The Exchanges

Q So we have a bunch of head scratchers. There's certainly this question of productivity, This question of the impact of concentration and technology, and at the same time, almost more than any time in your tenure at GMO, notwithstanding the late nineties, you've effectively been pounding the table on what you see as a very attractive value. What is that case for value today?

A The simplest case for value, Is that these value companies have a certain amount of undergrowth relative to the market, and they are trading at a bigger discount than you need to, to pay for that undergrowth. Price matters, as I learned from Robert Shiller, price matters with everything. To make it slightly oversimplified, Value stocks traded a discount by definition. Historically, they traded at a 25% discount, and they undergrew by three percent a year, and it turns out that a 25% discount and three percent a year undergrowth allows you to outperform by a point a year. In the more recent period, Where value has really underperformed. The interesting thing is that undergrowth has been almost exactly the same as history. So even though we have Google, even though we have Amazon, the fundamental undergrowth of value companies Hasn't been worse than normal. There have been a couple of other things under the surface that have mattered. One of them, crucially for the US, has been the fact that the dividend income you have gotten from being value has been lower than normal, and that's simply because the US has traded at much lower dividend yields. So the cheaper companies, you just get a smaller increment of additional dividends. There have been a couple of other things going on under the surface, but the key reason why Value was doomed to fail in 2007 was not because Amazon was des…

AI assessment note: “they are trading at a bigger discount than you need to, to pay for that undergrowth”

Q And how long did it go before you realized, hey, this actually will work?

A Well, it took a while. I can remember when we were coming up on my one-year anniversary, and this was quite important to me because I had been explicitly hired for a one-year trial period, and it was just about one year, and Jeremy brings me into his office, and he says, okay, well, we're a little bit late. We normally do reviews and pay adjustments for June 30th, and you know, it's the beginning of August, but Here's what your new salary is going to be. And I said to him, so this means I still have a job? And he had no memory that he had in fact hired me for a year. So once we got through that, I was feeling reasonably good that at least I was doing something of some value. Yeah, that first year was a little bit nerve wracking.

AI assessment note: “I can remember when we were coming up on my one-year anniversary”

Q The history of GMO inevitably comes to this 2000 to 2002 period where business was great, value underperformed for a while, business was less good, and then you had a bounce. What is similar and different from that period of time than where we sit today?

A The similarity to, well, not so much, 2000 to 2002, because 2000 to 2002 was a wonderful period for value. The similarity to the 1994 to 1999 period is this has been another dreadful period for value as a strategy. We see that kind of on a individual stock level. It's also been a lousy period for valuation driven investing at kind of an asset allocation level. Which is what I tend to focus on. So there is very much that similarity. I'd say there is a noticeable difference, though. I was talking to a client not long ago about 20 19 performance, and 2019 was another lousy year for value as a stock selection parameter. But they were very happy with our performance because we had been doing better than value. We weren't doing better than the Broad market, but they said, hey, we have you as a value manager, we're very happy with how you've done, and you're the last value manager we have. So we don't really want you guys to have really good performance, but we'd like you to perform well relative to value. And it is that tendency, the idea that value as a style Feels completely passe, and investors don't really get that concerned about the fact that 90% of the active investment managers they have have a growth bias. That feels similar to the late 19 nineties. A difference, though, is while some of our clients have terminated us after some tough performance, there isn't The anger about…

AI assessment note: “The similarity to the 1994 to 1999 period is this has been another dreadful period”

Q And what do you remember, if you can walk right through, but start with Schiller's class?

A One of the things that struck me, I remember in one of the first classes, he was talking about Investment advice. And he was talking about a call that he received from someone who was pitching an investment idea. And nowhere in the conversation did the concept of price ever come up. And he just said, well, you can't be investing. You can't be thinking about investing until you have answered the question, what is the price that I'm paying for something? And one of the things I love is when somebody says something that is both Incredibly obvious and incredibly clear, and yet you hadn't thought of before. And I was just like, oh wow, yeah, investing, of course you can't do this. Of course no one can tell you whether something is a good investment without talking about the price that you're paying. And time and time again, one of the wonderful things about Bob Schiller and Bob Schiller's work over the years Is how he asks some very simple questions that have, in some cases, not intuitive, but profound answers.

AI assessment note: “I remember in one of the first classes, he was talking about Investment advice.”

Q And how did that play out as you're going through your senior year trying to figure out what you're going to do?

A I wound up taking a seminar from him and asked him to be my thesis advisor for my senior thesis, and so had gotten to know him really quite well. And then at some .1 of the partners at GMO called up David to ask if he knew of any students at the Yale School of Management that he thought would be a good fit for the firm. And David said, no, I don't, but I have this undergraduate that I think you should talk to. And the response was, okay, well, thank you, but we're not really interested in hiring undergraduates. They never had hired anyone straight out of undergraduate, certainly for an investing role. But he talked them into at least interviewing me. So I went up and I interviewed. And as near as I can tell, favorably impressed absolutely no one at the firm. I came back down, and from what I can understand, since I wasn't in the call, Jeremy Grantham, the founder of the firm, called up David, and he was trying to be careful about this because Yale was a very big client of the firm, saying, you know, we interviewed him, seems like a nice kid, but we're really not that interested. So David, being the persistent man that he is, said, well, Talk to him one more time, because if you don't want to hire him now, maybe you'll hire him after business school. So I went up. I interviewed. Once again, I think I favorably impressed nobody at the firm. Came back down. And before they spoke t…

AI assessment note: “I wound up taking a seminar from him and asked him to be my thesis advisor”

Q Even though you mentioned that a lot of the fundamental portfolios are tilted towards growth, we also hear a lot about the impact of large pools of quantitative investing. Why do you think it's the case that more of that quantitative money hasn't sort of normalized these value spreads?

A One of the things about Quants is they tend to naturally gravitate to whatever has worked. If you are a quant, your favorite tool is the back test. And it has now been 12 years that value has underperformed. You are much less likely to come up with a quantitative stock selection technique that is predominantly value, because if you look back, you say, oh, well, this hasn't worked. And so I think whereas a lot of them had very value biased portfolios in 2005 and 2007, they don't. Now, there's also the underlying reality that some of the quantitative managers, ourselves included, do have a value bias. The ones that do have a value bias have not had great trailing one, three and five year performance, and therefore the flows haven't been going there. So you have a tendency for the quants to gravitate away from value. You have a tendency for the money to be gravitating away from value, and that combination means the quantitative investors that have been gathering the money Are in value.

AI assessment note: “You are much less likely to come up with a quantitative stock selection technique that is predominantly value”

Q You know, I like to ask about your biggest investment pet peeve, and, you know, we've talked about the, the lack of illiquidity premium at times, or the assessment of illiquidity premium. Do you have another favorite investment pet peeve?

A Yeah, I think it's the fact that people don't ask why, and they don't ask how. They say, well, you know, Equities give a higher return than bonds. Ok, great. Why do they do that? If it's about a risk premium for depression risk, which I think it is, well, under what circumstances should you expect that that's gonna go away? And if you actually think you live in a world that doesn't have depressions anymore, why do you think you're gonna get paid an equity risk premium? And one of the things that investors tend to get wrong is Their forward-looking return assumptions are driven hugely by backward-looking return analysis. And so, you know, you've got plenty of people who implicitly in their fixed income portfolios are saying, well, I think I'm going to get five, and I think I'm going to get five because that's what they've done over the last 25, 30 years. There is no way to get five out of a fixed income benchmark that is yielding 2.2. It just can't happen. It can happen over the course of a year. But over anything close to the, something similar of duration to the securities you own, it's impossible. And it just comes from the sloppy thinking, not thinking, how were those returns generated? And why were those returns generated? And I think people would avoid so many of the mistakes they make as investors if they just stop and ask why and how.

AI assessment note: “Yeah, I think it's the fact that people don't ask why”

Q Another challenge to value has been the significant shift in the economy towards technology and the disruption of technology across industries. How do you think about integrating the economics of that into any modeling of what would constitute a good value stock or portfolio?

A There's two pieces of that. There is, one is How does that shift impact the economic reality of companies that is not reflected in the standard accounting data? And a number of people have written about that, but we have done a lot of work to try to incorporate as much of that intellectual property and tangible assets into value measures as we can. So there's that aspect of it where it hasn't fundamentally changed anything except it's fundamentally changed what you are trying to measure, and so you better change your measurements. The other piece which is, I think, more difficult in principle for certainly a quantitative process is insofar as the world has changed in a way that means Returns to scale. Are more important. Figuring out which companies are going to accrue the benefits of scale and which are not is hard, and it's not just hard for quantitative investors. I think one of the things we have seen in the, in some of the trials of what's gone on with the Vision Fund is this basic idea that, well, we can determine who is going to be the winner here by throwing a ton of money at one of the competitors. And assuming that that means they will conquer everybody else. And it turns out that the reasons why you will scale do not simply come down to money. And if you were the guy with more money, you will win. So it's not that this makes it easy to do investing of one kind and no…

AI assessment note: “try to incorporate as much of that intellectual property and tangible assets into value measures”

Q questions, but before we do that, I want to ask you a question that I imagine you get a lot. Which is, if you had a nice-sized pool of capital, it could be for an institution, endowment foundation, pension fund, it doesn't matter, and asset prices are where they are today, maybe there's a liquidity premium, maybe there isn't, how would you think about it, and what would you do?

A So I think the first question you need to answer to be able to answer that is be serious about what do you think you're really good at? If I am sitting down across from you, Ted, and you can say, you know what? I've got a lot of experience. I think I am really good at finding extraordinary managers. Then the answer is, how do I structure my portfolio so that I'm going to get the maximum benefit of finding those extraordinary managers, and the interquartile range of returns is wider in most of the illiquids than it is in liquids, so maybe you, Ted, should have a lot of money in illiquids, and then the question is, how much can I afford to have in illiquids, and let's be serious about it. You do not want to find yourself in the situation that some institutions did in 2008, where They thought it was fine to be 75% illiquid assets, and it turned out it wasn't. So once you've decided what you think you're really good at, the second thing is be serious about what risks you can afford to take and what risks you can't, and make sure you are not running a portfolio that is taking risks you can't afford to take. Otherwise, there's a lot of differences. People assume that every investor is kind of in the same boat, but the reality is the world for A foundation that is not going to have any future cash flows is different from one that is going to be having future cash flows. The world of, …

AI assessment note: “the first question you need to answer to be able to answer that is”

Q Are there any other risks that you think are important if you're able to get past the behavioral challenges in a time like this?

A The markets and economies holding together Today does depend on government action in a way that is almost unique. Government stepping in really helped the financial crisis not turn into a depression, but what we have seen is Normal depressions end themselves, even without that much help. I mean, there's the human toll is, can be horrific, but they do end. This kind of sudden stop in the economy is really outside the realm of historic comparison. Frankly, governments are the only entities that have the capacity to do what needs to get done. So we are reliant on the government to do the right thing, which is always a little bit scary. The good news is the right thing isn't necessarily super complicated. It just requires people to say whatever my normal beliefs are about the role of government. It's got to be different right now.

AI assessment note: “markets and economies holding together Today does depend on government action in a way”

Q years out, you end up with highly concentrated industries, and certainly Jonathan Tepper's argument, we have that, not just in the tech companies, but really across the board, some of it due to regulatory ease, some of it from natural monopolies. Even if the growth slows, do profit margins in those businesses inevitably settle out at a higher level than other companies just because of the concentration in the industry?

A Yeah, I'd say that's probably the most important question in trying to decide what the U.S. stock market is worth these days. There is no question the gap between the biggest companies and everybody else in their industries, the gap in profitability has widened very significantly, and that widening has been much more pronounced in the U.S. than it has been elsewhere. And that's true, as you say, for the tech giants. It's true across other industries as well, and if you look at it, I'd say the most obvious thing is the US has been most accommodating of major economies to companies that want to aggressively expand. We did that because we had a very straightforward view of the dangers of concentration and monopoly power, kind of the underlying Bork doctrine that what matters is Where this impacts consumer prices. I think, frankly, some of the mergers that have been allowed to occur, you still scratch your head as to exactly how did we decide this was unlikely to impact consumer prices, but it's allowed more or less free rein in areas where the business does not directly charge consumers. I'd say the great uncertainty about what's going to happen in the next 20 years On the academic side, we are increasingly seeing the evidence of what other harms there are to the economy from increased concentration and monopoly power beyond simply consumer prices. So I think antitrust is going to…

AI assessment note: “the gap between the biggest companies and everybody else in their industries, the gap in profitability has widened”

Q And what are those things today as you look at sort of your portfolios, the inputs that go into those models of what it is that investors dislike that constitute attractive value?

A Certainly, if you look at what has been dominating performance in the market, and therefore in people's portfolios, it has been a wonderful time to be a dominant company. And the gap between the underlying fundamentals for big dominant companies relative to the also runs has gotten really big. Now, the area where I think there is something to really exploit about that is when you can pull apart The difference between what has happened historically that has accrued to the benefit of these companies and what will happen going forward that will accrue to the benefit of these companies. Google has a great business. It has a wonderfully scalable business. On the other hand, what they have, at least today, is an advertising business. Google has been able to grow extraordinarily fast by taking share from every other kind of advertising that has happened. The underlying fundamental truth that advertising grows with GDP has not changed, and as their share of advertising gets bigger and bigger their ability to outgrow Gets compromised. They are not going to be able to outgrow forever unless they fundamentally change the way they make money. Google's just this nice, easy example. I don't actually think that Google is necessarily that mispriced today, but being able to pull apart the difference between This is what happened historically, and I am going to extrapolate this into the indefini…

AI assessment note: “In the US you have definitely paid up for growth.”

Q That's a great broad context for thinking about investing. Where along the way did you find your own footing? In the activities you were doing within GMO that drove your belief in why you're going to get paid for what you're doing?

A So much of it comes from stepping back from what you are doing for a moment to just ask, why am I doing this? And I think A lot of what I have learned over the years, not surprisingly, having spent 28 years working with Jeremy Grantham, an awful lot of what I have learned has come from Jeremy Grantham, but some of it has been the explicit teaching, but a lot of it has been, Jeremy is asking me to look at this, rather than just looking at this and doing this analysis and giving it back to him. Why do I think he is asking me to do this? And it's the why questions and frankly the how questions that I think have been most valuable to my understanding of investing and are where I feel like at this point since I'm no longer that capable of doing the direct research myself. Our research infrastructure has passed me by, and I no longer have the requisite skills. But where I feel like I can be helpful to the analysts that are actually doing the direct work, it is by continually prodding at, well, why? Why this? Why that? Why do you think that this effect you are seeing is there? And what are the implications in terms of Other tests you could do to answer the question of, yeah, this is actually why this works. I don't know how you can get confident in any finding until you can answer the question, This is why I believe this thing should work. This is why my analysis of the, I don't know,…

AI assessment note: “having spent 28 years working with Jeremy Grantham... asking me to do this?”

Q Are there any others from Schiller that you remember over the years?

A Certainly the original idea of the cape, which again isn't even quite his idea, it is him just saying, well, we should really try to do this systemically, and the understanding to be able to pull apart the, what are the cyclical factors impacting earnings versus what is the underlying trend, and How do we try to make sense of that? And I remember one of the things, kind of embarrassingly stupid mistakes that one makes in trying to think about investing, I did this research piece on oil when I was taking this seminar from Jim Tobin, and we were just talking about, well, what should happen to the price of oil at The gas station, if there is a sudden supply chalk, right? So there is no more oil coming from Saudi Arabia, but you've got all this oil that you paid As the gas station owner, 20 dollars a barrel for, and now suddenly the price of oil has gone to 60 dollars a barrel. Should you raise your prices instantly? Is that profiteering? I was struggling with, well, is it, is it not? I don't know. How do I come up with a consistent way of thinking about whether something is a fair price or not a fair price? And it was one of those wonderful ways where Tobin was able to Teach simply the profound concept of replacement cost. The way to have a simple way of determining, is this a fair price or not? It doesn't matter what you paid. It doesn't matter what you will pay tomorrow. It is, …

AI assessment note: “Certainly the original idea of the cape, which again isn't even quite his idea”