Demystifying the World of Value and Asset Allocation in a World of Great Uncertainty
In a virtual event co-hosted by investment management firm GMO, Hubbis invited a group of 22 wealth management experts across Asia to ‘Zoom’ in for a discussion on where investors can locate value in a world in which uncertainty has not been more elevated since the end of World War 2. Is there value in the developed markets, or in the emerging markets, and if so, where, and what are valid allocation policies? The discussion was led by Ben Inker, the Boston-based head of GMO’s Asset Allocation team and a member of the GMO Board of Directors, and by his colleague Matt Kadnar, a member of GMO’s Asset Allocation team. Their mission was to offer their perspectives on what has changed since the pandemic struck, and what the world of valuations and asset allocations might look like as we all try to peer through the mists of Covid-19. The experts from GMO spoke at length and in considerable detail to our 22 hand-picked Asia-based wealth management experts, who represented leading banks and wealth firms in prominent roles such as that of CEO, CIO, Head of DPM, and Chief Economist. The discussion was both remarkably timely and highly illuminating.
Key Observations from GMO’s Asset Allocation Team
Five years in five weeks – the major rally has exceeded fundamental growth
On March 23, GMO’s Asset Allocation team assessed that based on the global valuations of the March 20 market nadir, annualised returns of 5% or more were thoroughly feasible for the universe of large capitalisation value plays across the developed and EM universe (except for large cap US stocks), even based on an anticipated economic downturn double that of the global financial crisis, in other words a GDP hit of 8% and recovery to begin at least two years later. But the rally from March 23 saw five years of gains compressed into five weeks, by the end of which the generalised return outlook had actually turned negative, according to GMO projections.
‘Comfort’ drove valuations ever higher through early 2020, but GMO’s Asset Allocation Team never felt comfortable
GMO’s Asset Allocation team analysed why investors, especially in the US markets, had for some years been prepared to buy into ever rising, and historically extremely high valuations. They summarise the psychology as ‘comfort’ – investors liked what was a fairly predictable world with stable, low inflation, stable GDP, high profitability, even if growth was not so dynamic, with those key factors accounting, GMO’s Asset Allocation team believes, for 90% of the valuation ‘comfort’. But the team never felt comfortable with that outlook, and today sees a vital difference – real uncertainty. Inflation remains low and likely will for some time, but the unprecedented global monetary and fiscal responses to combat the economic damage of Covid-19 and potential supply chain constraints could lead to a less benign inflation environment. GDP growth most certainly is not stable and will remain susceptible to a wide range of outcomes until the health situation improves globally. Finally, profitability has been hit for even the strongest companies in the current recession. These conditions make GMO’s Asset Allocation team very nervous, especially as current investor behaviour remains, in their eyes, rather illogical and excessively hopeful.
In a world of doubt and wide valuation disparities across regions and styles, GMO’s Asset Allocation team believes value should prevail
GMO’s Asset Allocation team therefore thinks that with uncertainty in such abundance, investors should demand to see reasonably priced assets in order to want to take risk. But that is generally not the case in the main markets, except in traditional value stocks, and selectively in the world of EM. However, some sectors, segments and markets that have under-performed the S&P500 for many years now offer some of the cheapest levels GMO has ever seen, and, if researched properly, provide some of the more extreme discounts to the broader markets GMO has witnessed for a long, long time.
But is a return to value a broken concept today? No, far from it, says GMO’s Asset Allocation team
Value won out in the long 26-year spell from 1980 to 2006, but from 2007 to the present day, value has underperformed, especially in the US markets, trading at bigger and bigger discounts to the market. Those wider discounts were not justified based on weaker fundamentals from value companies which ‘undergrew’ the market at their historical levels. Accordingly, just for value to again win out, value simply needs to stop getting cheaper, and does not require much of a reversal. Value‘s relative income benefit and rebalancing effect should continue to act as tailwinds.
With value at the core of the allocations, 5% real returns are potentially back on the table
GMO’s Asset Allocation team believes that with the right strategies, portfolios leaning into global value exposures (both long stocks and alternatives) can deliver between 4% to 5% a year better than traditional balanced portfolios without taking on board much beta, by allocating around 25% to EM, almost all Asian equity, and with a significant deal of long/short equity exposure (41% of the allocation).
GMO’s Benchmark-Free Allocation Strategy anticipates economic weakness, but leaves door open to V-shaped recovery
GMO’s Asset Allocation team does not expect a V-shaped recovery, as apparently so many investors do, particularly in the US markets, and therefore expects markets to drop from recent levels [the discussion took place in late June]). But a carefully constructed, diversified portfolio of long-only EM allocations , weighted heavily to North Asia and to some extend SE Asia, long/short equity exposures positioned to capture value spreads globally and select alternative and credit positions is a winning combination, the team believes. For example, EM value is available at a significant discount to book value, at under 9x earnings and with a dividend yield of close to 6%, all with ROEs better than normal for value stocks.
Diversification – Asia plays a large role in the GMO Benchmark-Free Allocation
The GMO Benchmark-Free Allocation Strategy currently is approximately 25% weighted to equity, almost all of which is EM equity and 75% of which is Asian equity, then 41% in equities long/short, 19% in alternative assets, 14% in fixed income and a tiny portion in cash. EM in total is roughly one-third, represented by 24.5% Asia EM equity, a further 5.3% in EM equities long/short, and 3% in EM fixed income. Meanwhile, the US is represented only by 5.9% in US Small Value, and other developed market equity risk represents less than the overall EM exposures. Developed ex-US is roughly 19% via long/short, and as GMO favours Japan in that developed segment, Asia is well above the roughly 33% represented just by Asia EM.
GMO’s suite of customised portfolio solutions
GMO told delegates how the firm works with clients to customise solutions, taking its core benchmark-free asset allocation framework as the base, and then leveraging that for institutional and asset management clients globally to suit their precise needs. GMO does so this across a range of different types of portfolios and asset types. To achieve this, the firm works with the clients to analyse their precise objectives in terms of expected returns, the beta, correlation, volatility, and drawdown characteristics, as well as constraints such as leverage, liquidity, and vehicle, and also how any customised solution fits within the overall clients’ portfolios.
Customisation and dynamism combined
GMO explained that customised portfolios shift allocations based on changing conditions from both a top down allocation perspective and, more so, within underlying investment strategies which are managed with various goals and processes.
The QE tsunami is one of the vital organs of uncertainty
Responding to a delegate’s question about the gargantuan levels of QE since the pandemic hit, coming on top of what had already been wave after wave of QE since the GFC, GMO’s Asset Allocation team explained that in such a universe, one in which negative rates prevail as a result, all assets will return a lot less than in recent history. Moreover, GMO’s Asset Allocation team does not see equity prices generally repricing to higher levels to reflect the lower or even negative fixed income returns.
And what about QE-inspired inflation?
A major element of the murkiness ahead is whether there will be inflation, rampant inflation or possibly a continuation of what GMO’s Asset Allocation team remarked is the inexplicably low or no inflation of the past 12-15 years. Whatever the outcome – and GMO’s Asset Allocation team genuinely does not feel confident in predicting what will happen to inflation, or not – GMO’s Asset Allocation team does not believe in the story that the US markets will be ‘exceptional’ and survive this crisis unimpaired. The team does feel strongly that higher levels of inflation in the mid- to long-term are a possibility and would impair the compounding ability of traditional portfolios carrying significant duration in both bonds and stocks, which are long-duration assets.
Contrarian views? Well, actually, today there really is no normal any more…
GMO’s Asset Allocation team was amusingly tongue-in-cheek during the discussion when commenting that believing in value is these days itself a contrarian view, it would seem. And espousing any belief that non-US equities somehow deserve to be in the same asset class as US equities and might someday outperform them seems to be even more radically contrarian, they remarked. But GMO is sticking to its guns.
GMO – a determinedly contrarian value-seeker
Mehak Dua opened the discussion. As a member of GMO’s Global Client Relations team located in the Singapore office, she highlighted GMO’s history dating back to 1977, when GMO was founded as a private partnership whose sole business is investment management, as it is today. One of the co-founders is Jeremy Grantham, a well-regarded value investor often quoted in the media. GMO’s quarterly letters and the 7-year forecasts produced by GMO’s Asset Allocation team are widely read in the industry.
The firm manages global portfolios with offices and clients around the world. Investment offerings include equity, fixed income, multi-asset class, and alternative strategies. GMO is known for blended fundamental and quantitative investment research expertise and a long-term orientation toward value opportunities. GMO is currently managing USD66 billion* of strategies from its HQ in Boston, from where the teams work closely with the firm’s six different locations around the globe.
“As a private partnership,” Dua reported, “our sole business is that of investment management, and we take only the longer-term view. GMO is willing and able to take and hold significant and unconventional positions when we see markets move to extreme valuations. We take a contrarian value investment approach to identify and exploit opportunities, and the rationale behind this approach is that economic reality and investor behaviour cause securities and markets to overshoot their fair value. We focus on compounding wealth for our clients by identifying mispriced opportunities and then exploiting them in a systematic and disciplined way.”
She also highlighted the firm’s differentiated research, explaining that GMO counts as clients some of the most prestigious and sophisticated investors globally. “We are well known for our candid, academically-rigorous market insights and advice that underpin the research that we undertake,” she explained.
She added that GMO has had a presence in Singapore since the early 2000s. “My keywords for you today are that GMO is value-sensitive, long-term in outlook, and often contrarian.”
Ben Inker then took the microphone, explaining that his mission for the event was to explain GMO Benchmark-Free Allocation Strategy’s actual and anticipated positioning during and following the pandemic, albeit acknowledging uncertainties surrounding its length and impact.
Inker is head of GMO’s Asset Allocation team and a member of the GMO Board of Directors. He joined GMO in 1992 following the completion of his BA in Economics from Yale University. In his years at GMO, he has served as an analyst for the Quantitative Equity and Asset Allocation teams, as a portfolio manager of several equity and asset allocation portfolios, as co-head of International Quantitative Equities, and as CIO of Quantitative Developed Equities. He is a CFA charter holder.
He first referred to GMO Asset Allocation team’s expected returns as of the market low of March 21, pointing to two lines for anticipated return across the two basic scenarios for equities, the partial mean reversion and the full mean reversion scenarios.
5% plus returns ahead? Yes, but that was back in late March
“In short,” he said, “we then thought equities should give you a return of 5% to 5.5%, in the long run, to account for the risk, and across the board, from large-cap to EM stocks. With the single exception of US large-cap stocks, which came into this crisis the most overvalued of all the major asset classes we can find around the world, all the classes we saw as of March 23 looked set for a combined up to 5.5% per annum performance.”
This, he elucidates, was based on March 20 valuations, when everything around the world of equity looked to be fair value or cheaper. “That got us pretty excited,” he enthused, “as we really haven’t had opportunities where we have seen asset classes at fair value or cheaper in the last several years and these forecasts were already taking into account our expectations of the likely hit that assets would take from the coronavirus event.”
On the pandemic itself, Inker added that GMO Asset Allocation team’s base case scenario has been a downturn that is approximately twice as severe as followed the Global Financial Crisis, when US GDP fell just under 4% from peak to trough, and it took two years for GDP to return to its previous peak.
“What we are effectively assuming is around the world on average it is going to be about an 8% fall in GDP and again about two years to recover,” he explained. “It is possible that we could get a quicker recovery than that, and it is also possible that we might get something deeper and longer lasting, I will come to that in a while.”
5% plus returns today? Not since the rally
“We did some buying back in late March,” Inker explained, “but at the same time recognised that risk assets would struggle to make sustained progress until the many uncertainties are cleared up. By May 31, after the markets had rallied, we looked at the same criteria again and a very different picture appeared. By then, the US markets were all priced to deliver negative returns and international large-cap developed market stocks were priced to deliver a very unappealing 1.5% return. But the one standout is the EM value equities, and that is where we are most excited about taking equity risk.”
“The core view,” Inker explained, “is that after the rebound, most global equity markets are not pricing in a sufficient margin of safety for the great uncertainty that remains. After modelling the impact of various economic environments on our forecasts and portfolios, we decided to de-risk our multi-asset class portfolios; we positioned them to be robust to several possible economic outcomes and importantly far less exposed to threat of large drawdowns. In mid-May, we therefore reduced net equity exposure of the Benchmark-Free strategy by 30% and now have a 25% long equity position in emerging market value stocks.”
The resultant benchmark-free allocation strategy ended up at approximately 25% equities, 41% equities long/short, 19% alternative strategies, 14% fixed income and 2% cash or equivalents.
Within each of these categories, the 25% equity was 24.5%, or virtually entirely, EM, while the 41% equity long/short comprised EM 5.3%, Developed Ex-US 13.6%, US Small Value 5.9%, Developed Ex-US Small Value 5.3%, Cyclical Focus 2.4%, Special Opportunities 3%, and ACWI ex-U.S. Equity Extension 5.3%.
Alternatives, representing 19% of the allocation, housed Event-Driven 4%, Systematic Global Macro 10.1%, and Fixed Income Absolute Return 4.9%. And Fixed Income at 14% comprised High Yield/Distressed 5.4%, EM debt 3.1%, and ABS/Structured Products 5.1%.
Inker reported that although looking at the S&P500, valuations today are similar to those at the end of 2019, GMO’s advisability on taking equity risk is significantly lower. “Why are we so much more nervous now?” he asked. He then pointed to a chart based on a model he and Grantham had built back in the late 1990s trying to explain market valuations. “We knew that historically expensive markets have a tendency to perform poorly going forward,” he reported, “but we also sought to discover why investors were so willing to invest at high valuations.”
When comfort becomes uncomfortable
And the word GMO’s Asset Allocation team found to epitomise this was ‘comfort’. “What investors like is not necessarily fast growth because fast growth implies pretty fast change,” he elucidated.
“What investors like is a predictable world. From an economic perspective what they really love is stable low inflation, stable GDP, and high profitability, and it is those three factors that explain 90% of the valuation of US markets going back to about 1925. So, in early 2020 we saw a very expensive market, but one that offered investors ‘comfort’, as, despite high prices, there was no particular reason to assume it was going to fall apart anytime soon.”
Uncertainty reigns, nervy times ahead
But the vital difference today, Inker elaborated, is uncertainty. “We do not know if it will be inflation ahead, or deflation, as we see evidence of both,” he explained. “There is an utterly unprecedented amount of monetary and fiscal stimulus around the world that may lead to inflation down the road, whilst we are also, of course, seeing the greatest fall in GDP since World War 2, and we are seeing ROEs around the world in the process of plummeting. All of the factors that were in place early in 2020 that made it seem like this was a market that was going to trade at a high valuation no longer exist. The result is we are quite nervous.”
He added that in the past decade, valuations in the S&P500 had been consistent with a bubble, but the behaviour less obviously ‘bubbly’. “Yet today,” he observed, “we are seeing a lot of evidence in the US of some of the kinds of craziness in stock markets that hadn’t really been there.”
He noted how Tesla is now the world’s largest automaker, and how the company Nikola has a market cap greater than Ford, despite being a pre-revenue manufacturing company, pledging at some point in the future to build electric trucks, but yet to build a working prototype let alone anything that they could sell. Yet after a reverse takeover and listing recently, the stock went up over five times.
“And we see a bankrupt company in the form of Hertz rising massively on a recovery bet that seems essentially impossible to realise,” Inker observed. “In short, we are seeing all this at a time where there is more uncertainty than frankly at any time in my long investment career, or even in Jeremy Grantham’s even longer career.”
Doubt means value should prevail
Accordingly, he reported that GMO’s Asset Allocation team thinks that with such uncertainty, investors should demand to see reasonably priced assets in order to want to take risk. “But we are not generally seeing that in the broad markets today,” he cautioned, “we are really only seeing it in traditional value stocks and in the world of EM.”
He referred to a chart to prove this point, highlighting the region-specific spread between the US and non-US markets which are, he explained, “really quite cheap”, having underperformed for now close on a decade.
“For those markets that have under-performed the US for many years,” Inker reported, “we are at or around the cheapest levels we have ever seen, and the most interesting - albeit somewhat risky - area to invest in right now is smaller cap value stocks, which everywhere around the world are trading at really quite extreme discounts to the broader markets.”
The next question, he explained, is to address whether value is actually broken. Referring to papers on the GMO website, he explained that the period 1980 to 2006 was fairly good for value, but from 2007 to the present day, value has underperformed. Notably in the US markets, he explained, the income advantage of value has shrunk, in fact, it has halved because of the high valuations of the overall market.
Value is not static
He then observed that value is not static. “What we have seen is over the last 13 years is that value stocks have traded at bigger and bigger discounts to the market, and as that happens there is less scope for the rebalancing to operate in your favour,” he explained. Value’s smaller than normal rebalancing effect and a widening discount of relative to the market have been the larger drivers of its recent underperformance. Yet in order for value to win again, we simply need it to stop getting cheaper, and that does not require much of a reversal, so we are really quite comfortable with the idea of being long value against the broad market as a pretty good way to make money.”
5% returns back on the table
Inker extrapolated that value stocks are priced to deliver somewhere between 400 to 500 basis points a year better than the broader market currently. “As a result we think we can get about 500 basis points a year in equity-like return without having to take so much beta by turning a good deal of our equity exposure into a long-short,” he clarified.
He then highlighted GMO’s Benchmark-Free Allocation strategy, pointing to an end May allocation that was clearly defensive, but that allowed considerable leeway for a V-shaped recovery. “We are worried that the world may very well be disappointed because it looks to us as if the equity market has very much priced in only the V-shaped recovery, and while that is a possibility we do not think it is the most likely outcome. In fact, we actually believe the markets almost certainly have to go down from here.”
He did however highlight the value GMO’s Asset Allocation team sees in EM and explained how the team has built in disappointments to its theories.
“The EM markets are priced for some bad times ahead due to the pandemic, so we believe it makes sense to take the risk in the emerging markets,” he stated. “The equity book we own in the benchmark free strategy is trading at a significant discount to book value, at under 9X earnings with a dividend yield of close to 6% and with ROEs better than normal for value stocks. When stocks are very cheap, it makes sense to take the risk of bad outcomes because the bad outcomes are not a particularly negative surprise. Whereas in the developed markets, frankly, we are very worried that the likely outcome here is going to be a negative surprise, so as a result in the rally, we have taken a lot of that risk off the table.”
GMO’s customised portfolio solutions
At that point, Matt Kadnar took over, to explain more about how GMO works with clients to customise solutions. Kadnar is a member of GMO’s Asset Allocation team and a partner at the firm. Prior to joining GMO in 2004, he was an investment specialist and consultant relations manager at Putnam Investments. Previously, he served as in-house counsel for LPL Financial Services and as a senior associate at Melick & Porter, LLP.
“Essentially,” Kadnar explained, “we take our asset allocation framework, and leverage that for our clients to suit their precise needs. And we do this across a range of different types of portfolios, equity, and some multi-asset portfolios that incorporate alternatives or hedge funds, and also customised solutions directly in the alternatives or hedge fund spaces as well.”
To do so, GMO works with the client to analyse the objectives in terms of expected returns, the beta, correlation, volatility, and drawdown characteristics, as well as constraints such as leverage, liquidity, and vehicle. “And we also like to assess how a customised solution fits within the overall clients’ portfolios, whether the custom solution is designed as return generating, defensive, or perhaps a diversifier.
Kadnar then offered the delegates several examples. The first was a dynamic multi-asset portfolio, with some key objectives, including an absolute return of CPI+4.5% over rolling 3-5 year periods, realised volatility half that of global developed equities, beta to equities (50% Global, 50% Australian) of less than 0.4, and high liquidity (80% in less than 30 days).
“This is designed for an Australian superannuation fund for a multi-asset portfolio. The outcome was 51% in equities, with 28% EM and 23% developed markets ex-US (due to concerns about high valuations), 29% alternative strategies (EAFE, US small cap value stocks, and absolute return fixed income), 13% fixed income and 7% cash or equivalents. He added that the strategy hedges all of the non-equity exposures back to AUD, implying that they are short about 50% Australian Dollars in this portfolio. “The Aussie being a high beta asset, it gives us a little bit of flexibility,” he explained.
Case study two was an alternatives completion portfolio with a return objective of cash +4% net per annum over rolling 5 years, a risk objective of 6-10% over rolling 5 years, an expected equity beta of less than 0.3, an expected fixed income beta of less than 0.4 (both of which are 5-year beta ex-ante), and liquidity of greater than 50% within 1 week, and less than 15% longer than 1 year. GMO’s proposed portfolio comprised 30% fixed income absolute return, 10% equity volatility selling, 15% event driven, 10% credit opportunities, and 30% systematic global macro.
“This is designed for an institutional investor as a completion portfolio for their overall alternatives’ portfolio structure,” Kadnar elucidated. “They have two other alternative managers, one more alpha-oriented, the other a trend-following strategy designed to be more defensive. So, we built this portfolio to complement those existing hedge funds. The result for us was derived from a combination of our core strategies which are long-tenured, alpha-oriented strategies, without structural beta.”
He explained that the underlying portfolios are very dynamic, with allocations changing against conditions both current and anticipated, and dynamic at the top level as well. “For instance today I have described our normal allocation, in which we have reduced the allocation to equity volatility, we have reduced the allocation to event driven strategies, while we have increased to the allocation to the core or alpha strategies in order to increase the defensiveness and lower the overall beta of the portfolio.”
Kadnar then ran the delegates through two other case studies to further illustrate the customisation available to different types of clients set against a different set of prerequisites. One was a best beta/best alpha multi-asset portfolio for a US pension plan, and the other was for an income-oriented strategy for an Asian insurer, with the key goal to achieve an approximate 5% payout level.
In summary, Kadnar highlighted how GMO will curate these types of customised portfolios for clients worldwide based on client expectations and the positioning of the portfolio within their broader mandates.
The QE tsunami – what does it mean?
At that point, the discussion opened to questions from the delegates. The first was to what extent the extraordinary policies of the central banks of the leading economies around the world, including unprecedented QE, will impact future returns.
“It is at the heart of the great uncertainty we face,” said Inker.
“It is quite possible that we are in a world of zero interest rates for the indefinite future, and in that world, one thing is clear – portfolios are simply going to make you less money than they used to. The fixed income portion of your portfolio will make a lot less. The risk asset portion of your portfolio will make you less as well because they will generally reprice to higher levels to result in lower returns. We used to refer to that or frankly a less extreme version of that scenario as ‘hell’ on the grounds that it was simply going to be impossible to achieve the returns that most investors assume they are going to get in the long run.”
The key issue for central bankers, he elaborated, is that cheap money for too long will result in inflation. And as low or falling and later even negative rates have been coming in waves since the GFC, and much of the developed world never fully healed from that, the only likely driver of higher rates will be inflation.
“The fact that trillions and trillions of dollars have been printed and, unlike during the GFC, this time that money is out to people to get spent,” Inker added. “I really cannot say how long it will take to translate to inflation, and how severe that will turn out to be, and, honestly, nobody knows why inflation has been so low for 15 plus years, or perhaps if that will persist. What we do know is bond yields below 1% in the US have only just arrived, whereas Europe and Japan had them some long time ago, and in neither case did equity valuations zoom far higher than historic levels. So, I question whether negative or extremely low rates will in the US translate to higher equity valuations, I think there is misplaced optimism on that. I think the US ‘exceptionalism’ is unlikely to survive this whole episode.”
So, what makes GMO contrarian?
“Still believing in value makes you something of a contrarian these days,” Inker quipped, replying to a delegate’s question on what positioning makes GMO contrarian today. “And any belief that non-US equities somehow deserve to be in the same asset class as US equities and might someday outperform them seems to be contrarian as well.”
But actually, he added that from the GMO standpoint, the firm is not always out of step with what other investors are doing. “It is just what we are trying to do is make sure that our investment views are driven by our understanding of the expected cash flows and riskiness of the assets that we are dealing with, not falling in love with or out of love with any particular asset,” he commented. “So, at any given time there is probably going to be something about our portfolio that’s going to look meaningfully different from what you see from the average investor, who in the recent years has been quite enamoured of the US and growth and large caps, and frankly at this point we are not.”
He recalled that, back in 2009, GMO’s favourite group of stocks around the world was US large cap, growth-oriented companies then considered cheap by the firm. “They have done very well and are certainly no longer cheap,” he stated, “so we are no longer quite as in love with them. But there is an interesting risk adjusted return because they are less risky than other equities, yet they are no longer the equities to deliver the best returns around the world.”
Gold – not much lustre for GMO
Inker also addressed the role of gold in a world of colossal QE. “There is no yield on gold, I have great trouble forecasting it as it has little or no economic utility, and therefore we have trouble allocating to it,” he explained. “That does not mean it is not a valid investment, but my job is to try to invest in assets that we think we can forecast and for gold we cannot.”
What does value diversification look like today?
A delegate asked about diversification. “Our portfolios are generally pretty diversified across both countries and sectors,” Inker replied. “Our EM portfolios are concentrated in Asia, which of course is about three quarters of the total market cap of the EM world. It is also the region doing best with the pandemic."
Kadnar added that GMO has been able to build a broadly diversified allocation in the world of EM, such as Chinese telecoms, Taiwanese semiconductors, Brazilian utilities, South African financials, Russian energy, and so forth.
Inker reported that the biggest EM equity holdings are China, whether listed in Hong Kong or in China itself, followed by Taiwan and Korea. “China is a giant market, it is not stunningly cheap, but the spread of value is wide, so there is plenty of cheap opportunity there, and the same is true of Taiwan,” he elucidated. “We are generally keener on East Asia than South Asia, and we have been underweight India largely on valuation grounds for quite a while, but we do see stocks worth owning kind of in some of the smaller Southeast Asian countries.”
He added that in GMO’s international developed portfolios, the firm likes Japan. “It is the one place where profitability really did seem to be improving in recent years and unlike the US in what appeared to be a sustainable way,” he reported. “With some of the lowest PEs we have seen in a while, very low leverage and lots of net cash, Japan is high on our list, although we do also like certain value stocks in continental Europe as well.”
From a sectoral perspective, Inker elucidated, value is to be found everywhere, so GMO is value centric. “The spread of value across sectors,” he reported, “is particularly wide now, and has widened substantially this year given due to vulnerability associated with the coronavirus-inspired shutdown. Actually, we have accordingly built a new portfolio run by our focused equity team, called the Cyclical Focused Portfolio, which is concentrating the portfolio specifically on those industries that have been hit hard.”
He explained that this team is seeking out value in industrials, transportation and financials where there are high-quality businesses but impacted cyclically, yet able to recover when conditions improve, as they will, at some point.
“We took a similar perspective in 2009 in the aftermath of the GFC,” he noted. “In this instance, we are carefully selecting those companies that are strong enough to survive the downturn and where the longer the downturn is, the more they can turn that to their advantage by stealing a march on their weaker competitors. We are quite diversified across sectors and countries; we like some of the cheap sectors such as the banks, some industrials and consumer discretionary. We are prepared to take moderately sized bets.”
What can go wrong with tech?
In the context of the S&P500 rallies in healthcare and tech, an audience member asked what GMO considers the biggest macro risks for technology at this time.
“The biggest risk is the spectre of regulatory and antitrust developments,” Inker responded. “In general, these are companies that are fantastically profitable because they have built themselves into monopolistic like positions and have been able to exploit that to make a lot of money. We are seeing that as more of a societal and economic downturn occurs, they are becoming even more dominant, so depending on which administration is in power, change might come sooner or later. The next two decades are unlikely to be as friendly as the past two decades.”
But he added that relative to a highly value S&P500, tech names do not appear what he terms ‘insanely’ valued. “Actually,” he remarked, “they are valued reasonably under the assumption that their profitability can be maintained and that their growth will continue. And that is a distinct possibility if left to their own devices. The question then is to what extent they are going to be left to their own devices in the future.”
The discussion closed with delegates returning to their home offices to mull over the detailed slides and the forthright presentations that GMO had offered. As they did so, and in the days since, there is nothing to determine that uncertainty is lifting any time soon. The job of an investor and wealth manager has in many ways, never been more difficult. The stellar rally has already passed, in just weeks after the March 21 trough, and the next steps will have to be taken very cautiously indeed. GMO clearly believes that the economies and profits will underperform the widespread optimistic expectations amongst investors, and, if that is indeed the case, the quest for true value will be even more essential.
The views expressed are the views of Ben Inker and Matt Kadnar through the period ending June 2020, and are subject to change at any time based on market and other conditions. This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
* As of 28 February 2020
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