GMO’s head of asset allocation discusses value’s underperformance, why a 60/40 portfolio is apt to be a losing proposition after inflation, and what the market is missing about emerging-markets value.
Our guest on the podcast is Ben Inker. Ben is GMO's head of asset allocation. In that capacity, he leads GMO's asset-allocation team and is a member of the firm's board of directors. He joined GMO in 1992 after obtaining his bachelor's in economics from Yale University. Prior to assuming his current role, Ben was an analyst on GMO's quantitative equity and asset-allocation teams, a portfolio manager of various equity and asset-allocation portfolios the firm offers, co-head of international quantitative equities, and CIO of quantitative developed equities. Ben is a CFA charterholder.
Ben Inker bio
Ben Inker articles
GMO’s Research Library
GMO Global Asset Allocation
GMO 7-Year Asset-Class Return Forecast, 2Q 2020
“Uncertainty Has Rarely Been Higher; Oddly, Neither Has the Stock Market,” by Ben Inker and Jeremy Grantham, June 4, 2020.
“Stocks Are Too Risky. What GMO’s Inker Says to Buy Instead,” by Jack Otter, Barron’s, May 24, 2020.
Mean reversion definition, Investopedia.
GMO Mean Reversion Strategy
“GMO’s Mean Reversion Strategy Is Tested in Today’s Market,” by Bailey McCann, Institutional Investor, July 25, 2016.
“60/40 Portfolios Face Double Trouble Ahead,” by Rick Friedman, GMO Insights, Feb. 26, 2020.
GMO’s ESG Capabilities
“Climbing the ESG Learning Curve: Lessons Learned in Emerging Markets,” by Amit Bhartia, Binu George, and Hardik Shah,” GMO Insights, Nov. 4, 2019.
“ESG Managers Say Pandemic Is a Stress Test That Proves Their Point,” by Alastair Marsh, Bloomberg.com, April 9, 2020.
“Emerging Markets: Tamed Child O’ Mine,” by Amit Bhartia, Mehak Dua, and Alvaro Pascual, GMO White Papers, July 7, 2020.
“COVID-19: Risk and Resilience in Emerging Markets,” by Amit Bhartia, Tiger Tong, and Uday Tharar, GMO White Papers, April 16, 2020.
“GMO: 5 Reasons to Own Emerging Market Stocks Now,” by Bernice Napach, ThinkAdvisor, July 13, 2020.
“Emerging Markets Value: A Rare Ray of Sunshine from GMO’s Strategists,” by David Snowball, Mutual Fund Observer, Dec. 1, 2018.
"The Trouble with Value," by Ben Inker.
“Risk and Premium: A Tale of Value,” by John Pease, GMO White Papers, July 30, 2019.
“During the Coronavirus Crisis, Does Value Investing Still Make Sense?” by Robin Wigglesworth, Financial Times, May 14, 2020.
"GMO Is Feeling Pain Reminiscent of the Late 1990s,” by Christine Idzelis, Institutional Investor, Oct. 10, 2019.
Portfolio Construction and Strategy
"How to Lose Your Job in Asset Allocation," by Jeremy Grantham and Ben Inker.
GMO Benchmark-Free Allocation Fund
GMO Alternative Allocation Fund
GMO’s Systematic Global Macro Strategy
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.
Ptak: Before we start our conversation, we wanted to share some exciting news. The Morningstar Investment Conference for investment professionals will be held virtually this year on Sept. 16 and 17. We're offering the same research, analysis, and insight you'd get at the live event for a reduced price of $149. And the best part is you can join us from wherever you are. For more information or to register, visit go.morningstar.com/mic. Again, that website is go.morningstar.com/mic.
Now, let's start our conversation. Our guest this week is Ben Inker. Ben is GMO's head of asset allocation. In that capacity, he leads GMO's asset-allocation team and is a member of the firm's board of directors. He joined GMO in 1992 after obtaining his bachelor's in economics from Yale University. Prior to assuming his current role, Ben was an analyst on GMO's quantitative equity and asset-allocation teams, a portfolio manager of various equity and asset-allocation portfolios the firm offers, co-head of international quantitative equities, and CIO of quantitative developed equities. Ben is a CFA charterholder.
Ben, welcome to The Long View.
Ben Inker: Thanks very much for having me.
Ptak: Let's start with the sources of securities returns, which is something your firm spends a lot of time thinking about and trying to unpack. Specifically, why should stocks be expected to deliver significantly higher returns than bonds if policymakers seem so determined to stamp out risk? That is, how and why should the future equity risk premium resemble what it's been in the past?
Inker: Yeah, that is kind of an absolutely crucial question. I think one underlying assumption that we have is that it is impossible for policymakers to truly stamp out risk. And therefore, it is reasonable to assume that stocks which embody, in essence, the riskiness of the stock market, usually amplified by the fact that most companies are levered. So, assuming that the economy has risks to it and stocks have at least as much risk as the economy because of the leverage that they bear, the cash flows underlying stocks should be more volatile than the cash flows underlying bonds. And it's not only that those cash flows are volatile. But when you think of when that downside volatility is going to hit, when our cash flow is going to be worse than your expectations, those will almost invariably be at the bad times for investors.
The bulk of investors out there are either individuals, say, saving for retirement or for a house or their kids' education, what have you, or institutions that are saving for collective retirements or institutions like foundations and endowments that are worried about future spending. And what you almost always find with stocks is that the very times where their cash flows turn out to be disappointing are the same times that for individuals, their income turns out to be lower, their job security turns out to be less. So, stocks will lose you money at bad times. And you absolutely deserve to get paid for taking that risk of losing money at bad times. Exactly how much you should get paid is a question. And it's one that's very difficult to answer with less than 50 or 100 years to look at.
And so, one of the ongoing debates in investing circles is the question of whether that risk premium relative to bonds or cash should have gone down. If we think about the riskiness of the economy, it's lower than it was 100 years ago. The economy is less volatile. However, we are right now living through the greatest volatility the economy has seen since at least World War II. And it's always a little bit hard to go back before then because, frankly, we're all backfilling, right? The very concept of GDP didn't really come into being until the early 40s. So, the quality of the data before that is not as good. But even if the volatility of the economy has gone down, we're living in proof that it can still be much higher than we're normally used to.
Ptak: Before we turn to the asset class forecasts for which GMO is famous another question along the lines of the similar one. ESG has become very popular. Your firm does some work there. How and why should a portfolio that's, let's call it, ESG good, be expected to achieve risk-adjusted returns that are on par with those of a portfolio that's we'll call it ESG bad. Shouldn't the opposite hold if investors demand to be compensated for incremental, let's say, material ESG risks that they're courting?
Inker: So, that's always possible. I'd say that's the equivalent of the idea behind sin stock portfolios, right? Nobody wants to hold tobacco firms or what have you. So, maybe you get paid a risk premium associated with it. The flip side of the argument is that companies who are doing the right things with regard to ESG are companies who are doing a better job of thinking long term. And in general, you would expect companies that do a better job of thinking long term to probably have better long-term outcomes.
If we were just talking about removing a random subset of companies--so, let's say, your ESG scoring causes you to say, the equivalent of every company that starts with the letters A through G, we're not going to hold. If you compare a portfolio that has all of the alphabets versus one that has only H through Z, you're not going to find any strong bias, or at least – honestly, I have never done the analysis, but I would assume you're not going to find any strong bias. The companies H through Z are approximately as good as all of the companies. There's a little bit higher volatility because you've got have a little bit less aggregate diversification, but at that scale diversification is a very minor issue.
So, I would say if ESG was completely random, you would expect similar returns, maybe a little bit more volatility. And the one thing from an active management standpoint is you've constrained your opportunity set a little bit. There are a group of companies that you can't buy because they score really badly. And maybe that reduces the scale of what active management can do. But as we all know, across averages, active management is unlikely to add a lot of value. So, across the market as a whole, if ESG was random, you wouldn't expect any change to an ESG portfolio versus a non-ESG portfolio.
ESG is not random. And our general viewpoint at GMO is the companies that tend to score well are probably better and thinking long term than the average company. And as long as the market is not fully efficient in pulling that out, you might well outperform a little bit at the margin. The difficulty of trying to determine that in any short period of time. Let's talk about ESG this year.
ESG this year in a lot of cases looks like it has done really well. It looks like it has done really well because of the industry biases it has. Energy companies score really poorly on ESG, largely because of the E problem, whereas tech companies and biotech companies tend to score a good deal better. And this has been a great year for a strong bias towards IT and biotech and against resources. But it's--I would say, in general, anyone who has a view that they would like their portfolio to reflect their ESG type values, there's probably no reason to expect they're going to get a systematically worse outcome from doing that. So, I would be certainly in support if it makes them feel better, it probably has very little impact on their portfolio long term and maybe it helps the world get better.
I would say on that front, frankly, one of the things I was most shocked by this year was I got an incoming email request. And actually, when I did not respond to it, I got repeated pings from a company doing a survey for Gazprom, looking at investors' impressions of Gazprom through an ESG lens. And if this is something which has gotten so far that a Russian state-owned company cares about what investors think, then it's really impacting things. And frankly, I was really quite excited to see that. Now, I don't actually analyze Gazprom myself. So, I sent it off to one of the teams at GMO that actually has something useful to say. But if we're impacting even those kinds of companies, then I think there's really a good chance that the ESG push is going to change the way businesses operate.
Benz: Switching over to forecasting, we're in the midst of a bull market that has run almost uninterrupted since 2008. Have market cycles gotten longer in your view, and what are the implications for forecasters like you?
Inker: Market cycles have been drastically uneven in their length throughout all history, right? You can say, hey, this has been a 10-year bull market. Well, it hasn't really because we certainly did just have a 20% down leg not very many months ago. And if we're going to excuse the occasional down 20% leg in generally a market, then the bull market that went from 1982 to 2000 was an 18-year bull market. And from the late 40s to the middle 60s, there was kind of a 20-year bull market. Bull markets can be of varying lengths. To some degree, they tend to be driven by the length of economic cycles because bear markets don't always coincide with recessions, but they often do. And we had a long period of growth in the U.S. without a recession, although obviously we have just been through one and it's not clear what's going to be happening to the economy after this.
If one is looking back and saying what allowed the economic expansion to go on as long as it did from kind of late 2009 until the beginning of 2020, there's a couple of things that come to mind. One is we started from a really low point. So, we had an expansion that was starting from a point where the economy had a tremendous amount of excess capacity. Because the Global Financial Crisis, the recession of 2008-2009, was the worst recession we had seen since the Great Depression. The other piece of it, which was a mixed blessing, was that this was the weakest expansion in U.S. history judged by the rate of GDP growth. So, in most recoveries from recessions we have had quite rapid comeback in GDP growth, and this time, it was pretty gradual. And the bad news about that was, well, less growth, less income growth and less overall growth in the economy. The good news is, even over 10 years, you hadn't built up that many excesses in the economy. And then we have the COVID recession, which is really a unique recession. It was much less driven by forces intrinsic to the economy and much more of this exogenous shock of a type that, well, we haven't really seen in 100 years. But if we're trying to ask the question, what should we expect of the next expansion, I don't think we know much. And I would be hesitant to make too many predictions based on the last cycle.
Ptak: How important do you think the market in the economy whipping around is to mean reversion? It's a bedrock part of your approach. And one of the things that we've seen, and you alluded to it is the fact that we've seen consistently tepid growth. I'm speaking of the U.S., but I think it holds globally. And so, what kind of fly in the ointment does that present for a strategy like mean reversion which is such a central part of what you do at GMO?
Inker: Yeah. The drivers of mean reversion are in fact a variety of different factors, some of which are kind of more on the supply side, some of which are more on the demand side. A market in an economy that is exhibiting more volatility is probably going to pass through normal or fair value more often, just because the higher volatility allows for that. But some of the underlying drivers for mean reversion in the longer run have been things like the mean reversion of the return on capital for corporations, mean reversion in factors like inflation. And it's tempting certainly from anyone who has been sitting in the U.S. to say, wow, all the volatility until this year had completely disappeared. That was kind of uniquely true of the U.S. in this post Global Financial Crisis period. The U.S. has been very much a lucky country in terms of sidestepping a lot of the problems that various parts of the world have suffered in the last 10 years. But we believe even with that, there's a lot of naturally limiting processes, which should drive mean reversion in the long run even if over any particular period, a one-year or a five-year period, you can't be at all certain that the mean reversion will occur.
Benz: The starting point for many of our listeners is the U.S. 60-40 allocation. Your most recent asset class return forecast as of the end of May projected that a 60-40 portfolio would lose about 4.2% or exactly 4.2% per year after inflation. So, that would mean that a portfolio that was 60-40 would have lost around 26% of its real worth by May of 2027. So, to orient our listeners to your approach, can you decompose that forecast into its constituent parts and talk about how you get there?
Inker: Sure. I mean, one of the things that's sort of a subtle point about our forecasts, we refer to them as seven-year forecast, they're actually forecasts assuming seven-year average reversion of assets, which means as you look out over multi-year periods, you can't simply take these averages and compound them out. So, it's a little bit different from that. But with that said, right now, the biggest problem for a 60-40 portfolio is that both the 60 and the 40 look quite expensive relative to history. The valuations of stocks are quite high relative to history. That's particularly true in the U.S. for the S&P 500, which is the index that people are most familiar with. We think that depending on the level you think qualifies as normal from a valuation standpoint, U.S. stocks are priced to give a negative real return of somewhere between about 1.5% and 5% real.
Now, the other problem with the 60-40 portfolio--and I would argue this is actually more intractable problem--is the bond side of things. Bond yields are obviously extremely low relative to history. If bond yields were to move back up, not even back up to the historically normal levels of, let's say, for the last 25 years of U.S. bond yields, maybe 5.5% to 6%, even if they go back up to 2.5% or 3% from today's levels, that is going to be a strongly negative real return. Now, if you believe that bond yields aren't going to move--and I'm sympathetic to that in the near term, because the Federal Reserve has basically tried to promise that they are not going to increase short-term rates for years and with short-term rates stuck at zero, a 5 or a 10-year bond has reason to stay low for quite a while as well. The problem is, even if the yields stay where they are, we're looking at negative expected returns in real terms, so bonds are going to lose you money after inflation. We think U.S. stocks are probably going to lose you money after inflation.
The good news if you have a global stock portfolio and our strong recommendation for anybody is you should start off thinking about the global stock market rather than just the U.S. stock market. Non-U.S. stocks are invariably less expensive than the U.S. That's true in Europe. It's true in Japan. It's true in the emerging world. So, if you can have some international diversification, things look better. But looking at the U.S. stock market, on a normalized earnings basis, we are at one of the most expensive levels in history. And it's going to be hard to generate strong returns from there. If valuations come down, there will be capital losses. If they don't, we've just got a lot less earnings per dollar invested and those smaller earnings means smaller dividends, smaller ability of companies to invest relative to their market cap. And we think the long-term return to U.S. equities is low even if valuations don't revert, and in our forecast, we assume they will be reverting on average over seven years. And if that's true, the returns over the next seven years are quite likely to be negative in real terms.
Ptak: Let's contrast that with emerging-markets value where you're considerably more bullish. I think that when I looked at your asset class forecast chart, which you're known for, as of May, I think it was 9.9% real, if I'm not mistaken, that's a big number, a portion of which I would imagine comes from the earnings yield. Nevertheless, what gives your team confidence that you won't see multiple compression and kind of just muddle along there?
Inker: Well, the biggest reason why I don't think we should see multiple compression is because the multiples are pretty low. The price earnings ratio of at least the EM value portfolio that we're running is 8.8 times. So, there's a couple of good things about that. One is, that means a very high earnings yield, a double-digit earnings yield. And since it's those earnings that generate the long-term returns for investors, we are generally happy to buy companies with double digit earnings yields, unless the reason why they have a double-digit earnings yield is because their earnings are about to crater.
We really don't believe that for the portfolio we're running for a couple of reasons. One is the ROE. The return on capital for these companies is really pretty good. They're not very levered. The volatility of their ROE isn't all that high. So, while I am assuming their earnings are going to be falling this year, because the earnings of the vast majority of companies around the world will be falling, I think that 8.8 times trailing earnings is probably something around a normalized earnings figure. And the reason why I really like that relative to the S&P 500 is the S&P 500, we think, is trading somewhere around 26 times normalized earnings. And so, we can get these stocks for a little bit over a third the price and that huge discount, one, we think gives you a lot of safety from compression of valuation metrics. Because from 26 times, hey, we know – we've seen stock markets trading at 6, 7, 8 times normalized earnings. So, the potential fall for any market trading at 26 times is pretty high. Whereas the potential fall for a market trading at 8 or 9 times normalized earnings is not as extreme.
And the other nice factor when you're dealing with markets that are trading at sheet is, even if they stay that cheap forever, you're compounding out a really nice return, because you can afford to pay so much in dividends. The trailing dividend yield of this portfolio is a little bit under 6%. And again, I'm not counting on getting all of those dividends this year. We're going to see dividend cuts, because after all, this is the worst recession the world has seen since the Great Depression. But I think as the world eventually reverts back to normal, those dividends should be able to come back. And so, while I am waiting for the world to fall back in love with the emerging, I am getting paid very nicely to wait.
Ptak: We want to talk some more about value investing. Before we do that, I'm curious, what's the biggest point of disagreement on your team with respect to asset class forecasts and how have you resolved it?
Inker: There's, I would say, a couple of open questions within our team about asset class forecasting and normalized valuations. One is the extent to which interest rates should normalize either adjusted for inflation or not. The historic evidence for it isn't really all that strong. But from my perspective, the theoretical rationale for why interest rates should be bounded and probably mean revert is very strong. The other point of disagreement is the extent to which the fair value of stocks should be impacted by the level of interest rates.
The way we have dealt with that question is these days we actually have two sets of forecasts. And when we're building our portfolios, we're building them explicitly taking into account both. One, which I think is the forecast you were referring to a little while ago, assumes that everything reverts to a historically normal level. So, the real yield of bonds reverts to a normal level. The normalized P/E of markets reverts to a historically normal level, which is around 16 times. And then, we've got another set of forecasts, which assumes that real bond yields have fallen in a permanent fashion and the allowable equilibrium equity P/E has gone up. And so, we are explicitly building portfolios saying we're not 100% sure that that scenario is true, but we better take it into account as a plausible one, and we want to make sure that our portfolios will do decently well in either of those two scenarios.
Benz: Switching over to discuss value investing, can you talk about why value investing is in such a funk? You've stated previously that value wasn't cheap enough relative to the broad market before the financial crisis, and that could explain the underperformance since that time. But was that apparent at that time that value wasn't quite cheap enough to fully recover?
Inker: I think so. I wrote a paper I think it was in 2005 that was called “The Trouble with Value.” In it, I made the argument that the value of value, the discount that it was trading at relative to the broad market, was much smaller than it had been historically. It was a level where it didn't really deserve to outperform.
Now, I was not predicting the dismal performance of value in 15 years since then. My guess was value was probably going to tread water if that circumstance didn't change, which means perform about in line with the overall stock market. It has, in fact, underperformed the overall stock market considerably. There's a few reasons why--most of them are slightly complicated reasons. I would say the average investor would assume that if value has been underperforming, it's because their underlying fundamental performance, so their underlying growth relative to the market, has been a lot worse than it was during the periods where value outperform. It turns out that's not the case.
If we split the world between 1982 to 2006 and then 2007 to today, and we asked, how much have value stocks grown relative to the overall market, it turns out in both periods they have under-grown the market by about 5 points a year. So, they have under-grown, but value always under-grows. If you want to ask the question what has caused the change from that earlier period where value outperformed by a couple of points a year to this period where it's underperformed by a couple of points a year, there's three really noticeable shifts.
One is on income. And I think this is actually a particular problem for the U.S. stock market, which is less of an issue outside of the U.S. And that comes from the fact value stocks tend to have a higher dividend yield than the overall market, but the extent to which they can is driven by the valuation of the overall market. So, what do I mean by that? 1982, the U.S. market had a dividend yield of 6. A value portfolio had a dividend yield of 9. Today, the U.S. stock market has a dividend yield of less than 2. And the value half of the market has a dividend yield of about 3. So, we've gone from having three extra points of income to one extra point income, even though the relative income is the same. You get about 50% more income by buying value. So, the more expensive the market is, the more trouble value has been in.
The second reason why value stocks have done worse over the last 13 years than they have prior to that has to do with what we call the rebalancing effect. So, when you're buying value stocks, you're not actually buying a static portfolio. Every year, the value index even changes and you lose from the value index those companies that have done really well and are now trading at higher valuations and you acquire from the growth universe those companies that have disappointed and are now trading at lower valuations. That rebalancing always helps value and hurts growth. Because whenever a growth company ceases to be a growth company, that's bad, and when a value company ceases to be a value company, that's good. That benefit has been smaller in the last 13 years than it was before.
And we tried to dig into understanding why. And the biggest reason we can find is actually the third problem for value, which is very straightforward--if we look from 1982 to 2006, value stocks traded at a bigger discount to the market in 1982 than they did in 2006. So, the upward revaluation of value was worth I think about 20 basis points a year for value. Now, over 26 years 20 basis points a year actually adds up. Over the last 13 years because we've gone from a period when value was just about the most expensive we have ever seen in history to today when it is just about the cheapest it has ever been in history, that revaluation has cost you a full couple of points a year. So, the drop in the relative valuation of value has caused the negative return. And it's also caused this rebalancing to be less positive. And the reason why it's because there's this bigger gap between the valuation of growth stocks and the valuation of value stocks. And whenever that gap is growing, it's kind of harder for companies to move from one to the other.
We think if the valuation of value were to stay stable for a while, we get a couple of very nice things off of that. One is, we'd stop getting these 2 points a year of negative return associated with value getting never cheaper. The other is, we get more benefit from the rebalancing of value stocks moving growth and growth stocks moving value. And so, even if the valuation of value did not mean revert, we think value would deserve to outperform by maybe about a point a year. If it does mean revert, you deserve 2 or 3 points a year in addition to that, because at this point, value stocks are truly trading at the cheapest valuations we've ever seen in a lot of markets. In the U.S., maybe it was a little bit wider in the peak of the internet bubble. But if so, it's only a few months in 2000 that (wherever wired) than we are today.
Ptak: I wanted to shift to portfolio construction and strategy if we can. Around 40% of what I would consider to be your flagship, the Benchmark-Free Fund, is in what you describe as long/short equity with another 19% in alternative strategies, the biggest of that chunk being what you call systematic global macro, which is a 10% weighting. Can you talk about the role of non-traditional strategies like these play in portfolio construction? Why would you offer so much in long/short when maybe you could stake more in emerging equity or maybe hold more cash as kind of a barbell versus the alternative strategies you've opted for?
Inker: Yeah. So, the portfolio we're running today is abnormal even for us. Our bias is, when you are getting a decent return from traditional assets, you might as well own them. And so, today, we think the valuations of emerging-market equities are attractive and so we're happy to own them in the traditional way, just own the stocks in a long only fashion. But there's a limit to how much portfolio concentration we're prepared to have in even our favorite asset.
So, today, we've got 25 points of the portfolio in emerging-market value stocks. Now, that is a very large position relative to their weight in the global portfolio or the weight they would have in most traditional multi-asset portfolios. And the trade-off here that we're grappling with is they are far and away the cheapest assets we can own. They are also the riskiest assets we can own. After all, emerging markets, their economies are more volatile than is the case in the developed world. And crises tend to hit them harder. So, the potential downside of emerging is pretty considerable. However, the flip side is their pricing in a pretty bad outcome. So, the possibility of getting a surprisingly good outcome when you've got a portfolio trading at single digit P/Es is a lot higher in our minds than the possibility of a surprisingly good outcome when you've got something like the U.S. large-cap market where people seem to think, well, nothing bad is ever going to happen here. So, we've got about as much in emerging-markets value stocks as we're prepared to own.
And then, the question is, OK, well, what's the next best asset to own. For this winter and this spring until May, the next best asset to our minds was international value stocks. But as this bull market continued to run in this spring, we got increasingly nervous about the valuation of global equities. It's not that equities were more expensive than they were at the beginning of the year. If that relative to the way investors normally react markets were suddenly far more expensive than we would have expected, given the underlying uncertainties in the global economy. And we became convinced that the developed stock markets were basically priced only for a V-shaped recovery, which is a possibility, but is not the only possibility. And so, if you've got markets that are priced for the best-case scenario, the bad news is if you get the best-case scenario, they don't really deserve to go up, because that's what they were priced for. And if you get something worse than the best-case scenario, we think they deserve to go down.
As we looked at it, we therefore thought, well, owning traditional stocks really looks like a pretty bad risk reward trade-offs. The problem is, as you were implicitly pointing out, well, owning bonds or cash may have a lot less risk to it, but also has very low expected return. So, the question we were faced with is, well, how can we generate good expected returns to a portfolio without having that much exposure to broad equity beta. And the reason why we have 40% of the portfolio, the single largest piece of our portfolio, in equity long/short positions is because today we do see an opportunity, which is the coequal best opportunity we have ever seen from a stock selection perspective, with 2000 in being able to buy value stocks hugely cheaper than the market. So, we think value stocks deserve to beat the market by, let's say, around 4 points a year for the next five years.
Now, that 4 points a year, is actually pretty similar to the long-term equity risk premium. So, we think we can get paid something similar to the long-term equity risk premium by taking this value bet. And the good news about it is it's got much less sensitivity to the economic outcome, than a simple long only holding of equities, which is our normal default positioning and the default positioning of the vast majority of investors. It's not that we don't have some sensitivity. After all, in a really bad economic scenario, value stocks, value companies are likely to be hurt worse than growth companies, so if the worst-case scenario is something as bad as the Great Depression. In the Great Depression (readouts) that 4 points a year of superior expected return from value over the next five years I think maybe as bad as zero or minus one. So, there is a scenario in which I think value not only underperforms over the next five years but deserves to underperform in the next five years.
However, that is a scenario which is an economic catastrophe. And in that economic catastrophe, I'd rather get zero or minus one per year than what I think the equity market would have to deliver from here, which would be kind of profoundly negative returns. And if we did get that mystical V-shape recovery that we all hope for and that I think, frankly, the market is pricing in, value stocks, which have underperformed growth stocks by double digit percentages so far this year, at the very least deserve to get that back pat. So, I think in the V-shaped scenario, we deserve upside because value deserves to win if the economy comes back strongly. If the economy comes back weakly or does not come back at all, that outperformance is smaller, but I still think I've got a much better risk-reward trade-off than a traditional holding of equities. And I think I've got a much better expected return for the mean outcome than I can get out of traditional bonds or cash.
So, today, I really like the opportunity set in what we call liquid alternatives, and I like that a lot better than I did, frankly, in March. And the difference between March and today is in March I had cheap equities, not so much U.S. large caps but basically all equities around the world other than U.S. large-caps looked cheap. I had cheap credit. I had wide spreads and lots of things. Now, we've had a strong recovery and none of those conditions still pertain. But I still have the widest spread of value I've seen in history and I think that's going to be predictive of strong returns going forward.
Benz: When it comes to adding value for clients, how much of it do you expect to source from allocations among asset classes versus alpha from securities selection within asset classes? And how has that expectation changed over time if it has?
Inker: It has changed over time. It's changed for a couple of reasons. One is, I do think that markets have gotten somewhat more efficient on average over the past, say, 30 years--the 30 years of my career. And therefore, security selection is a little bit harder than it used to be. Whereas we have not seen any evidence that market's pricing of overall asset classes has gotten any more efficient. And therefore, we do think in the long run the potential value added from asset allocation hasn't really changed.
So, if 25 years ago, and let's say, it was not quite 25--I don't know. Oh my god, it was 25 years ago. Jeremy Grantham and I wrote a paper called (“How to Lose your Job in Asset Allocation”) where we suggested probably it should be two-thirds security selection, one-third asset allocation. That's from the standpoint of expected value added. I'd say, today, it's probably more like 50-50. The place where it gets squishy is, today, I think the possibility for active management to add value in equities is really very good because the value spreads are so wide. And you could call that an asset-allocation bet, or you could call that security selection. And I think our equity teams would want to call that security selection. Maybe the asset-allocation team would like to take some credit for it in expectation of the returns we are going to get going forward. But probably somewhere around 50-50 seems sustainable. What we have found, frankly, is both security selection and asset allocation tend to be episodic and lumpy in the alpha that they deliver. Unfortunately, we will see times and this year today has been one of those times where both asset allocation and security selection have been costing us money at the same time. But we do think the opportunities today for both security selection and asset allocation are really good relative to traditional portfolios.
Ptak: For a closing question, you are in the business of making forecasts. Many of the individual investors and financial advisors listening to this are making forecasts too but they lack your resources, experience and expertise. So, if you are engaged by one of our listeners for an hour and they ask you to provide a quick tutorial on how to arrive at duration forecasts, what would you counsel them to do?
Inker: I think even more important than coming up with a forecast at a given point in time is coming up with a reasonable unconditional forecast for the asset class or the activity. So, my recommendation is to start there. And frankly, what I like to recommend that people do is they think about the asset or the activity in terms of what economic service am I providing here. So, I'll give you a simple example for equities. OK, if I am buying equities, I am at heart supplying capital to corporations and I'm supplying that capital in a really low risk way because I'm supplying that capital and I never get to call it back. So, I never get to take my money back, there is no maturity level, there are no required cash flows back to me the way that they would with bonds. So, I'm supplying capital on a really low risk basis to corporations. And therefore, it can make sense for corporations in return to offer me a higher return than they would for capital that was raised on a more restrictive measures whether through bonds or from a bank loan. And so, I think the first question is, does it make sense to assume that equities will deliver a higher return in the long run. Yes, it does, because of the nature of the activity that it's doing. Where does that return come from? It comes from the corporate return on their equity capital.
And so, then you can start asking questions, under what circumstances is it safe to assume that I'll get that return that I think I deserve. And that really comes down to the two questions of – what should I expect the corporate return on their equity capital to be and how much cash flow am I getting from that corporation in return for the capital that I'm providing. So, if we take a growth company, I'm getting a very small amount of cash flow, maybe they are trading at 50 times earnings, or in some of the growth stocks these days either over 100 times earnings or frankly, they are loss making, so it's a little bit harder to measure. In order to get a good return out of that, I need strong growth, I need a really good return on equity capital and I really better expect that I'm going to get it.
So, I think the way to come up with durable expectations is understand the risks that I'm taking, understand the economic service that I'm providing and the long-term return that I deserve to get out of that and then ask the question where does that return come from and do today's conditions, are they consistent with earning the return I think I'm going to get. So, I think giving money to EM companies, particularly EM value companies, man, that's a pretty risky proposition, I should get paid well. Do I think I'm getting paid well? Well, I can buy them for less than book value; I'm buying them for 5 times cash flow, that's the 9 times earnings with a dividend yield of close to 6, yeah, it's pretty to understand how I get a pretty good return out of that. If I do that analysis for the S&P, and that's still a pretty risky proposition because after all we've just seen that the volatility of the U.S. economy can be a lot higher than it has been in recent years, I should get a pretty good return. The question is, well, with a dividend yield of 1.9% trading at well over 2 times book value, over 10 times price to cash flow and with a price to normalized earnings well into the 20s, well, I have to assume in order to get that return I have to assume things are going to get a lot better than they were at the beginning of the year. And my big concern about making that assumption is, man, conditions at the beginning of 2020 were about as good as they have ever been. Corporate profitability was exceptionally high; stability was high; people thought they could forecast out into the distant future because nothing bad had happened in so long.
I don't see how you can today forecast a strong return from the S&P 500 unless you're prepared to assume that things only get better for U.S. large-cap companies. Whereas for assets that are trading with lower expectations, you don't have to assume particularly good things.
Ptak: Well, this has been a fascinating discussion. Thanks so much for sharing your time and insights. It's been I know our listeners really appreciated as do we. Thanks again.
Inker: Thanks very much for having me.
Benz: Thank you, Ben.
Inker: Sure. Thank you.
Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
Benz: You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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