In this frank interview, MarketFox columnist Daniel Grioli speaks with veteran investor Jeremy Grantham, founder of asset management firm GMO, about how he got into the investment industry, the possibilities of a melt-up and the impact of Trumponomics on Emerging Markets.
Daniel Grioli: Today we have a very special guest on the i3 podcast. To many of our listeners he needs no introduction but for some of you we will introduce him anyway, it is Jeremy Grantham, he is the chairman and founder of GMO, an asset allocation and investment strategy group based in Boston. I was going to introduce Jeremy as chairman and founder but he corrected me and said that his title is more accurately chief bullshitter and propagandist. One that note, I’d like to introduce Jeremy to the podcast.
Jeremy Grantham: Hello, nice to be here.
Daniel Grioli: Thank you very much for joining us. We like to start our podcast by going back right to the beginning, and it would be interesting to find out a little bit about your journey and how you became an investor?
Jeremy Grantham: At weekends, my family in South London had some very good friends up the road, and he worked for a European wide scaffolding company and he was head of marketing. And he always told a good story like most long term employees. And I thought that would be a good idea to invest in his company; it was clearly going to take over the world. And it was called ACRO Engineering. And at 16 years old I had a home safe account where for the last 15 years I’d been putting my half crowns and occasional 10 shillings in this little box and then I take it down to the bank, and they’d open and stick it in my passbook and stamp it.
Jeremy Grantham: So I arrived, without any discussion with my parents, I arrived and said could I speak to the bank manager of our little local Barclay’s bank, and he was quite entertained by the idea, and I said “Could I use my home safe account to buy some stock?” He said no one had ever don’t it before but there was no reason he could think of why not. And so I used up most of my money to buy some ACRO shares. And eight years later, I was off to Boston to Harvard business school, and the shares had pretty well, not outrageously well but maybe had doubled in eight years, and I sold them to my mother at a slight discount. And she also had got a small holding, the company that went bankrupt, which makes you feel pretty bad as a son, but it wasn’t a bad trade.
Jeremy Grantham: From 16 years on, I was thinking about investing and did quite a bit while at business school with a few friends. And immediately afterwards I went into management consulting only to discover that my friends in the investing business were having much more fun. And so after a rather painful 18 months, I transferred to investing and came from New York back to Boston working for a mutual fund ground.
Daniel Grioli: Who would you say were your early mentors or influencers during that period?
Jeremy Grantham: Well, at an even earlier period, I was brought up by my grandfather, my father died in the war before I met him and my grandfather was born a quaker and even though he gave up on religion, he was a typical quaker in how he lived his life, and he was a Yorkshire, which are very frugal, we like to say they make Scotsmen look like spendthrifts, anyway, they’re very careful and they don’t like flashy expenditure and they love bargains. And I so I grew up with a great Yorkshire type even quaker type love of bargains and careful spending.
Daniel Grioli: Very good. So you got into the business in Boston after a stint in management consulting, what prompted you to start your own firm?
Jeremy Grantham: What would not prompt you? I mean, people id start new firms, it was an area where you could, you didn’t have a huge capital requirement, all you needed was a certain amount of confidence and good fortune. And we planned and plotted from day one and it wouldn’t work out, and then you’d try another one, and that didn’t work out. And the third one, a guy from another mutual fund group and I put together a team and we were ready to go and we propositioned my boss at Keystone Mutual Funds, and he said he wouldn’t and then he said he would and then he said he wouldn’t do it with us but he would start his own, and would, we joined with him.
Jeremy Grantham: And since I knew him for 18 months, I jumped ship and we set off. So one mutual fund manager with some decent amount of experience and one kid with 18 months experience. And we hired a couple of more people and rolled the dice. My senior partner thought we’d have a billion dollars at the end of one year and we had a $100,000. Four orders of magnitude, that’s a good miss.
Daniel Grioli: It’s hard to be a full casting improve some [crosstalk 00:06:06]
Jeremy Grantham: Yeah, I think that was probably the biggest misery, and it wasn’t my poor cast anyway, it was him. And he became very good at propaganda in an age when not too many people worried about it. And our firm called Batterymarch financial management kind of flashed onto the scene as doing new and original things, a lot of computer work and my contribution was that we should get into indexing, so we did. In 1971, we offered an index, a pretty much co-equal first with Wells Fargo and we split the business. It was very slow to start but eventually in a couple of years we were splitting the business with Wells Fargo, which for a small firm new to the business was pretty good. And it was a real testimonial to my senior partner Dean Lebaron’s ability to propagandise. And so I owe him by the way. I owe him the idea that in the investment business, if you have a good idea that’s one thing, but it’s much better if you can put it across.
Daniel Grioli: What led you to GMO from Batterymarch? How did that [crosstalk 00:07:19]
Jeremy Grantham: Fell out with said Dean Lebaron really and a whole cluster of us left and decided that it would be better to completely please ourselves, and it worked out well.
Daniel Grioli: Clearly.
Jeremy Grantham: No, I mean the first few years. You need a running start when you … That’s your maximum vulnerability in an investment firm, it’s the first few years. And since any known investment style can have a down leg, you better not have a down leg when you’re starting. And there is never been a manager so good that he never had a down leg, so you need unmitigated good fortune.
Jeremy Grantham: To give you measure of our good fortune, we won the first nine years in a row straight by an average of eight points a year, and those of you who know the rule of 71 or 72, that means we doubled the money that our clients had relative to the market. And since the market was up fairly handsomely, about a double over the time period, we quadrupled it. And that is a very, very good way to start a new form. I look back, and that’s long ago now, we’re forty years old and that was the first nine years, I look back quite nostalgically sometimes. And we took it for-grated, it just seemed you went to work, you did your best, and you won. It didn’t turn out in the long-run to be quite that easy.
Daniel Grioli: Reminds me of a piece of research that you might appreciate, being a Yorkshire man, about cricketers who score 100 on debut, they’re statistically less likely to get dropped, they end having longer careers and they’re more likely to have a higher batting average through that career.
Jeremy Grantham: And further more if you have the nerve to get 100 on your debut, you’re probably quite a tough nut as well in everything in life. That must be fairly nerve wrecking, your first professional outing, and to do with a 100 runs means you’ve got talent as well as nerve so you’re going to go far.
Daniel Grioli: One of things that GMO is quite famous for is this legendary capacity to suffer as an organisation, to stick to your process despite what the market throws at you and even despite what clients may do. What do you attribute this resilience to?
Jeremy Grantham: Well, back in the critical era of ’98, ’99, I had a very substantial control over a big chunk of the firm. And my values had spread around my division, which was quantitative. And one of my values is be patient, have confidence in the end that a good analysis on the market would be right. Good analysis on the company can always miss the point, but good analysis on a broad market or a broad sector, very likely in the long-run to be right, you have to worry about the timing. Our timing was terrible but at least when we looked at the data every time we suffered it, it got cheaper, and our confidence went up, at least mine did. And it got cheaper and cheaper and cheaper and the confidence went higher and higher. And it really was with hindsight of course obvious that we would win if we could stand our ground.
Jeremy Grantham: The market in 1929, sold at 21 times earnings, and it never sold above that until the end of ’97. And then it moved past the record high, and we kept our cool, and we were playing in the market. And when it hit the all time peak of 1929, we thought we better start getting pretty darn defensive, and we did. And within six months, we were about as defensive as we could be, and we watched the peak of the market go through 21 to 25, 27, 29, 31, finally 35 times earnings, which one has to agree is not a little bit above 21. And during that too and record a year their earnings, they claimed were going up very fast as well. The market almost doubled from its previous peak of late ’97, that is pretty painful period, and we lost perhaps 60% of our new asset allocation business then. But the numbers became so ridiculous that at 35 times earnings, you were pretty sure it was going to go down.
Jeremy Grantham: But better than that, under the surface, there was an unprecedented gap the value stocks, and the growth stocks, or about co-equal with what it had been in 1974. And there was a definite world record gap between small cap and large cap. And there was a preposterous gap between US REITs and the S&P. US REITs for example yielded 9.1%, and the S&P yielded a never seen that lower level of 1.6, and people said, yes of course but S&P has a lot of growth, and we worked out exactly what the different was. And the S&P had outgrown the REITs index by 1.0% a year, and in return you’ve got more than a seven point premium on your cash dividend.
Jeremy Grantham: We had a very large bet on REITs and at the bottom of the market, the REITs index was up 35% and the S&P was -50, which is a nice spread. So we much more than made up for the pain, but we’d lost a lot of business and none of them came back. However, luckily, lots of other people looked at our performance and said, splendid fellows, they stood their ground, we like that kind of style, and they threw money at us. And we in a space of five years, we went up by seven times.
Daniel Grioli: How did you maintain your motivation during that period because two and a half years of the market going against you, it must have felt like an eternity at the time? How did you keep your focus, your discipline?
Jeremy Grantham: One of the ways is to redo the research, push it a little further, look for mistakes that you’ve made, and we’d come out of those research fits feeling better each time. It was good data we had, we’ve covered everything, there was no question that this was a classic bubble of the old school variety. Nothing like it between 1929 and 1999, the two great bubbles of US investment history, and had all the symptoms. We read the history books, we knew all about 1929, and we knew we were in the Real McCoy and that it would badly. We actually were interviewed by the Economist and we got to say in very early 2000 that we thought the S&P would half and the NASDAQ would go down by three quarters, 75%, it went down by 82, and the S&P had the decency to drop by exactly 50%. And so we nailed that sucker.
Jeremy Grantham: Incidentally, The Economist did a follow up story congratulating us. And I was having hip replacement, I was in bed on Beacon Hill here, and my son calls up and I said, “Oli, Oli, you got to read The Economist, they’re really saying nice things about me and about our firm.” And he’s saying, “Dad, turn on the television, turn on the television.” I said, “Oli, Oli you got to be serious, this is a really big thing for me.” He said, “Dad, turn on the television.” So I turned it on and unfortunately that was 9/11. And if there was ever an issue of The Economist, it was read by nobody, as in nobody that was it. The only time they said really nice things about us, it’s sad to say was a dismal time for everybody in the financial community. One of our guys unfortunately had left and gone to a firm there. It was really sad.
Daniel Grioli: Indeed, indeed. On this capacity to stick with your view and refine your research, based on that experience that you went through, what suggestions would you give to investment teams and investment committees that you think would help them to make better decisions?
Jeremy Grantham: Well, I think challenge every idea, do not let it get into a religion. I think value managers tend to be worshipping a little too much in the church of value, these are the rules and the patron saint is Ben Graham. Actually, Ben Graham 1963 late stage conversion to really being a lot more open-minded about the central truths, which I wrote a couple up if years ago. Challenge everything, keep your mind open, trial and error, try things in a small way, learn in the real world how they work and do it quickly, move fast, be an early adopter. And we were one of the first to do a lot of things. One of the two or three first firms into [inaudible 00:18:03] building computer models with PhDs and Particle Physics veering away. We were one of the first and serious asset allocation and quite a few other things. One of the first people to … We tried having a [inaudible 00:18:20] unit to capitalise on the thought that they were mis-priced assets, which they were, but in the end it was too high maintenance, it didn’t fit too well with more regular products.
Jeremy Grantham: But that was the point, try everything, we plenty of failure along the way but we had plenty of successes. And when you are an insider, your hit rate is much better than Venture Capital. As a general principle, you know more, you know the clients better, you can hear what they’re short of, what they want, listen to clients. Can you tailor your service to be more useful to them. Try and work as an agent rather than selling them something, work with them, help them in any way you can think of, and then be brave. In general, 90% plus of all investment management is too chicken.
Jeremy Grantham: I was saying to my colleagues just now actually that there is pretty big gap and hit rate between your general ideas and those one or two every few years where you really think, my god, this is too good to be true, I can hardly believe, look at this idea. And you don’t win all of those because every now and then you make a mistake of missing some subtle points but you win probably 80% Plus of those and you win if you’re lucky, if you’re good, you win 60 of the rest. And yet we don’t differentiate typically in our industry. It’s something I complain about fairly continuously, nag I think is the word. My colleagues here when you have a good idea, when you think the wind is in your sail, you’ve got to hit the sucker.
Jeremy Grantham: Classic example, 18 months ago, the Shiller PE, the [inaudible 00:20:20] PE on emerging was 10, it had never been lower than 10 in 25 years. That day the Shiller PE on the US was 21 or 22. Two years earlier or three years earlier, a few years earlier anyway in early ’08, emerging had sold at a premium to the S&P. So you knew it could be a premium and now it’s down less than half and as cheap as it has ever been absolutely. And that’s just 18 months ago. And nothing else was very attractive. Why would you put 10% in emerging, why would you put 15, why would you put 20?
Jeremy Grantham: I’m pleased to say in a way that I put 50% of my sister’s pension fund and my children into emerging, and when I wrote this up, I have to say why didn’t I put 100, what was I thinking of? I couldn’t even take my own medicine. But this is the point, you have one asset class that is cheap and every else is expensive, and the one asset that is cheap is 28 countries including China, India, Brazil, the countries that will be the main backbone of growth from here to 2100. It’s massively diversified isn’t it, so why would you worry about diversification and yet such is the mantra, diversify, diversify, diversify. And that’s transferred into terrible career risk, which runs and ruins to some extent our business. So everyone feels, well, I put 20 or 18 into emerging, how dangerous, how risky. And 82% into overpriced, diversified rubbish. And how do you justify your existence with that portfolio.
Jeremy Grantham: And there is a lot of career risk if you make a 40% move, which would have been nice commercially and you miss it, and the market goes down strongly, and emerging goes down more because people think it does, they’ll shoot you for being an idiot. Of course, emerging was so much cheaper, it would not have gone down if the market had broken nearly as much as the S&P. I’ve done a research on that, people get carried away with the relationship with the market, the so called beta. And Beta is important, but value is important. If you go into a market overpriced like emerging market did in 2008, you will drop like a stone. I mean, they went out 60% in three or four months. They fell much faster than the S&P.
Jeremy Grantham: If you go in cheap, as small cap and REITs, which act like small cap most of the time. In 2000, small cap value was up three S&P -50, as I said, the reads were up 35. But they were high Beta stocks, they were 1.2 times the market beta and they went up with the S&P down 50 because value was so as always so important when it becomes extreme.
Jeremy Grantham: I don’t think there is no material chance if the market breaks tomorrow that the emerging will end up at the bottom having gone down materially more than the S&P. In fact, I think the odds are much better than 50/50 that it will have gone done materially less.
Daniel Grioli: Interesting to hear your views on emerging, and we’ll come back to your market views a little later, but before we do, you’ve been very frank in your quarterly letters about the divergent of use amongst you and the other senior members of your team, and we’ll dig into the detail about that a little later on. But first, I just wanted to ask you a general question about how you accommodate different views because it seems to be a rarity in our industry, there seems to be a tendency towards group think or enforcing our house view, so how do you accommodate that diversity and then how do you integrate it into a portfolio that you’re all comfortable with to greater or lesser degree?
Jeremy Grantham: Let’s take asset allocation, my sidekick for 10 years and my co-manager for seven or eight because the boss quite a long time ago, Ben Inker, and it’s his job to make the final call. He listens to me talking about possible melt-ups and he listens to James Montier, who’s very well-known particularly in Europe but also Australia, talking about potential melt downs and he has to work out how much influence. And actually, it’s served an interesting purpose because he’s tried to build in resilience more than we’re used to. We ask on almost every investment how does it do on the upside, how does is do on the downside, and you can if you try hard you can get a slightly more resilient portfolio than you would if you were ignoring that possibility.
Jeremy Grantham: It also keeps firmly in everybody’s mind that we live in an uncertain world and very few bets are certain. And to have experienced thoughtful people making their best case at opposite end extremes, I think can only keep the brain turning over and keep everybody challenging and thinking and arguing, which is how you get to good weighted average decisions, and that’s what Ben does really. And he doesn’t have to tell us whether he’s giving James Montier more weight than mine because that’s not very good for business. So he does it and he keeps it to himself and I can see that he earns a little more emerging because of me than he would have done, maybe quite a bit more.
Jeremy Grantham: And so that’s the small victory on that one and then James will have a small victory on something else, and that’s fine. You can’t run an organisation where people don’t think for themselves. How can everyone think the same thing who’s got a brain? That’s a first. And if you don’t want them to think for themselves, don’t get them. So you have to deal with that problem and the only way you can do it is have different opinions, have everyone work, have everyone try and persuade each other, and have one person who’s proven that they can handle it make the final decision against the responsibility for winning or losing really.
Daniel Grioli: I think very true. I think you need a group of people that are intellectually curious and also have enough self confidence not to feel insecure as a result of the debate that comes with working through this sorts of questions.
Jeremy Grantham: Yeah, and by far the biggest risk in the long-run is to try and avoid risk, to try and hedge everything out, forget it. You’ve got to learn to take some risks, hit the ball hard. You don’t get that many great opportunities to make money and you have to whack it.
Daniel Grioli: Continuing on this theme of how you’re seeing the world at the moment, you’ve been quoted and misquoted about what you see as being different in the current environment, here is your opportunity to set the record straight, what is or isn’t different this time?
Jeremy Grantham: Let me just jump ahead a second to my paper of first trading day in January, which was bracing for possible near term melt-up because that has been laughably misquoted because having been misquoted a lot last year, I thought I’m going to get them this time, I’m going to put in the actual numbers. And I said, this is what a melt-up would look like if it met the pattern of the least of the classic melt-up, it would have to go up 60% in the final 21 months. And of course, it’s been going up pretty steadily, so what would that look like? And my best guess is that it would … And you have to have the prices accelerating, it would take between 9 and 18 months. The quicker it gets there, the lower the number has to be, so if took nine months, 3,400 on the S&P, we’d do it, and if it took 18, it would be 3,800. And that 25% to 35% the day I wrote it.
Jeremy Grantham: And it was reported as me saying the market would go up 60%. I said, “By the end of the bubble, it will have been up 60%, not that it’s going.” So I put in the numbers, didn’t stop people misquoting. I should have spelled it out at least twice, the front and the end of the article that it was 25% to 35% would get us into bubble territory. And it may go deeper into bubble territory. In 1929, it did not go up 60% in 21 months, it went up 105. So there are always complete outliers but this has all the indicators of a market that intends to end up as one of the great bubbles in my opinion.
Jeremy Grantham: The basic building block is eight or nine years or 10 years of building a base. And we had that through the 20s ending in ’29, and we had it through the 90s ending in 2000. We also had it through the 50s, but the 50s didn’t work because after World War two everything was so cheap and so different, millions of soldiers coming home, taking in university degrees et cetera, et cetera, building families, having babies, and with lots of buying power from selling their war bonds up their sleeves.
Jeremy Grantham: And the end of 10 years, the market had been wonderful but it was still cheap. In 1955, it was nothing like a bubble and there were none of the other indicators of bubbly-ness, which are the touchy feely crazy behaviour stories that you read about in 1929 and you experienced if you were around in ’99 of where CISCO became the biggest company in the world for eight seconds and pets.com became market cap of hundreds of millions of dollars with the Loony idea of racing around with pet food on a bicycle or whatever. And there were hundreds or even thousands for all I know of these crazy internet stuff.
Jeremy Grantham: And every day you’d go out for lunch and as I like to say, the classics symptoms of all was that they weren’t showing our local football team the Patriots playing in replays, there were talking heads telling us to buy pets.com, and that has not arrived. And back in November when I was writing this thing, you could say that for eight or nine years, it’s been one of the great boring bull market where people have been pessimistic all the way up, and they were just beginning to perk up a little bit in November, December.
Jeremy Grantham: And I describe that’s what you need to see, you need to see a lot of perking, you need to see the beginnings of really crazy behaviour, crazy stories, and you need your nephew to come out of the woodwork and have the first question on the telephone be, what’s be happening in the stock market or what’s happening to Bitcoin. And it was like lighting the touch paper and retreating to a safe distance. The first thing arrived on our website on January the second and the first six trading days of the year were all time world record highs, one after another, six in a row, first time anything like that in history has ever happened.
Daniel Grioli: I’ve think we’ve had 13 all-time highs out of the last 18 trading days I think.
Jeremy Grantham: Som like that. And the emerging markets is up 10% yesterday on Friday after the year. And the S&P was up 7.7, and EFA, the other developed index of the developed countries was up a little bit less about seven points. So a kind of global event, but better than the surge in price. And the biggest characteristic of a blow-off phase is acceleration. You go from the last nine years as average 1.33% a month and you accelerate the typical blow-off phase to 2.5% a month, and you can see that on any chart. It’s a lot of difference, it compounds pretty darn fast. And of course, 7.7 is three months worth in three and a half weeks. And even better than that, the bubbly stuff has gone crazy, so the tone of the newspapers in one month is almost unrecognisable. And certainly going back three months, is completely different.
Jeremy Grantham: Last year we had a week in the spring where we had three new highs in one week and no one cared, it wasn’t on the news, it wasn’t in the newspapers. Now, when we have three in a week, we read it in the FT, A Times, and we read it in the Wall Street Journal.
Daniel Grioli: Trump tweets it.
Jeremy Grantham: Trump tweets it, we have it on television and news and everybody is happy. And Bitcoin, the craziness of Bitcoin and all those little things that go up 10 times in three months, that is exactly what you want to see. Ideally, we want to see an IPO window say in the Spring, a new higher level of deals, mergers and acquisitions, that would be classic, and another dozen crazy stories. A lot of the indicators of confidence are shooting upwards and look very interesting. But my feel is not yet, we still have room to go, we’re not as crazy anywhere near as ’99, the hard stocks are actually terrific companies with real earnings and they’re nothing like as expensive as the idiots [inaudible 00:34:57] in ’99.
Daniel Grioli: Is a distribution phase or a rotation in market leadership something that you’re looking for as a possible …?
Jeremy Grantham: No, typical end of a bubble is that the leadership gets narrower and narrower, it goes from 40 type stocks, to 30, to 20, to 10, to CISCO. And the same thing in 1929, all the junk stocks that were brilliant in ’28, get dropped by the wayside and you concentrate on Coca cola and Radio and General Motors. And that seems to be a very distinctive pattern, and it causes a very odd thing and that is conservative low volatile stocks that should do much less well on the upside that do better.
Jeremy Grantham: In 1928, the junk trashed the Blue chips, but in 1929 the opposite happened, market went up the final 35% and the junk was down, they didn’t even get the sign right. And nothing like that happened until 1972, and ’72 wasn’t bad, ’72 ushered in a 62% real decline by far the biggest decline since the depression still today. And that was preceded by this odd divergence. And last year, we have a high quality fund and high quality index. And that was eight points ahead of the S&P, and the junk was seven points behind. That’s not bad, not enough to completely ring my bell but it’s a promising down payment. It’s what you should see if you’re perhaps getting to the last six months or nine months of this game.
Jeremy Grantham: Now, if it really travels at this speed, if we were to go even at a slower rate, 10 points in the next two months, we would actually hit the 60% in 21 months in two months. And because it’s moved so fast, it wouldn’t have to go to 3,400, it could do it at 3,200, which is 10% away. And so the faster you go, the lower the price level needed, if you’re going to take another 18 months, then you have to get up to 36 or 7 or 8 from here.
Daniel Grioli: And that’s because the acceleration is the key feature?
Jeremy Grantham: It’s because acceleration is a key feature, it’s also because if you can hit the target tomorrow 10% in a day, it means to go back 21 months, you’re picking up more months. And since the market is been going up nicely, you get more in your tail. If it takes eight months to go or 10%, you lose eight months of your 21 months, so you’re losing performance. The faster you go up, the better, the quicker you hit your 60%.
Daniel Grioli: Sure, I get it. So related to this-
Jeremy Grantham: You asked me the question, what is different? And I wrote a lot of papers on this, a couple anyway. And basically, I ended up saying, what the hell is not different. We don’t have children like we used to, population growth has really come slamming down from … In terms of the labour offered to work force, trendline growth used to be about one a half percent a year and now 0.2, that means that comes straight off GDP growth as a trendline growth potential. And then productivity had dropped from 1.7 to 1.3 because the manufacturing, which is still good has gone down from 40% to 25 and finally it’s on its way to 9 or 10 now. And you just can’t get anymore blood out of that stone, it’s very productive but it’s very few people doing it.
Jeremy Grantham: And in the service sector what can you do when you’re cutting someone’s hair or managing their money? There is just so much you can do. Productivity in a service-driven society tends to get less, and people are obsessed about entertainment but that’s one fairly narrow focus. And for every benefit you get from a smart telephone, you waste half an hour doing unnecessary Facebooking and emailing and keeping up with your emails, real drag on time and playing spider solitaire because you can’t stop, I’m a bit of an addictive personality, so I curse this smart instruments.
Jeremy Grantham: But do not think that they are all productivity gains because they’re no. And productivity has slowed. So productivity at 1.3, labour at 0.2, that is 1.5% growth rate potential that I’ve been saying since ’09, so I was very early on that one. The IMF, World Bank by the way have come down from almost 3 to 1.5, so they have joined me. And the FED is now at about 2 down from 3.
Jeremy Grantham: We simply don’t have the trendline growth potential that we had anywhere in the developed world, Europe is even worse. And yes Australia, Canada probably have a little more oomph with resources and so on and New Zealand, but darn the rest of us. But even there you’re going to slow down, you have the same population slowing that we have.
Daniel Grioli: You’ve also written quite a bit about the presidential cycle, what do past presidential cycles suggest may happen in the future? We’re heading obviously up to midterm elections?
Jeremy Grantham: Yeah, I used to love the presidential cycle because in the old world that we lived in, they were a wonderful demonstration of subtle pressure on the FED by the government. They’re completely independent as I used to like to say and completely independently they would decide to stimulate the economy in year three, which would give you a nice residual run-up to the election in year four. And they did that so effectively that year three since FDR first term 1932, year three had more performance than the other three added together. That’s not bad, you have to admit and not by a little by the way.
Jeremy Grantham: And year one and two where you squeezed the economy so that you would have some room to stimulate in year three, hardly had a positive return at all. When we checked that in the UK, the joke was that they actually had a better 1932 to present effect on the US presidential cycle than the Americans. They were like a hedge fund, a slightly leveraged version of the US. There was not a hint of a prime-ministerial or election cycle. If you checked, Australia you would find it’s got a little presidential cycle, even Japan who were legendarily different did better in year three. The FED’S reach was very powerful.
Jeremy Grantham: And if you examine the increase in the interest rates, it wasn’t material, the increase in money supply wasn’t material, so how did this come about? It was moral hazard, they made it known and the insiders knew that they could count on more support in year three. And the moral hazard is very simple, if it goes wrong, we’ll bail you out, if it goes right, you’re on your own, which is pretty nice.
Jeremy Grantham: And that was confined to year three until we had Greenspan, the infamous, who didn’t play by the old rules and he insisted on overstimulating in year one and year two. So we had ’97, ’98 up years instead of down years or flat years, they went up steadily the whole time with plenty of moral hazard from Greenspan. And then you reach year three ’99, it’s certainly going to go up, it always does, so it shot through the roof. And then you had the election year of 2000, which is meant to be a flat year where you get re-elected and everything has become so top heavy, so ludicrously overpriced that led by the internet and then the tech, they collapsed.
Jeremy Grantham: And so he broke the game and spoiled it completely. The next time, it worked fine but then in the last go around of ’05, ’06, same thing, nice up years when they should be down, of course ’07 is going to be up, and then ’08 when you should have a nice quiet re-election, the whole damn thing blows up again. Greenspan and his bootlickers, Bernanke, and Yellen, all the same, all bragging about creating a strong stock market and its wealth effect. And there is a wealth effect, that’s great, trouble is there is anti-wealth effect when the market breaks. And the anti-wealth effect cuts in just when you don’t need it, when the economy is under stress. In ’08, when the market is going down and ’09, you have an anti-wealth effect that hits you up.
Daniel Grioli: It seems that president Trump is having a very impact on animal spirits at the moment, do you think this is fully reflected in the market?
Jeremy Grantham: It’s always impossible to know to disaggregate the effects for there are no numbers you can attach to Trump or his effect. What I do know however is what I wrote last year, which was, yes, the US market might do very, very well, it might even be melt-up, but I think emerging if that happens will do as well, maybe do even better. And so far, so good. It’s pretty hard for me to believe that what Trump does plays that bigger role in Brazil, Argentina, Thailand, Taiwan, Russia, China, I don’t think it does.
Jeremy Grantham: This suggests that this is more global thing, or what a coincidence this happens to be one of the first time for 10 to 15 years that we have a synchronisation of global economies. The headline in one of The Economist issues was, There isn’t a major country with a down GDP forecast, they’re all chugging along nicely. Now that should be pretty darn important in getting markets to go up. How about profit margins, up global peak. US is actually not a peak, it’s very strong but not a pick. But globally, taking them all together, this is a peak, and that should be pretty good too.
Jeremy Grantham: What’s not to like in the sense of the influences on the market? The market loves low inflation, we’ve got global low inflation, it likes GDP stability, we got GDP stability, it doesn’t like growth particularly, but it likes stability, and it likes profit margins where at a peak. So this is supplying everything that the global markets like and the global markets are winning. This does not therefore statistically seem very indicative that Trump is the driver. Trump is like most presidents taking credit for winning the World cup or the bad weather or whatever; this is not Trump.
Jeremy Grantham: However, let’s be fair, he’s engineered the last glorious gasp of corporatism, corporations have been hanging their workers out to dry for the last 30 years and gobbling up all the productivity gain, before about 1980, productivity was evenly split between the worker and capital and actually about 1975, all of the productivity gains go to corporations and the super rich, which is not a way you can run an economy, and definitely because they run out of buying power, which we’re doing down at the average guy level.
Jeremy Grantham: To get back to his Tax plan, he’s engineered a reduction in regulations that will help corporate profits and a reduction in corporate tax. Now, corporate tax is pass-through by the way, there is more nonsense written on that. When I was at Royal Dutch as an economist, we use to everyday hand over to the government three quarters of our top-line, three quarters of the Break Tax, same in Australia, is taxed. And do you think that oil companies made amazing amounts of money because they had this tax collecting function? Absolutely not, they just passed it through and they made the same return on Equity that they did in the US, which had no gas on gasoline was talking about. So, it’s a pass through.
Jeremy Grantham: The problem today is that we’re a little monopolistic, a bit sticky, and it won’t pass through quickly. It may take a couple of three years before the whole effect of a corporate tax cut is passed through and completed away. If that does not happen, then capitalism has seized to function and we’re in really deep trouble. But for the near term, it will help profit margins and so will deregulation, we need regulation. Corporations never volunteer to do anything for what you might call the strategy of the commons, they’re not going to look after the air, they’re not going to look after the oceans, they’re not going look after the soil or any of these things, they’re going to go for maximum short-term profits. And they need regulating, and if you want to deregulate them, which he does, then they’ll start pouring acid down the streams of West Virginia coal areas, which they do now. And they’re not going to volunteer to spend money, which is not associated with making a profit, so they need regulation.
Jeremy Grantham: Anyway, you get a short-term fix, we got a little more winds in the sales of the corporations who have been flying for these last 20 years, and that will help the melt-up phase I think.
Daniel Grioli: A bit of extra kerosine on the fire?
Jeremy Grantham: A little extra kerosene on the fire; good for the oil company.
Daniel Grioli: We quite of touched on this earlier about the spread between cheap and expensive stocks, and any investor in value has suffered approximately nine years I think, it is of under-performance to growth, is value broken, is there some of these things that you talked about such as profit margin are they restraining the forces of main reversion?
Jeremy Grantham: It used to be until 20 years ago for the previous 100 years, if you only a cheap portfolio, you’d outperform by 2%, 3%, 4% a year. And if you had a bad year where you lost by 10, you then have an extra 10 points plus four in the kitty and you’d have an explosive rarely. But on average, up and down you’d go but you’d end of any time period having the best part of four points extra a year if you had the cheapest 10% of PE or price to book or better yet a sexy dividend discount model, which we had. And everything worked fine. And since 2000, that has not been the case.
Jeremy Grantham: You can get some money if the factor value gets very cheap if you push it down hard enough, it will bounce back, but what you’re not getting is the extra four points a year for showing up. And so if the factor didn’t change, if it went in normal and came out normal, you’d win by four pre 2000. And since then, if nothing changes, you win by zero. So yes, it is different. Like going back to my point, what isn’t different. That is one of the many things that has been different in the last 20 years. And interest rates obviously gone to all-time lows, they’ve been different, and profit margins have been much, much higher, 70% higher than average of the prior 100 years that that’s been different. And you must expect the world from time to change, and the idea of that it’s always the same, it’s nonsense.
Jeremy Grantham: I made a bit of a joke with this old John Templeton alleged phrase about the four most dangerous words in the English language, this time is different. To which I said, no, no, it’s almost right, the five most dangerous words in the English language are this time is never different because if you have real confidence that it’s always the same, you’re going to end up making magnificent high confidence bet and you’re never going to be right. Let me just point out that Japan had sold over 25 times earnings until it went to 65, that should be at the back of every value manager’s mind. It took several years going from 25 to 65, and you cannot survive that, your psyche will not take it, your clients will definitely not take it. And when we went from 21 to 35 for a new record in 2000, our clients did not like it. It was a miracle we had any left. It wasn’t bad luck that we lost 60, it was a miracle, a testimonial to our skill in BS that we had 40% left.
Daniel Grioli: That’s a great warning I guess for being careful in setting our expectations, but how does that, what you’ve just discussed in terms of value apply to all of these smart beta products that you see coming out at the moment? They’re obviously based on long term back tests, and they’re picking that period that you described where there was sort of a [crosstalk 00:53:12] 34% in the bag.
Jeremy Grantham: They came out of the woodwork of course exactly at the time when those things started to end. And we’ll still be picking through the data, trying to explain what changed 20 years from now. It is not obvious to us, and my god, we’ve tried to workout what exactly is different now because profit margins still tend to regress at a respectable rate for most companies. One of the things that has changed, which is clear to everybody, is the rise of great value destroyers. There were no Amazons and Apples and so on trumping through the woodwork, crushing competition. Here is the book industry, whack. Here is the food industry, maybe, one after another. And here is the gasoline motor industry. There are really rapidly moving changes and very powerful companies that make more money than you can shake a stick out.
Jeremy Grantham: Apple just announced something like $30 billion a profit for a quarter, and some giant old utility company, one of the biggest in America, announced a quarter where its revenues were a couple of billions. I’m thinking, Jesus, this is a name that existed 80 years before Apple was still [inaudible 00:55:04], its revenues are tiny fraction of Apple’s profits and it’s only 10 years ago that Apple was featured as a great value destroyer, that they’d taken capital and nothing would come out of the other end. And in 10 years they metamorphosed into a monster. So you’ve got these monsters walking around the planet now, are they making life very difficult for a lot of companies to create value that would have done it without them.
Jeremy Grantham: I would list that as one of the many profound changes that have happened. And with government connivance, the power of brands monopolies has increased, and the deals and the take overs and half the number of companies now no longer exist. we’ve halved the public companies. And starting a new company, keeping up the bigger of capitalism, it’s just different now. It’s just much harder a mote to attack these guys, it’s very, very deep. And it’s all different.
Jeremy Grantham: And yes, a good value manager who is plotting all these things, studying everything, challenging everything. And one of the things you have to challenge is do you really think the old technique are going to work and if so why. And what about the data of the last 20 years, it’s not the data of the last two years, everything looks different for 20 years, which is getting to be a long boring time for clients. So try and work out how the new world is working and build value techniques that incorporates some of the changes. I’m not saying this is easy and I’m not even saying that we’ve decoded it, but it’s a problem at a level of complexity that we never had to deal with.
Daniel Grioli: Do you have any ideas of which tools may not be working and what tools may show some promise?
Jeremy Grantham: Yeah, we’re full of ideas and none of which I intend to unveil in this interview.
Daniel Grioli: Fair enough.
Jeremy Grantham: Yes, I think our account efforts are definitely regrouping and showing promise last year and this year, we’ve gotten off to a very good start despite the fact that value was terrible last year and is flat this year, we’re doing much better. So I do think some of our new ideas are paying off and they should be even I hint at them.
Daniel Grioli: Okay. Hopefully, we find out more about them in due course?
Jeremy Grantham: Yes.
Daniel Grioli: But just coming back to this idea about tech companies taking over the world, there seems to be a lot of talk lately about the growing backlash against some of them, they all operate with a certain social licence. And up until now, governments haven’t been too responsive to their monopolistic nature and people have been very happy to share private information with them-
Jeremy Grantham: And now there is bit of a backlash.
Daniel Grioli: Yeah. Do you think that’s an emerging risk for this companies?
Jeremy Grantham: I think it may well be and I hope it is because I think corporatism, the dominance of corporations in America is the total. If the rich corporations and the rich individuals don’t like a bill going into congress, it will not pass. There is a lot of work being done on them, 31% of bills passed and if the general public love it, it goes to 32, and if they hate it it goes to 30. It’s called Gilens’ flat line after a professor at Princeton. But if the rich and powerful corporations get in their lobbing and threatening, it goes to 65 past, thanks god it’s not 100. But if they hate it, it goes to zero, nothing goes through.
Jeremy Grantham: The corporation and the super rich, who are very closely allied, basically run the US system, representative democracy is pretty well seized. We need to get the pendulum moving the other way, capitalism is a pretty neat system but you have to regulate it, and you can’t let it run rampant. I didn’t realise, I arrived here in 1964, I had no idea I was arriving at the sweet time in the social contract. Now, civil rights aside, but for everything else, they were thinking of pensions, they developed these wonderful pension funds, they owed allegiance to the city they were in, the state, and of course the USA. And now, none of that is true. And they go to the highest bidder and they maximise their profits and to hell with everything else.
Daniel Grioli: You can see that with the Amazon bidding war that’s going on there.
Jeremy Grantham: Absolutely, absolutely.
Daniel Grioli: Whichever country wins is going to suffer … Whichever City, I should say, wins is going to suffer the bidders curse there, the winners curse definitely.
Jeremy Grantham: Yeah, these guys know how to … They play the game. Capitalism has refined its rules, but back in the day in 1964, a CEO made 40 times the average worker, it seems like a lot doesn’t it, 40 times? And now it’s 350 times. And what can you say about that. An hour’s work has not changed since 1974, so they had a nice run from ’64 to ’74. The last decade of the good old era. And then we have the ’74 on, 40 years plus of the rise of corporate power, and we better start pushing the pendulum back a bit. I don’t want to turn into the kind of Labour party era post World War two in England. But somewhere between here, the total dominance of big capital and then the total dominance of the trade unions.
Jeremy Grantham: There is a lot of territory, which I think is the sweet compromise, a balance, and I think we were pretty close to that in 1964 here. Corporations did fine, the growth rate was much higher, productivity was terrific, it was the golden era ’60 to ’64, the 1960s was just brilliant. And we’re a pale shadow of that kind of growth now. I hope the pendulum goes back, I hope the justice department does something about monopolies, I hope it breaks up a few firms into multiple pieces, which look very necessary. I hope it regulates once again good behaviour and particularly for the environment, and particularly for climate change before we’re all trying to play tennis in 52 degrees centigrade.
Daniel Grioli: On court, yes, that’s very hot in Melbourne. Just wrapping up the interview, one final question, what are some of the most useful mentor models that you’ve used that you think investors should learn and use in the way they approach markets?
Jeremy Grantham: Well, read Ben Graham’s 1963 lecture, the last one he gave. And he’s reexamining the hard value roles that he talked about in which people swear by and he’s saying, “We really underestimated what the market was worth, we gave a testimony to the senate in ’55 and we all agreed that the market was selling at fair value. Now, it’s gone up 50% and we were clearly wrong.” You need so much data, the trouble is by the time you’ve got enough data, the underlining realities have changed, and this is a wonderful wise observation. And he said, “Whatever you do, never get out of the market on your strong assumption that it’s high enough.” Always own some stock because if you get out and it goes up and the game has changed, it will do you so much psychological damage, you’ll never be a useful investor again.”
Jeremy Grantham: Some of the players out there run the risk this time, there are so dedicated to the fact that we were going to 14 times earnings, they might spend the rest of their life stopped out of the market. So keep an open mind, reconsider everything, study the history but know that it can be different, and it spend long chunks of time being the same and regressing nicely and then it changes, and you have to keep your eyes open. Challenge every thought, every iron rule. They’re no longer iron rules; they’re aluminium rules. Or you say aluminium? I don’t know.
Daniel Grioli: We do say aluminium, yes.
Jeremy Grantham: These rules are bendable and dentable and the iron rule era has gone.
Daniel Grioli: Thank you very much for your saged advice and admonitions, I definitely wouldn’t categorise it as bullshit or propaganda. I think our listeners will enjoy hearing this conversation very much. Jeremy, thank you for your time.
Jeremy Grantham: That was fun. Good.
About the [i3] Podcast
The [i3] Podcast is a conversation with some of the leading institutional investors around the world, discussing their philosophy towards investing, in particular towards portfolio construction and investment strategy. The [i3] podcast is available on iTunes, Google Podcast, Spotify, Stitcher or your favourite podcast platform.