head of asset allocation.
During the Dotcom implosion, the GMO aggressive long short strategy, which was long undervalued stocks and short overvalued stocks achieved an 80 percent cumulative net return for clients. The firm is led by Jeremy Grantham and currently manages about $60 billion.
Ben Inker, welcome to Bloomberg.
BEN INKER, HEAD OF ASSET ALLOCATION, GMO: Thanks very much for having me, Barry.
RITHOLTZ: So your current role as head of GMO’s asset allocation team, how did you arrive at that position? Tell us a little bit about your career path?
INKER: Well I, have been at GMO for the entirety of my professional career. I joined GMO in 1992. I was hired as a research analyst working for Jeremy Grantham. And since Jeremy was the person who was kind of most focused on top-down asset allocation stuff at GMO, well I did a lot of different kinds of research over the first, I don’t know, eight or 10 years of my career.
I was the person who had done the most work on asset allocation and as our business in asset allocation grew, I was, you know, his assistant portfolio manager and then the manager, and then overtime, the head of the team, that is the short form.
RITHOLTZ: Interesting. So you started early 90s which was quite an interesting decade to cut your teeth on. How did your early experiences during that era shape your views of the market.
INKER: Yes. So I came at a time when kind of the forces of let’s say, mean reversion had shown themselves to be powerful. We have seen in the 80s you know, when both bonds and stocks got to ludicrously cheap levels that they recovered, we had just experienced a pretty extraordinary bubble and the bursting of it in Japan in the late 80s and into the early 90s.
So one of the things I got early on was this kind of strong understanding and belief that markets can do crazy things, but over time, they do eventually come back whether that’s because they have gotten absurdly cheaper, absurdly expensive. You know, I then got to participate in the next great bubble which was quite painful for us as investor. But then, you know, got to experience just how crazy the world could get.
So it with a fascinating kind of crucible to grow up in as an investor.
RITHOLTZ: So you say that was painful but in the end, ultimately the firm and Grantham’s calls ended up being right, it was a big moneymaker to the downside. Does that offset the pain? What do we take away from when markets go crazy but ultimately, you know, as always, that sort of excess ends in tears?
INKER: Yes, I think, you know, it is truly the case that market in the short term may be a voting machine but in the long-term is a weighing machine, and at the end of the day, at least four assets that where valuation is relevant and it is astonishing that we live in a world where there are more assets where valuation is not a relevant thing anymore.
But for the vast majority of financial assets out there, where valuation is relevant, valuation will eventually out — you know, at the end of the day, everything is worth the present value of the future cash flows and what we have seen time and time again is the market will forget that and as the market forgets that, it will do some sort of objectively silly things.
RITHOLTZ: (LAUGHTER)
INKER: But in the end, those cash flows or the lack of them is a profound discipline to the market which will pull things back. Now the time frame that they are going to pull them back over is uncertain, and one of the things we lived in the late 90s event is that while in the end, the collapse of that bubble was positive for us, it was positive for our client because we did manage to make some money for it and helped GMO grow as a business, the reality is there were a number of other money managers that saw what we saw and did some of the things we did and for whatever reason couldn’t hold on.
Either the firm — the firms themselves folded or the people who were doing the what I would call “the right thing” were eventually told by their bosses “We can’t stand this pain anymore. Either you change what you are doing or we are going to change the person in charge of your area.”
So, yeah, if you have a long enough time horizon, you can rely on the market eventually becoming sane again, but I don’t think anybody should fool themselves into thinking taking those bets is easy or is guaranteed to work out well for the people who do them.
RITHOLTZ: So that raises the obvious question. Here we are, it’s 2021, markets have had a fantastic recovery from, choose your timeframe, the lows in 2009, the breakout in 2013, the crash and recovery in 2020, where are we in the market cycle?
There is obviously a lot of valuation questions, a ton of froth, but also a ton of fiscal stimulus and very, very high monetary stimulus, where are we in the cycle?
INKER: It is a more difficult question than I’d love for it to be.
I think the evidence of the froth is everywhere around us. We are seeing stuff every bit as crazy and in some ways even more inexplicable than some of the stuff we saw in the Internet bubble.
But if one thinks back to the Internet bubble, right? We had all time high valuations for the S&P 500 coexisting with real interest rates of four percent, right? The inflation index bonds in the U.S. has tipped, yields went over four percent. So the alternative to investing in equities that had never traded at such high valuation was low risk assets that offered really good perspective return.
Today, that it absolutely not the case. We know low risk assets whether it has been engineered by central banks or whether it is a more natural outgrowth of the economy, low risk assets are offering extraordinarily low returns.
And what I wish I knew the answer to was whether those incredibly low rates are sustainable or not. If they’re sustainable, then the difference between now and 2000 is that the general level of risky assets from a valuation perspective probably makes sense, the extraordinary gap between kind of the secular growth names versus value names still doesn’t make sense even if you believe that, you know, the S&P valuation or MSCI world valuation is sustainable, that gap doesn’t make sense.
But it may be that the overall market on average makes sense if inflation is truly permanently gone as a meaningful risk in the developed world. I don’t know the answer to that, but I will say one of the things I have been surprised by on average over the last 20 years is that even in those times where you would’ve expected inflation to be accelerating, it has been pretty tame.
So I don’t know whether the market has to fall from here. I do think even if the market level makes sense, we got a speculative bubble going on, and that speculative bubble will have to break. But whether the breaking of that speculative bubble is associated with the market falling by 30 percent, 40 percent 50 percent as it did in 2000, or whether it is going to be driven by a strong outperformance by value stocks which are simply not priced to deliver the low returns that are sustainable if low risk assets are going to permanently lose you money after inflation. I just don’t have the perfect answer.
RITHOLTZ: So you write very thoughtful quarterly or so letters that I enjoy. And I don’t recall if this was December’s quarter or October quarter but a couple of quarters ago, you had explained as some of the tech stocks keep rallying as some of the valuations continue to stretch, no one could really guess where this ends but the most likely end will be when the Fed starts to tighten and raise rates.
First, am I oversimplifying that or is that more or less right and do you still hold that sort of belief?
INKER: You know, it is not — it won’t surprise you at all to hear that the most common question I am getting from clients these days is what is the catalyst, what’s going to be the trigger for the turn here? So one thing we have absolutely done is gone back and looked at the profound turning points in market and try to see, okay, well what was the catalyst in 2000? What was the catalyst in 1989 in Japan? What was the catalyst in 1929 in the U.S.?
Sometimes there is a catalyst. But a surprising amount of the time, even in retrospect, there doesn’t seem to be one. Right?
The catalyst for the cracking of the Internet bubble in 2000, I don’t know, I mean I was certainly there, I was staring at the market.
RITHOLTZ: (LAUGHTER)
INKER: But even 20 years later, I can’t tell you exactly what it was.
RITHOLTZ: Let me float a theory at you on that because I was also there and watching the ILX and the Bloomberg terminal all the time and I have a very vivid recollection of the first or second week of March 2000. And remember, we had that giant Y2K concern and there was a ton of hardware purchased in anticipation of that.
And you very quickly, I don’t remember if it was Dell that had a terrible quarter preannounced or Intel. It might have been Dell like the first week of March, I think it was their window to announce that their previous guidance was going to be wrong, so it could have been like March 8, 2000. It’s funny how all these things have been happening in around March ’08 and ’09 was the bottom and ’08 was to March 2000 was the top, and then again the bottom in 2020.
But is that the sort of thing that is a credible precipitant or is it really just the reveal and the collapse would happen otherwise?
INKER: I don’t know, certainly the basic thing the market was getting wrong in ’99 and 2000 was this belief in incredibly strong continued growth in corporate profits. If you look at what people were saying, sure there was the Dow 36,000 argument that was basically saying there should be no equity risk premium, but if you look at what analysts were saying and how analysts were assuming decent returns going forward was you know, expected earnings growth had never really been higher.
So they were expecting something like 15 percent annualized earnings growth, you know, they always over predict earnings growth but that was some of the highest levels ever. You know the reality of what was going on — the funny thing is in March, we had this extraordinary day and I’m sure you remember it as vividly as I do where the market in the morning collapsed like 12 percent or 14 percent, and then in the afternoon made this extraordinary, recovery to wind up down I don’t know, one or two, and it was this kind of intraday volatility that had been seen more or less ever.
And that was maybe kind of a shot across the bow if you look at what happened across 2000. You know, the first group to really crack was the pure Internet startup. And then a little bit later, in my memory, this was really late spring early summer was the hardware names, including Dell. Software guys held out farther until the fall but then they cracked and maybe it was as simple as disappointing earnings numbers.
But it wasn’t obvious at the time that it was disappointing earnings numbers and I certainly don’t remember a change in the – you know, the general tenor of market commentary and being around this sudden realization that earnings weren’t going to be there.
RITHOLTZ: Quite interesting. So let’s talk a little bit about the forecasts that you guys make on a regular basis, the seven-year forecasts, what are the primary inputs into that seven year forecast that let you conclude U.S. stocks are likely to deliver negative real returns over the next seven years?
INKER: The basic underlying idea behind the forecast that goes back to when we started publishing them in the mid-90s is that the market is — spent very little time looking normal. But overtime, goes through normal reasonably often. So in principle, what we’re really saying is look, we don’t know exactly what the future is going to hold, but let’s assume that at some uncertain point in the future,, we will call it seven years from now, everything looks normal.
So the PE of the market looks normal, profitability looks normal, and the return we’re going to get between now and then is going to be driven by whatever earnings growth will occur whatever income we’re going to get from that asset, and then either a gain or a loss associated with PEs reverting to normal and profitability reverting to normal.
Now one thing that has changed about the forecast is we do now have two different scenarios that we are explicitly using. One of them is kind of the traditional one that we started using since 1995 which is that fair value in the long-term normal.
So the stock market should be trading around 16 times normalized earnings, bond yields will be somewhere between two percent and three percent above inflation, kind of the old style assumption of where equilibrium is.
And in more recent years, we’ve built in another scenario which we also consider to be a reasonable one. It is predicated on the idea that interest rate has permanently fallen from those levels. We used to call that scenario “hell.”
RITHOLTZ: (LAUGHTER)
INKER: We now call it “partial mean reversion” we stopped calling it “hell” maybe because we were offending some people but mostly because we were confusing them because our forecasts in hell are generally better than our forecast otherwise because the allowable valuation in a world where interest rates are permanently falling is higher.
So for any given level of the market, if equilibrium valuation is higher, the return will be higher.
Now today, particularly for the US, even in that low interest rate environment, today’s valuation for stocks in the U.S. really looked too high. In the rest of the world, that’s less true and if interest rates are truly permanently low, you know, the emerging markets in general are probably trading at a very reasonable valuation.
But in the U.S., even if we make that adjustment, we come to the conclusion that the — that the market is overvalued and that’s I would say the last couple of years, we generally said that is more true for large-cap than small-caps.
But among the extraordinary things that happened in 2020, despite an environment that was unquestionably worse for smaller cap companies, the Russell 2000 outperformed so at this point, we think even a small cap in the U.S. are unlikely to be a significant haven.
RITHOLTZ: And that outperformance really came in the last few months of the year, didn’t it?
INKER: Yes, and the trigger in terms of the catalyst or performance, the obvious catalyst on that performance was the vaccine news.
RITHOLTZ: Right.
INKER: And that vaccine news was unquestionably wonderful news for humanity and wonderful news on a prospective basis for the global economy. But wow, it was an awfully big move in the stock …
RITHOLTZ: (LAUGHTER)
INKER: Particularly given that they weren’t all that cheap to begin with. So it was a move that directionally made sense, but from our perspective the scale of the move was just inexplicably large.
RITHOLTZ: So you mentioned emerging markets which have been cheap for quite a while. What are your thoughts on developed ex-US, is the rest of the developed world as pricey as U.S. equities?
INKER: No, the valuations are lower than the rest of the world. Now some of that is driven by the fact that IT is a smaller piece of the rest of the world’s industrial set and information technology firms do probably deserve to trade at higher valuation than the kind of more traditional ones. But even when you adjust for that, we do see a big gap between what a company would trade at in the U.S. and what that company would trade at if it were somewhere else in the world.
So we see the non-US developed markets looking cheaper than the US, we don’t see them looking by any means dirt cheap, the place that I think is most intriguing today in the developed world is actually Japan where the valuations are reasonably low and it is a place where it is easy to imagine that profitability can improve in a sustainable way.
Because if you look at the return on capital in Japan, it’s been lower than that of the rest of the world for the last 40 years.
And in principle, there is nothing to stop these companies from doing some of the same things that companies in the rest of the world have done, and being able to really improve that. And so you know that the simple math is if you have two stock market tradings at the same PE and one of the has significant scope or earnings growth relative to the other, that one is cheaper.
So within the rest of the developed world, we are intrigued by Japan today because of the potential for kind of significant earnings and profitability growth over the next five or 10 years, but for really cheap markets, we think you can find more in the emerging world than in the developed world today.
RITHOLTZ: Let me stay with Japan for a few moments. Historically not big stock buybacks to at least not compared to the U.S., and there is always a little bit of currency risk of dollar versus yen, how do you incorporate the currency risk into your thesis.
INKER: I mean there is always currency risk whenever you’re buying an asset that is denominated in another currency. What we find is in the longer run, that risk tends to dissipate. Because let’s imagine you buy Japanese stocks and the yen really falls.
So you’re taking this loss in the near-term. The good news, once that has happened is Japanese companies are now going to be really competitive relative to their global peers because of what happened to the yen.
So what we tend to find…
RITHOLTZ: Meaning their products are cheaper.
INKER: …is as your time horizon lengthens, the extra risk associated with the currency tends to fall away because countries that experienced a fall in their currency normally experience better-than-average earnings growth than companies that experienced a rise in their currency experience subpar earnings growth. So it kind of comes out in the wash and that is more…
RITHOLTZ: Makes sense.
INKER: …strongly true in the developed world than it is in the emerging world because in the emerging world, sometimes, you know a falling currency can turn into a currency crisis which is more problematic for the company. But in the developed world, I don’t get that worried about that the currencies most of the time. I do get nervous if I’m buying into a country where the currency is at a given point in time substantially overvalued. That doesn’t seem to be true Japan today.
You know, the risk in Japan I would say the primary risk is if they don’t get that religion, if they don’t start paying more money out to shareholders, if they don’t do some rationalization of their capital structures, they are not going to improve.
And the returns will be black, but we are seeing the evidence that both at the macrolevel, the government is trying to push these companies to change and we’re seeing on the grounds that more and more company management is receptive to hearing about this and then receptive to making moves in the right direction.
RITHOLTZ: Interesting, you mentioned emerging markets and we tend to speak of them like they’re a monolithic block, but they’re really very, very specific countries with different risks and different potential upside. What do you see in the emerging market space that is especially interesting or something that you’re less interested in?
INKER: Yes, you’re absolutely right. Emerging markets is not this monolithic thing. From my perspective, that’s really part of its charm. These countries all have very significant risks associated with them, but in a lot of cases, those risks are very idiosyncratic. You know, Turkey has problems, Russia has problems, China has problems, they do not have the same problems by any stretch of the imagination.
And so the kind of thing that could prove to be a real challenge for Turkey might actually be something that works out pretty well for Russia, or Korea, or Brazil. So what we find is when people think about the risks in emerging, they tend to focus on, oh my God, what if this really bad thing happen in this country?
And the good news is you can invest across, you know, 30 odd different countries and the same thing is unlikely to blow through all of them. But it is still the case that the countries that wind up really cheap, there’s almost always a pretty good reason for that. And so the diversification of being able to invest in a wide array of them is incredibly important.
So for example, today, Russia is very cheap. And that’s not just because of the energy stocks. In fact, you know our emerging markets team really likes Russia today but there — their favorite stocks are not really in the energy space.
The market’s cheap, the market’s cheap partially because, you know, Russia is a bit of a pariah state at this point given some of their misbehavior and people don’t really like investing there. The levels of corporate governance from the standpoint of protection of outside shareholders stinks and their economy isn’t in great shape.
Okay, those are all pretty good reasons for the stocks to be cheap, but at the same time, they are also avenues for which some improvement could lead to quite good returns.
RITHOLTZ: So what I’m hearing you describe is sort of a corruption discount which raises the question, does that unusually high level of corruption within the Russian economy and government, does that need to improve to see Russian stocks do better?
INKER: Something probably needs to improve for Russian stocks to do better. An improvement in the kind of the level of corruption and the level of corporate governance will help and it — while it’s not a guarantee by any means, it is fascinating that kind of in recent quarters, I have been getting pings whether it is email or voicemail from consulting companies representing some of the big Russian state-owned enterprises who are canvassing current and former shareholders to understand what kind of governance improvements they would like to see.
It is not that you know, Gazprom has suddenly become a paragon of corporate governance but it is fascinating, they do care enough to at least want to know what either people who hold them or have held them in the past would like to see them do. And again, you know, one of the things that Arjun Divecha, has who had been our head of emerging markets going back into the early 90s, the extraordinary returns that you can get periodically in emerging do not tend to come when things are good and become great, they come when things were absolutely horrible and become merely bad.
The scope for better corporate governance in a place like Russia, man, they don’t have to jump over that high a hoop for things to get better. And given the very substantial discount that investors are currently demanding for these assets, a little bit of improvement would go a long way.
RITHOLTZ: Quite interesting.
So you guys are known as not only contrarians but value investing, and we see value go through regular periods of under and over performance, it’s been pretty cyclical. But you described this past decade as quote “truly a hellish time.” What’s going on with value investing?
INKER: Yes, well that is a question that we have spent an extraordinary amount of time trying to analyze. One of the things we really like to do when looking at any asset whether it’s been doing well or poorly is not just look at what its returns have been but trying to understand where those returns have come from.
And value at this point, famously has underperformed as a stock selection technique since about 2007. So we got a 13-year period of value underperforming. 2020 was a particularly spectacular year for that, it was the single year for value relative to growth in history. But even before that, value had been underperforming.
Now the question is why. I would say the common — the common received wisdom is, well, the reason why value has underperformed is because they have proved to be value trapped. The growth stocks have grown in a way that is, you know, qualitatively different than what had happened before and these guys have just fundamentally been a disaster.
If we look under the surface at where the returns have come from, we find that’s actually not true. Value stock have certainly undergrown the market. Now they undergrew the market in the period in which value won as well. If you look from 1981-2006 which was. a period when value outperformed the market by about two-and-half points a year in the US, value stock still under grew the market by about five points a year. So how can you win if you are under growing by five points a year?
Well there’s a couple of ways. One of them is more income, one of the reasons why value stocks don’t grow as much is because those companies pay out more of their earnings to shareholders. So you get more income out of value. But the other important piece of the return to value in the long run comes from the fact that value isn’t a static strategy, you’re not just buying a group of stocks and holding them for the next decade, you are buying a group of stocks because they look cheap today and you are refreshing that group of stocks over time. And that rebalancing, that refreshing of that portfolio has been very additive to returns to value over time. That’s even been true in this more recent period.
So the rebalancing effect always accrues in favor of value and helps make up for the fact that the value stock under grow. If we look at the underperformance of value, and since 2007, the value half of the market has underperformed the overall market by about a point and a half a year. As we break that down, the relative valuation piece of that return which is to say the amount of the return that came from the fact that value stock traded at a different discount to the market at the end of the year than they did at the beginning of year has been — has cost you two points a year.
So more than 100 percent of the underperformance of value has come from the fact that value has been getting cheaper and the thing about that as a source of return is it’s not a sustainable one, right? You can’t have a group of stock have its valuations go in the same direction forever. You get kind of absurd things eventually. And we do think that because that valuation discount has gotten to the point where it’s some of the widest we have ever seen, we have a hard time believing it is going to spend the next five or 10 years getting still wider. And if it were to just stay where it is, he and the other sources of return for value stayed where they are, value would win.
So we think under the surface and this is the same kind of analysis we did that had us confident in value in 1999 and 2000, under the surface, the value effect is still there, but it’s hidden by the changing valuation.
So we think if we could get stable valuation gaps between value and growth, value would win.
We also think that the gap between value and growth had gotten extraordinarily wide, it is trading at kind of 70 percent wider than it has on average over the last 40 years which is to say if value was going to move to the same relative valuation versus growth stocks that it’s traded on average over the last 40 years, value stock deserve to beat growth by 70 percentage points.
But we don’t need to assume that that is going to happen in order for value to win going forward. We just need this pattern to stop and frankly one of the things that gives us confidence that this pattern is going to stop is just how crazy some of the market action has been in recent months.
Jeremy Grantham, our firm’s founder has written about and talked about it and interviewed. This is what we believe to be a full-fledged speculative bubble and those events have a tendency to end themselves in the space of months usually, more than years.
RITHOLTZ: So let’s stick with that idea, I asked some other value questions for you but I want to stick with the bubble issue.
Back in 1996, Alan Greenspan made his famous irrational exuberance speech and lots of people were discussing how bubbly and frothy the market had become and how valuations have gotten so extended, but the market powered higher another four years. So arguably, 1996 wasn’t the ninth-inning, it was, you know, the fifth or sixth inning.
Are you suggesting we are closer to the ninth-inning here and that this is a full throated bubble everywhere? Or is it more pockets of froth and this could still go for years and not weeks or months.
INKER: Well I would say the scale of what has been going on in recent months is really quite qualitatively different from what we saw in 1996 or 1997. It does have kind of much stronger parallels to what we saw in 1999 or early 2000’s, right? 1996, yes, we’ve I think Netscape went public and there was some fascination with that. But we didn’t have a huge swath of Internet companies going public. We didn’t see, you know, huge amounts of capital having moved into that state or was kind of being fascinated by companies that traditional measures didn’t look all that appealing.
That took quite a while to happen. What I would say about this market is what we are 11 years in to a bull market here is not the case that what is going on now is something new from the standpoint of rising valuations, what I’d say is new and different and something that we weren’t seeing until certainly 1999 in the U.S. is we moved kind of away from the fascination with the giant oligopolists and monopolists to more fascination with companies where the proponents of them are telling us “look, what you’re missing is you are trying to value this company on traditional security analysis.”
And traditional security analysis doesn’t matter anymore, and that’s — to me, that’s a different statement than the accurate statement than people were making about say Amazon a few years ago which was, yes, Amazon doesn’t look like it’s very profitable, but of course, it must be profitable. Look at the way it is growing. And look at the way it is funding that growth without having to raise capital. That must mean under the surface they are actually quite a profitable company and the accounting is just not keeping up with that.
That is true and that helps explain how some of these companies have done extraordinary things.
But if we talk about you know, a Tesla, if we talk about a Doordash. If we talk about, you know, a quantum case where the company management was saying, look in 2028 we think we might be making $1 billion and it was priced at you know, at the peak in December something like 80 times those 2028 company forecast earnings.
Man, that’s not the same thing as saying the accounting is wrong.
RITHOLTZ: (LAUGHTER)
INKER: That is saying, we are in a new world where valuation doesn’t matter. And I’d make the argument that that kind of mentality leads to a level of knowledge sustained in the pricing of asset that will prove to be unsustainable in a finite period of time.
RITHOLTZ: Quite interesting.
Last question on the value thesis only look at historical ways to measure value, price-to-book is something that’s really come under attack over the past couple of years. What do you think the best way to define value and trying capture the value premium actually is.
INKER: Yes, so it is one of the fascinating things about these episodes, there’s almost invariably a significant amount of truth to the complaint that people have with whatever asset it is that has been performing poorly.
Price-to-book is a profoundly flawed measure at this point. Its flaws come from two basic issues that are much more prevalent now than they were 30 or 40 years ago.
The first is the changing way that corporations are doing their investment. You know, 40 years ago, if most corporate investment was in the form of building a new factory, you know, putting up a new building something like that, that kind of investment is recognized as investment under GAAP accounting and under the foreign version, and the IASP accounting.
The investments that corporations are more likely to make today in intangible asset through R&D and similar kind of spending are not properly treated by the accounting standards. And so they don’t show up as assets on corporate balance sheets unless a corporation has bought another company whose assets were predominantly about intangibles and then it shows up as good will.
So we got this issue that for a lot of companies, a lot of the investments that they make aren’t properly capitalized and don’t show up on the balance sheet at all, and then we compounded that with the rise of stock buybacks.
And in the case of a stock buyback, if a company buys back its stock at a price-to-book greater than one, its book value has a tendency to implode. So one thing that is increasingly prevalent today is you have perfectly solvent companies with negative book value. So today, I think for example McDonald, has negative book value, that does not mean that McDonald’s is in any danger of going bankrupt anytime soon, it means that the price-to-book has really become flawed.
So if you are buying companies on the basis of price-to-book, you got a problem. You got a particular problem with the growth to your company because those are the ones who have been doing the most investment that had not been properly capitalized, so you’re going to systematically underestimate the value of all of them, and you are also going to get screwed up valuations for anybody who has been buying back stock.
We think if you’re going to be a sensible value investor, you have to adjust for that.
Now if you are buying your stocks one at a time, the right way to do it is to build a discounted cash flow model about what the future is going to look like.
If you’re going to be a more traditional a what people tend to think of as a quantitative investor, what we think you have to do is you have to go back through time and reclassify those expenditures which should have been understood as investment and start putting them on the balance sheet. So what we’ve done is we’ve gone back over the last 50 years and we have rebuilt the income statement and balance sheet for every company in our database, so that we’re at least starting from the economically meaningful valuations.
Now, from then, we have gone on to build a discounted cash flow model to try to understand the future of these companies. But the key aspect at the frustrating thing about talking about value today is I truly believe value as a style has been really out-of-favor that it deserves to outperform.
I also believe that, you know, the price-to-book and even PE based style indices are a really poor way of getting at that and they have way too many effective data errors showing up as either very cheap companies or very expensive companies.
So I love value today. I’m scared and somewhat skeptical of that as represented in the value indices.
RITHOLTZ: Quite fascinating. So we’ve been discussing intangibles and I want to spend a little more time focusing on that, so we see the rise of asset light companies, lots of intangible assets, R&D patents, processes, et cetera, and these tend to not only generate high profit margins but we’ve seen multiples rising over time.
How can an investor take advantage of this gap between the way we account for those assets and how they perform in the market?
INKER: Well, that is always one of the kind of challenges of security analysis. Even if this stuff was accounted for properly. There is a difference between the patent that a company has been given that turns out to be worth next to nothing and those rare patents that embody the intellectual property that is going to be absolutely fantastically valuable.
So it is not, you know, generically possible to get this right all the time. but I do think it’s really helpful to try to get as close as you can to the economic truth here to answer the question of well, is this a company that is trading at you know whatever, what like Amazon looks to be a few years ago, 400 times earnings, or is it the case that those earnings numbers are really wrong and the valuation is more reasonable.
I think you can get closer to that, but I think it’s also the case that you hit upon kind of the key distinction between the fairly rare company that turns out to be extraordinary and most of the of the corporate system which is there are some companies that have shown an ability to have a return on capital much higher than the average company and to maintain that for an extended period of time.
RITHOLTZ: Let’s talk about some of those companies when we look at the S&P 500, the six largest companies now make up about 25 percent of that index, and they’re all big cap tech companies, can you maintain a sort of bearish view on the market without being bearish on those companies that at least so far have proven to be absolutely extraordinary?
INKER: Well, they have proven to be absolutely extraordinary. One of the things that it is important to keep in mind is you can maintain your status as an extraordinary company without maintaining extraordinarily high levels of growth. So I will come up kind of a very simple case, let’s take Google or Alphabet. A truly extraordinary company, you know, their monopoly on search although I’m sure they would argue they do not have a monopoly on search but their extraordinary power in search has led them to be able to make wonderful amounts of money and very high returns on capital on advertising,
And they have seen extraordinary growth over the last 10 or 15 years. Now, but at the end of the day, you called them a technology company and they sort of are, but another way of thinking about them is they are a company that is funded by advertising revenue. And if we go back 15 years ago when they were a tiny piece of global advertising revenue, the fact that advertising revenue doesn’t grow that fast, it grows approximately in line with GDP, wasn’t a big deal.
If you are 50 basis point of the market and you believe you can get to be 10 percent of the market, well that is a 20-fold increase and whether that market has grown materially or not is irrelevant because you’ve grown 20-fold either plus a little bit because the market has grown or minus a little bit because the market shrunk.
Now, Google and Facebook are putting material parts of global advertising spend and their ability to outgrow advertising gets harder and harder, right? It is certainly not the case if you have gone from 10 percent of that market, well if you gone from half a percent of that market to 10 percent of the market, you’re not going to be able to grow your share 20 fold again, the best you can do is be 100 percent of that market.
And as your share grows, it becomes more and more the case that the stuff you don’t have is advertising that is spent differently for a very good reason. So I’d say with all of these companies, their — as their scale grows as a percent of economic activity that they are capitalizing on, their ability to achieve extraordinary growth deteriorates.
So Google will not grow over the next 10 years the way it grew over the last 10 years, the other piece that they are now fighting against is they are such big dominant companies that what they do has a real impact on the global economy, and some of those impacts are not necessarily so positive. So they have a regulatory risk that I don’t know exactly how much of that is going to materialize in limitations of their business model, limitations of their profitability.
But man you got to keep in mind, yes these companies have done extraordinarily well, but if we look over the last three years or four years or so, you know, Apple has done great but Apple four years ago was trading at 13 times earnings …
RITHOLTZ: Right.
INKER: And it is now trading at approximately 39 times earnings.
So 300 percent of that return comes from a tripling of PE.
RITHOLTZ: Right.
INKER: Now that is not exactly right because economically, their PEs are little bit different from the stated numbers, but in general, what I’d say about the tech giants is they are not going to grow the way they have grown historically, they might be facing some idiosyncratic risks that hit them and don’t hit, you know, technology firms as a whole.
And the bad news is in general, their valuations are a lot higher than they were just a few years ago. That is not the recipe for wonderful returns out of them, but on the other hand, I don’t think those are the stupidest valued companies out there, right?
Of the largest companies in the U.S., you know, Apple, Microsoft, they look expensive to us but maybe they are twice fair value, maybe they are 1-1/2 times fair value, that’s expensive but that’s not stupid. One our model…
RITHOLTZ: Give us some examples. Stocks like Netflix or Zoom, are they in that category also?
INKER: Some of them have gotten to levels that we considered to be very dangerously expensive, not all of them but we can find a significant cohort of companies that look to be trading five times fair value, ten times fair value, 20 times fair value or more.
RITHOLTZ: Wow.
INKER: Normally, you don’t see very many of those companies. And today, we see quite a wide array of them. So we do think that there are more easily valued companies today than we’ve seen certainly in the U.S. since the Internet bubble.
RITHOLTZ: Quite interesting. I’m going to shift gears here and I want to address your founder Jeremy Grantham who has been outspoken about climate change, how does GMO approach the idea of either ESG investing or low carbon investing?
INKER: Yes, it is kind of a fascinating challenge for us because on the one hand we absolutely agree with Jeremy that climate is this overwhelming challenge for mankind and that as a society, we don’t seem to generally understand how big these impacts will be.
So you know from an ESD perspective, the environmental stuff absolutely matters and it is going to matter profoundly as time goes forward. But at the same time, as valuation driven investors, we believe there’s kind of an appropriate price for everything and even though, you know, oil companies are likely to face tough times ahead and may well be in the case, in a situation where they are not even going to be able to produce all of their current reserves, there is a price at which there a decent investment anyway.
So what we have tried to do in our model is make adjustments where we know how to quantify for those environmental metrics that that strike us as being problematic for the future of the company from kind of a risk or future earning perspective, and also understanding particularly on the government side of things where poor governance means worse outcomes for shareholders.
Where I think we are ramping up our activity is going beyond that into more corporate engagement which is tough particularly on the — on the quantitative side. Quantitative managers are used do not really interfacing with company management and we build our proxies and we try to vote our proxies in a sustainable way but the question is how can we get these companies to do better? And that’s significant effort in the firm, we hired a group into the firm — a former independent investment firm called the Usonian who they — they’re fundamental stock pickers in Japan and one of the things that they have specialized in is a form of friendly engagement with management.
You know, corporate activism in Japan can have this very bad taste in the mouth for corporate management where certain foreigners have come in and you know, tried to strong-arm management into really changing their ways.
What they have found is that if you can find a constructive way to talk to management about things they can do to improve the way the outside world understand what they’re actually doing and relatively small things they can do to improve their actual, you know, impact on the environment, they can be pretty receptive to it.
So we’re trying to learn from their example and do that more broadly, but it is still a work in progress.
RITHOLTZ: Quite interesting.
I know I only have you for a limited amount of time so let’s jump to our favorite questions that we ask all of our guests starting with what are you streaming these days? Tell us your favorite Netflix or Amazon Prime shows that you might be watching?
INKER: Well, my wife and I have been really enjoying Lupin on Netflix, it’s not that original, I think it’s now one of the top — the top shows at the moment but kind of wonderful kind of escapist entertainment. We have also been watching Spycraft which is about the kind of the technology that spies have used over the years to get their information.
And one thing I have definitely watched of late this is admittedly this wasn’t on Netflix but that this has been a difficult period, right, certainly as a value manager, it’s no fun when your stocks are not participating in the bull market but just in general, life has not been as much fun as is been stuck at home.
And one show that I particularly appreciated during the fall is just a nice way to feel a little bit half an hour was Ted Lasso on Apple TV.
RITHOLTZ: It’s so good, it was delightful.
INKER: Yes, and just filled with in general pleasant people, you know, just people you kind of want to have a beer with.
RITHOLTZ: I’m with you on that, I have I have a hard time with — there are a handful shows that I know people really like and I have tried them out and none of the characters are redeemable. Why do I want to spend an hour with the people I wouldn’t want to spend five minutes in an elevator with?
So the next question I assume I know what the answer is going to be but I’m going to ask it anyway, who your mentors who helped to shape your career?
INKER: Well, certainly Jeremy Grantham is first and foremost among them. I’ve had the privilege of getting to learn from him for close to 30 years. But I would say I’ve been extraordinarily blessed on the — on the mentor side of things because before I got to GMO, I had some utterly extraordinary teachers who really taught me lessons on investing that absolutely resonate to today, kind of my thesis advisor when I was an undergraduate was David Swensen, the manager of Yale Endowments…
RITHOLTZ: (LAUGHTER)
INKER: And I’ve had the further blessing of being able to be on the investment committee there for the last decade or so and so both learned from him early on and have learned from him more recently.
But for kind of my traditional investing and finance underpinnings, the two other finance professors that I was fortunate enough to have were James Tobin and Bob Shiller.
RITHOLTZ: Jeez.
INKER: So I have been extraordinarily blessed in terms of being able to learn from absolutely brilliant and groundbreaking investment bankers all throughout my career.
RITHOLTZ: Tobin, Shiller, Swensen, Grantham, yes, you could do worse than that.
Let’s go to everybody’s favorite question, tell us what you are reading these days, what are some of your favorite books what are you enjoying currently?
INKER: Yes, in terms of my kind of long term favorite books, I would say the book that I come back and reread every few years and enjoy it every single time is “A Short History Of Nearly Everything” by Bill Bryson and I have loved much of what Bill has written over the years.
But what I particularly love about that book is it’s an exploration of how we came to know the things we know of the world. And I find that an absolutely fascinating topic and never gets old for me.
In terms of what I am reading today, I am rather embarrassingly sort of between books, most recently I was going through a fun book, it’s one of those kind of classics where you don’t understand how they managed to pack as much skin as they did, but EH Gombrich’s “A Little History of the World” and again wonderful kind of primer on how the world has got to be where we are.
RITHOLTZ: You mentioned the Bryson book, I literally this weekend just finished reading his book “At Home”, and like all his works, every page is just a delight, I don’t know how else to describe it.
And our last two questions, what sort of advice would you give to a recent college grad who was interested in going into investing as a career?
INKER: I guess, the first thing I would say is if you’re interested in going into investing as a career, make sure you actually love the act of investing and the act of doing research. Getting into it because you’re hoping to make a lot of money or because there seems to be some glamour in it is a lousy reason to do anything.
For one thing, you never know what the future will hold, but I will say the people who I think have had the satisfying careers I watched are the people who are doing the stuff they really enjoy and that is, I think more important than anything.
Investing can be a ton of fun because you’re continually trying to solve problems.
On the other hand, it is also is an industry where you are going to be wrong a lot. And if you can’t handle that emotionally, if those times when you are wrong cause you to start doubting your self-worth, you are going to burn out.
So you got to love investing as a craft, you’ve also got to have the right kind of emotional mindset or you’d be better off doing something with kind of less manic-depressive highs and lows.
RITHOLTZ: Interesting, and our final question, what do you know about the world of value investing today that you wish you knew 30 years or so ago when you first got started?
INKER: The thing I wish I had known how to do and it is something that I continually have to remind myself to do is whenever you are talking to someone who thinks you are dead wrong about investing, make sure to listen very carefully to what they have to say because there’s probably some truth to what they are saying.
And even if you believe in your heart of hearts at value investing as a philosophical underpinning is the right way to do it, that doesn’t mean people aren’t raising perfectly valid challenges to the way you and others are expressing that.
RITHOLTZ: Quite fascinating. Thanks, Ben, for being so generous with your time.
We have been speaking with Ben Inker, he is the head of asset allocation at GMO. If you enjoy this conversation, well, be sure and check out any of our nearly 400 prior discussions.
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I’m Barry Ritholtz, you have been listening to Masters in Business on Bloomberg Radio.
