GMO’s head of asset allocation reflects on the quality anomaly, why value stocks are the cheapest they’ve been in years, and whether it really is different this time for Japanese equities.
Our guest this week on The Long View is Ben Inker. Ben is the head of asset allocation at GMO, a Boston-based investment manager famous for its asset-class forecasting. Ben joined GMO in 1992 after completing his bachelor’s in economics from Yale. He’s been an analyst, a portfolio manager, and a CIO, and is a partner and board member for the firm.
Background
GMO Benchmark-Free Allocation III
Reflecting on the Past Few Years
“GMA Questions Links Between Higher Interest Rates and Value Stocks,” by Eric Rasmussen, fa-mag.com, March 27, 2021.
“GMO’s Inker: Why Investors Shouldn’t Fear a Recession in 2022,” by Jeff Berman, thinkadvisor.com, June 30, 2022.
“Profiting From a Bubble in Growth Stocks,” webcast with Jeremy Grantham, Simon Harris, Ben Inker, and Catherine LeGraw, GMO.com, March 25, 2021.
“GMO: There’s Joy in Missing Out,” by Julie Segal, institutionalinvestor.com, Jan. 31, 2023.
Current Outlook
“Update on the Bursting Bubble in Growth Stocks,” webcast with Jeremy Grantham, Simon Harris, and Ben Inker, GMO.com, June 15, 2022.
“Beyond the Landing,” by Ben Inker and John Pease, GMO.com, 3Q 2023.
“Value Is Really More Resilient in a Recession Than You Think,” by Ben Inker, Catherine LeGraw, and John Thorndike, GMO.com, June 6, 2023.
“Value Does Just Fine in Recessions,” by Ben Inker, GMO.com, June 1, 2023.
Non-U.S.
“Japan: This Time Really Is Different,” by Drew Edwards, Rick Friedman, and Ben Inker, GMO.com, Sept. 6, 2023.
Other
“Ben Inker: ‘The Portfolio We’re Running Today Is Abnormal Even for Us,’” The Long View podcast, Morningstar.com, July 28, 2020.
“Jeremy Grantham: The U.S. Market Is in a Super Bubble,” The Long View podcast, Morningstar.com, Feb. 8, 2022.
Dan Lefkovitz: Hi, and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes. I’m filling in for Jeff Ptak this week.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Lefkovitz: Our guest this week on The Long View is Ben Inker. Ben is the head of asset allocation at GMO, a Boston-based investment manager famous for its asset-class forecasting. Ben joined GMO in 1992 after completing his bachelor’s in economics from Yale. He’s been an analyst, a portfolio manager, and a CIO, and is a partner and board member for the firm.
Ben, thank you for joining us for a second time on The Long View.
Ben Inker: Yeah, very happy to be back.
Lefkovitz: I enjoyed your previous appearance, and I’ve enjoyed listening to you over the years at the Morningstar Investment Conference. I wanted to start by asking you about Jeremy Grantham, the co-founder of GMO, the G in GMO. Many of our listeners will be familiar with Jeremy as a contrarian value investor, a famous student of asset bubbles. Some call him a permabear. Curious how Jeremy has influenced you as an investor?
Inker: Well, as someone who I have worked with for over 30 years and spent the first, let’s say 15 years of my career working directly for, he’s had a huge impact on me. He taught me so much about investing. But of course, he also taught me, as you call him a permabear, that the way the world views you can be pretty limited and the stuff that can get the press is not necessarily a reasonable description of who you are. So, that’s been another piece of it. But I came in as a research analyst working directly for Jeremy. So, he taught me so much about investing and how to think about investing. And maybe the first lesson he taught me when I started doing work for him was that it is never enough to look at the returns of an asset. You need to understand how those returns were generated. And that’s been one of those lessons that I have turned back to on basically everything I have tried to do since then to understand the markets.
Benz: Well, while we’re on the topic of investing legends, this is a week when Charlie Munger passed away. I’m wondering if you can reflect on his impact on your thinking about investing and on the investing landscape more broadly.
Inker: In addition to being such a smart and insightful guy who had such a way with words, to me, a key thing about what Charlie did and what Charlie did for Warren Buffett was get him thinking about and understanding the importance of quality in investing. And that is something that has always been a really key part of how we think about the world at GMO. And I think it is an underappreciated feature of companies when people are thinking about investing. People tend to be so focused on growth. Is this a growth company? And if it’s a growth company, cool, I’m prepared to pay a premium. But growth comes and goes. Growth is difficult to predict. Quality is a pretty stable characteristic and quality has some lovely features to it. And it also has some nice convenient things for portfolio management. One of the things that Warren said that was very useful in the framing that Charlie helped him give is, if you are trying to buy—what was the term, fair companies at extraordinary prices, you’ve got to turn over your portfolio a lot. If you are trying to buy extraordinary companies at fair prices, you really only need to sell them when the prices are no longer fair. And there’s some nice pure simplicity about that.
Lefkovitz: As long as we’re on the topic of quality, Ben, wanted to ask you about GMO’s ETF that recently launched with the ticker QLTY. I think it’s the first ETF that GMO has launched. It’s actively managed and it focuses on quality stocks. You’ve described the quality anomaly or factor as weird. Can you explain why it’s a weird anomaly?
Inker: The reason why equities give an equity risk premium in the long run is because of the fact that if you own stocks, you can rely on the fact that in very bad economic times you are going to lose a bunch of money. And it’s that risk that you’re taking and the inconvenience of the fact that losing money in bad economic times is the worst time to lose money, right? That is losing money at the same time you’re at more risk of losing your job where your income, even if you have your job, is worse. You do not want to lose money in really bad economic times. And the one thing you can say about high-quality companies is they will fundamentally hold up better in really bad economic times. So, in a rational world, they should give a lower long-term return. The risk that you should get compensated in owning equities is less, is smaller with high-quality companies. So, the one group of stocks that really deserves to underperform in the long run and where that underperformance would be fine. People should be willing to accept that.
The weird thing, the quality anomaly, is that they don’t underperform. In fact, they have outperformed. And that is kind of crazy. That is something that if markets were efficient, absolutely should not happen. But we see it in equities. We see it in all slices of the equity market. So, it’s not just about a handful of extraordinary companies. We see it in lots of markets. We even see it in the bond market. There is this strange problem in financial markets that people underprice quality characteristics. And it’s a good thing for us as active investors. But it’s maybe one of the weirdest persistent anomalies in markets because it’s not just, oh, stocks starting with Q do particularly well. Or I don’t know, even if value stocks outperform in the long run. You can come up with perfectly reasonable explanations for that. It is very, very difficult to come up with a rational reason why higher-quality companies would persistently outperform. And yet they do.
Benz: So, you alluded to this in your response just now. But I wanted to ask about other geographies outside the U.S. Does quality work equally well outside the U.S.? And should we expect to see more ETFs from GMO focused on quality in other markets?
Inker: For us, launching an ETF part of it was about the strategy and part of it was about where the demand was. And ETFs are a much bigger deal for U.S.-based investors given the unique tax advantages they have for U.S.-based investors. And U.S.-based investors really like U.S. domiciled stocks. So, this was an obvious first ETF for us. It’s also one where because it’s not that high a turnover strategy, it is something that we can do actively that can be really pretty tax-efficient.
In terms of the next ETF, some of that is going to be driven by other strategies we run. But it’s also going to be driven by where do we think U.S. domiciled investors are likely to be interested. And I don’t know whether a non-U.S. quality strategy is going to capture the fancy of U.S.-based investors. It should. Quality has outperformed broadly across markets and across time. And there are certainly high-quality non-U.S. stocks.
I will say it is an interesting thing and I get accused of saying only negative things about U.S. stocks. But if you look across the global stock universe and you were to just pick, regardless of domicile, which are the very highest-quality companies around the world, a disproportionate share of them are U.S.-based. And so, the U.S. is a place where you can run a high-quality strategy and really not have to compromise much on truly buying very high-quality companies. In some other geographies, it’s a little bit dicier. You can always define the highest-quality 25% of, let’s say, the emerging-markets universe. But some of those companies will not be as high-quality as you could get in a high-quality U.S. portfolio.
Lefkovitz: Ben, before we get to your current outlook, I wanted to reflect a little bit on the past few years. You previously appeared on The Long View in mid-2020, so the midst of the pandemic. I went back and listened to that episode and there were some areas where you were very prescient. You were negative on bonds, which contributed to a bearish outlook for the U.S. 60/40 portfolio. And of course, we had the worst bond market ever since then and a bear market for equities as well in 2022 in the U.S. But on the flip side, you had a lot of conviction at that time in equities outside of the U.S., including emerging markets. What do you think accounts for the U.S.’s continued dominance from an equity market perspective?
Inker: There are a few things. A couple of them, I think, are more likely to be temporary than permanent. Since the middle of 2020, a couple of things have happened. One is the U.S. dollar has been particularly strong and the U.S. dollar today looks pretty overvalued, which is a problem for U.S. domiciled companies relative to non-U.S. companies on a forward-looking basis. But over this period, the fact that the dollar has been strong has been kind of a headwind for U.S. dollar returns for non-U.S. equities. Another thing that has happened is in most of the rest of the world, valuations are down substantially from where they were in 2020, and in the U.S., they’re not. So, the U.S. has moved to a bigger premium on average than it was trading at versus the rest of the world since 2020.
But the other thing that’s harder to deal with and harder to know exactly what to do about is there are a handful of giant companies in the U.S.—the Magnificent Seven gets talked about a lot these days—that have fundamentally done really well. Now, they’ve also gotten more expensive. But on a fundamental basis, they have done quite well. They are a really big piece of the U.S. market. The S&P 500 has outperformed the rest of the world; the S&P 493 has not. And a problem when you are trying to forecast markets is the more concentrated they get, the tougher it is to make the simplifying assumptions that you can make about a more diversified index. And the Magnificent Seven have certainly done better relative to all other companies around the world than we would have guessed. It doesn’t mean they will continue to forever. But in this period, they were the thing to own.
Benz: I wanted to ask about interest rates, which have so dominated the investment narrative in recent years. When rates were low, we had the TINA theory, the idea that there is no alternative to stocks, and now it’s higher for longer. Can you talk about how you factor interest rates into your calculus at GMO? I know you’ve had some contrarian views on the influence of rates on equity-style leadership, for example.
Inker: I certainly think there are some narratives about the way that interest rates impact investments that aren’t actually true when you start really digging in. But there is a fundamental one that is very important. Equities need to deliver a decent equity risk premium over risk-free assets because of the risks you’re taking when buying them. If they’re going to be properly priced, you should be getting a premium to T-bills and Treasury bonds in long-term equity returns. But if T-bills and Treasury bonds are offering much less return than they have historically, equities can get away with delivering significantly less return as well. So, in an environment where interest rates are permanently low, equity valuations can be higher. And the way we deal with that in our equity forecast, or our overall asset-allocation forecast, is we come up with forecasts for a few different interest-rate scenarios. We call them normal low and ultralow. And the overall expected returns that we use to build our portfolios is based on a weighted blend of how likely we think those scenarios are.
There are a few tricky things. One of them is that the interest rate that matters is not necessarily the interest rate that exists today. It’s where interest rates are going to be on average over the next 20 to 50 years. And even in 2020, when interest rates were really low, we didn’t think it was particularly likely that interest rates would stay that low over the next 20 years. So, we would have said, oh yes, today bonds make very little sense, but that doesn’t mean you should put all of your money in the stock market because it looks better than bonds. Because in a world where interest rates were going to rise, that was going to hit both stocks and bonds.
Lefkovitz: Ben, you’re skeptical of some of the conventional wisdom about how interest rates impact particular styles of stocks. Talk about that.
Inker: It comes back to one of the lessons Jeremy Grantham taught me at the very beginning of my career, which is you need to be really careful about how returns are generated. There is this assumption that growth stocks are a longer duration investment because you get less in dividends and more in growth. And therefore, when interest rates fall, that should be a bigger plus for them than it is for value stocks. And that sounds very straightforward. And it would be if when you invested in growth stocks, you were investing in companies that were guaranteed to achieve the growth you were hoping they would achieve. But it turns out what makes growth investing difficult is predicting growth is difficult. And the pain of a growth shortfall in a company that was priced for growth is a big deal. And that aggregate pain has been the reason why over the last 50 or 100 years, growth stocks on average have underperformed the market by a little bit. In the absence of that pain, they would have outperformed quite strongly.
So, the problem with thinking in terms of, oh, I’m going to run a discounted cash flow model, I’m going to do a dividend discount model, and it’s going to be on the basis of my best estimate of what’s going to happen to, I don’t know, NVIDIA over the next 20 years is it turns out the impact on returns if your forecast was too bullish, you were overestimating how much growth there was going to be, is a huge negative if growth stocks are trading at a big premium. So, if you say, well, interest rates are low, and therefore growth stocks should be trading at a big premium, if growth stocks are trading at a big premium, every time one of those growth stocks disappoints, you’re going to get a really big negative return. And so, if you actually model out the complexity of the fact that neither growth nor value investing is a static strategy, there is always turnover to the portfolio, if you assumed the growth-valuation premium could go up substantially when interest rates went down, you would come up with a set of return components that would guarantee that growth would underperform in the long run.
I didn’t do a great job of explaining that. But if you oversimplify the way you think returns are generated from a style of investing, you’re going to get wrong answers. You are going to come to inaccurate conclusions, and lots and lots of people do that with regard to growth and value investing. And those oversimplified narratives have consequences.
Benz: I wanted to ask about GMO Benchmark-Free Allocation, which is one of the funds you worked on. It performed very well in 2022, which was a down year for both stocks and bonds. And you talked about having what you call JOMO—joy of missing out—because you were light on fixed income, light on growth stocks, no crypto. Have you been surprised by 2023? It seems like in a lot of ways it’s a return to the pre-2022 regime where we have growth over value and a small group of U.S. mega-caps pacing the market. Can you talk about that?
Inker: In one sense, 2023 being a much better year than 2022, did not take us by surprise at all. Our forecasts as of the end of 2022 were much, much better for both stocks and bonds than they were at the end of 2021. And our portfolio had moved accordingly. We had substantially more equity stocks in the portfolio than we did, and we’ve continued to buy stocks during the course of 2023, and we’ve continued to buy bonds, although the last few weeks we have not been. So, I would admit I’ve been surprised in 2023 by how extraordinarily concentrated stock returns have been. I’m not surprised it’s been a better year for stocks generally. I am surprised that the Magnificent Seven have returned an average of, I think, something like 100%. And the rest of the U.S. market has delivered more like 3%.
The value versus growth nature of the market with growth really having a very strong year is a surprise to us because value was quite cheap at the beginning of the year. It’s also been a very weird year for that, though. Value has lost to growth by a very large margin on a global index basis. It’s not only the case that all of that is driven by the U.S. In both non-U.S. developed markets and emerging markets, value has beaten growth. But it truly is driven by those seven companies. Within small-cap stocks, the spread between value and growth in the U.S. has only been a few points. On an equal-weighted basis, even within the large-cap universe, it hasn’t been all that big. It has been shocking how concentrated the returns have been. And not entirely unprecedented. We have seen a few times like this in the past, but quite rare.
Lefkovitz: Well, let’s get to your current outlook, Ben. You recently presented at a GMO client conference and your presentation was entitled, “Spoiled for Choice.” We’d love to delve into the asset classes where you have the highest conviction. But before we get into the specifics, why at a high level are you so excited about the opportunity set right now? There’s still a lot of risks out there—a risk of recession, there’s the higher-for-longer interest-rate dynamic—yet you’re calling the investment environment wildly better than two years ago.
Inker: Well, the reason why the investment environment to us looks wildly better than it did two years ago is not because there aren’t risks. There’s always risks in the global economy. We don’t really know how to forecast recessions particularly well. I feel comfortable in saying that because I don’t think anybody else does either. Recessions basically always come as a surprise to investors. So, when we’re looking at markets and trying to decide whether we’re excited or fearful, it tends to be much less driven by, well, is there a risk of a recession out there? And much more about, well, how much am I getting paid for taking equity risk or taking recession risk? When we’re getting paid well for taking risk, we’re excited about taking risk. And today, in a number of pockets around the world, you can get paid quite well for taking risk.
The other thing that makes us excited as investors, though, is if you choose not to take risk, if you choose to own much less-risky assets like T-bills or Treasury bonds or inflation-protected bonds, they’re offering so much more than they have in years and years. So, the exciting thing for investors is whether you’re looking to buy an equity portfolio, a fixed-income portfolio, or a diversified portfolio across assets, the outlook looks pretty good. Bonds look good today for the first time in years and years. Cash is offering a higher return than we have seen in this country in 20 years.
One of the things that I think gets underappreciated—hedge funds have gotten, in general, a bad rap because over the last 20 years they haven’t returned all that much. One of the reasons why they haven’t done very well in absolute terms is because cash rates on average have been close to zero. And if you are performing a hedged activity, your underlying return is cash. And in the ‘90s, that cash averaged, I think, about 5%. So, you were starting with a 5% return, and if you could do something else on top of that, it wasn’t that hard to get to a double-digit return. When that cash is starting at zero, your chances of getting to that double-digit return are really low. And the nice thing about today is cash is yielding 5% again. And that’s good for cash. It’s helpful for fixed income of all kinds because the yields have been dragged up. We think it has helped drive stock valuations down.
And one of the things that I think people don’t fully appreciate—2022 was a bad year for stocks; 2023 has been a good year for stocks, particularly in the U.S. And again, most of that is driven by the Magnificent Seven. But even if the stock market in round numbers is about where it was a couple of years ago, it’s still substantially cheaper because two things have happened. One is we’ve had a significant amount of inflation, and that increases fair value for stocks because stocks are real assets. They create the goods and services that go into inflation. When inflation goes up, the fair value of stocks goes up. The other thing that’s happened is over the last couple of years, we have seen economic growth. And as that economic growth occurs, fair value goes up.
As we look at it, it hasn’t gone up faster in the U.S. than it has on average in the rest of the world. But it has gone up. And so, even U.S. stocks, we think, are substantially better than they were a couple of years ago. And when you get into the cheapest 20% of the U.S. stock market, what we refer to as deep value, we think those stocks are probably cheap in absolute terms. And it’s been a while since we have been able to say there is a group of stocks in the U.S. that we think is cheap in absolute terms.
Benz: Related question, thinking about the Magnificent Seven lifting the U.S. total market, do you think there’s something structural going on with the market that’s causing the total U.S. market to be so concentrated? And is it self-perpetuating? Have you looked at that or thought about that?
Inker: The time that I would say is most comparable to what seems to be going on in the U.S. right now is the Nifty Fifty era in the early ‘70s. And we see the connections in a couple of different ways. One is the simple concentration level of the U.S. stock market. The top seven stocks in the U.S. are something around 29% of the S&P 500. That is much more concentrated than it has been on average over the last 50 years. The last time it looked similar was in the Nifty Fifty era. It also got pretty concentrated in 2000 during the internet bubble. But that was, to our mind, a different environment. Those big companies were very much big because they were expensive. So, that really was a bubble and was guaranteed to burst.
The Nifty Fifty was an interestingly different environment. Those companies were big. They were expensive. And the Magnificent Seven, to be clear, are more expensive by a significant margin than the average company in the S&P 500. But what’s been interesting in the years running up to today is the way they got there was not some short-term investment fad, but the fact that these companies in general have delivered really strong growth for a long time. And that was the interesting thing about the Nifty Fifty era. The Nifty Fifty stocks were the so-called one-decision stocks. They were companies that were so extraordinary, you could buy them, and you never had to sell them. And the reason they got that way is because for a weirdly long period of time, from the early ‘60s to the early ‘70s, that group of growth companies didn’t disappoint. So, I talked earlier about the difficulty in investing in growth being those growth companies that disappoint—I’ve tried to get people starting to talk about them as growth traps. I’m not sure I have succeeded, but I’m going to use that term. The growth traps are a real problem and give you big losses as a growth investor.
In the 10 years to 1973, almost none of those big-cap growth companies disappointed. And in the 10 years to 2023, in this Magnificent Seven cohort, they haven’t disappointed either. Actually, they all did basically in 2022. But, on average, they have really achieved the growth that people thought they would achieve and done extraordinarily because of that. So, these are expensive companies. They are legitimately also huge companies. Apple may be more expensive than the average company, but they make tons and tons of money. They are legitimately a huge company, so is Microsoft, so is Google. And so, it’s not just that they’re expensive. They are huge. And they have done something that has been very difficult for huge companies to do historically, which is, continue to grow.
Whether they are going to continue that in the future is a hard question. All of these companies have a certain amount of monopolistic or oligopolistic power, which is a lovely thing to have if you are a company. It is a thing which becomes more problematic as that company becomes a bigger and bigger part of the economy. And historically, one of the difficulties of being a really big company with a lot of market power is the government starts to be interested in what you are doing and wants to start stopping you from doing the things you would like to do. So, I do think the next 10 years are going to be a lot tougher for these companies than they have been over the last 10 years. That’s an easy thing to say because the last 10 years have been awesome for all of these companies. But this is not just a fad. This is about a set of companies that have done fundamentally extraordinarily well that doesn’t tell you they are going to continue to. But they have been pretty special companies and with the notable exception of Tesla on our data, almost all of them are also really quite high-quality companies.
Benz: A related question is, to what extent do you think fund flows are in the mix and that you’ve got a lot of investors and financial advisors just buying U.S. total market and calling it a day, and those investors are inherently valuation insensitive? Is that contributing, do you think?
Inker: It certainly could in a sense. An index investor, as you say, is inherently a price-insensitive investor. They’re never going to say, ooh, Apple looks expensive. I’m going to buy less. But on the other hand, if companies’ liquidity was completely correlated with their size, that is, the ability to buy a certain amount of Apple without impacting the price was proportional to its market cap, it’s not obvious that passive investors are going to push up the price of Apple any more than they’re going to push up the price of the smallest company in the S&P 500.
I do think the bandwagon effect of people preferentially buying strategies that have on a backward-looking basis done well has helped push up these companies in particular because they have done so well for so long that there’s a whole bunch of different strategies you could have that happened to have large allocations to these companies and they’ve all done well. So, whether you are a momentum investor or a growth investor or a tech investor or a U.S. investor or what have you, you bought them all. But flows can’t have a permanent impact on returns. That would get eventually fairly stupid because as companies become more and more overvalued, the underlying fundamental cash flows they can deliver to you goes down and down and down. So, I’m kind of skeptical of a lot of statements about inevitability of passive is going to do this and it’s never going to unhappen. In the Nifty Fifty era, the dominant asset owners bought the Nifty Fifty. But over the next 10 years, because those companies ceased to be as special and some of them disappointed, that group of companies did fundamentally quite badly, and the flows changed.
Lefkovitz: I wanted to ask you about your conviction in value equities over growth. You call the current outlook for value equities exceptionally good. It seems maybe at odds with your preference for quality.
Inker: Well, the thing about value is, if you look at the way it generates returns, the bulk of the returns you get in investing in value come from the value stocks you buy that cease to be value stocks. So, it is the companies that graduate from the value universe to the growth universe that are the real drivers of returns. You can get pretty good returns from companies that stay cheap and compound nicely, but, on average, value companies undergrow. That’s not a surprise. After all, on average, growth companies outgrow. And it’s this term we refer to as “rebalancing” that is the single biggest driver of returns for value. Rebalancing is driven by two things. One is, how many of the value stocks move to the growth universe and how many of the growth stocks move into the value universe. And two, how big a return, either positive or negative, is associated with moving from value to growth or growth to value.
The reason why we’re so excited about value stocks right now is because they are trading at such a big discount to growth stocks that when a value stock upwardly surprises and graduates to the growth universe, it gets a huge return premium. And when a growth stock disappoints, becomes a growth trap and falls into the value universe. Because of the big premium growth stocks are trading at, that is a strong negative return. And so, when value stocks are trading at a much bigger discount than normal, we get excited because that rebalancing is going to be bigger than normal. And looked at on average across stocks, it’s actually worked out pretty well this year.
The outperformance of growth, again, has been truly dominated by a handful of companies. So, if we look across the median company, that positive rebalancing for value and the negative one for growth stocks on an equally weighted basis has been a big deal this year. And so, value, one, has worked pretty well outside of the U.S. this year. And even within the U.S., hasn’t been anywhere near as much of a disaster if you weren’t cap weighting. So, this year, I have been surprised by how well growth has done. I think in the longer run, these growth traps are going to be a problem for growth. But we’re still seeing under the surface, even in a very good year for growth, that that rebalancing is operating the way we would expect it to and is a really big positive for value stocks.
Benz: You just mentioned non-U.S. and we did want to spend a little bit of time there. You’re bullish on Japanese equities, which for so long have been such a disappointing asset class but seem to possibly be turning a corner. Our Japan index is up nearly 30% in yen terms. What gives you faith that this isn’t another false dawn for Japanese equities? And why have you specified small-cap value as especially attractive in Japan?
Inker: So, Japan is a great example of a market where you want to dig under the surface and understand where those returns are coming from rather than simply looking at the returns and declaring, aha, it is a disaster; you should never invest there; or it is brilliant, and you should invest there. In the 1980s, Japan famously outperformed the rest of the world by a huge margin. They didn’t do that because they were outgrowing. They did it because the valuations moved to a 3 to 4 times premium over the rest of the world. And over the last 30 years, a big part of the reason why Japan has been a disaster has been the fact that that valuation premium has completely disappeared. They started off trading at 3, 3.5 times that of the rest of the world and their relative valuation has fallen continually. However, even that huge valuation negative doesn’t fully explain how bad Japan has been.
The other piece that has been the driver of disappointing returns in Japan is their return on capital has been half that of the rest of the world. As an investor in stocks in the long run, the two things that matter the most are, what is the price you are paying? So, what is the valuation of the assets? And what is the return on capital of those assets? And Japan has seen falling valuations and a horrible return on capital.
Why are we excited about Japan today? Well, that valuation premium is gone. Japan is now trading modestly cheaper than the world outside of the U.S. and substantially cheaper than the U.S. The other really exciting thing is their underlying return on capital has hugely improved. And we see signs that it is going to continue to improve. So, in Japan, their operating margins, they have basically doubled since Prime Minister Abe came back into power in 2013. And that’s really awesome because they needed to get that done. Japanese companies were not sufficiently focused on the profitability of their sales. They were more focused on revenue.
The other thing they need to do is start worrying about their balance sheets. The average Japanese company has net cash sitting on their balance sheet. The average Japanese company truly has no debt, if you were to look at their debt relative to the cash and cashlike assets sitting on their balance sheet. And that’s actually a good thing from a safety perspective. It’s hard to go bankrupt if you don’t owe anybody any money. But it’s also a kind of crazy thing to do if you are in an economy where interest rates are close to zero. Because that cash sitting on their balance sheet is earning zero. And you as an equityholder are not very interested in assets that are earning zero.
So, what we need to see for continued improvement in Japan is for Japanese companies to start being more rational about their balance sheets. And part of what makes us excited is we’re seeing that. We’re seeing the Japanese companies starting to act in that way. And slightly bizarrely, the Japanese government is strongly supporting those actions. If you think about government action and corporations in general, anything the government does actively with regard to corporations is probably a bad thing. In Japan, their Ministry of Economics and Trade has put together this white paper in policy about encouraging mergers and acquisition activity. If you can imagine the Department of Justice doing a similar thing in the U.S., well, you’ve got a better imagination than I do. So, we’ve got the government on our side. We have some relatively simple things Japanese companies could do to improve things for shareholders. And we’re seeing lots of evidence from Japanese management that they’re starting to listen.
Why do we particularly like small-cap value today? The story I am telling you is not a unique story. You will have heard this from other investors. As you said, the Japanese market in yen terms at least is up 30% this year. That’s really all driven by foreigners. And one of the things that foreign investors in Japan tend to do is they buy the names of the companies they know. So, large-cap stocks have substantially outperformed in Japan. And the smaller-cap stocks are trading at a really nice discount to the extent that there’s still a whole bunch of smaller-cap names in Japan that are actually trading at a discount to the net cash on their balance sheet, the so-called net nets. That is not a thing that exists anywhere outside of Japan in any meaningful numbers. It still does in Japan.
The other thing I really like about small-cap value in Japan, we like value everywhere. We’re nervous about small-cap value some places, particularly in the U.S. and the U.K. And the reason why is small-cap companies in the U.S. and the U.K. have really leveraged themselves up. They have a lot of debt and in a bad economic circumstance, they could be in some real fundamental trouble. The nice thing about the small-cap companies in Japan, they don’t really have any net debt. So, in bad economic times, they’re not going to get driven into bankruptcy. They are higher-quality companies than small-cap value is in most places.
And then, finally, the last thing I absolutely love about Japan today is the yen. The yen is in technical terms stupid cheap. This is the cheapest this currency has been since I think 1971. And that is a wonderful tailwind for Japanese companies. And it is a particularly wonderful tailwind for Japanese companies where most of their costs are in Japan. If you are a well-known multinational Japanese company, some of your costs are in Japan, but plenty of them aren’t. Toyota builds cars all over the world. The fact that the yen is cheap is nice for Toyota, but they build plenty of cars in the U.S. And the U.S. dollar is expensive and that’s a problem. One of the nice things about the smaller-cap companies is they tend to have more of their costs local to Japan. And when the yen is cheap or when any currency is cheap, the thing you want to do is buy the companies who are getting the benefit of that cost advantage.
Lefkovitz: Well, staying in Asia, when we last spoke to you in 2020, you had a big bet on Chinese equities. And since then, of course, we’ve had the Chinese government intervention, the regulatory crackdown that kneecapped several of the biggest names in the Chinese equity market. I think GMO breaks China out as a separate asset class from emerging-markets equities. Talk about how you’re approaching China. Some investors are seeing it now as uninvestable.
Inker: We do not view China as uninvestable, but we took down our weight in Chinese stocks by a lot in 2020 and 2021. There were two reasons for that. The most important one is Chinese stocks were trading at a big premium to stocks in other emerging markets. And if the reason why we liked emerging-markets stocks was that they were trading cheap. Well, you didn’t get that if you invested in China stocks. So, it was an easy thing to move outside of China. We had a cheaper portfolio, one that we thought had a higher expected return. And we also had this other really nice feature, which is more balanced fundamental risks.
I don’t view China as uninvestable. And the reason why is because there are lots of places where there are very substantial geopolitical risks to what you’re investing in. And historically, if you had a diversified portfolio of stocks in places where geopolitical risks were high, you’ve done fine. A big part of the reason for that is those risks tend to be pretty idiosyncratic to that country. And so, the very bad event that happens in Turkey is different from the bad event that happens in Brazil or Mexico or South Africa or India. So, the diversification really helps you such that the disastrous election or what have you in one of these markets doesn’t drag down your entire portfolio. That became less true in emerging as China became a larger and larger piece.
And so, from a fundamental risk perspective, we view emerging markets as stocks in countries that have higher geopolitical risk. And when we’re going to be investing in those areas, our preference is to make sure that no single geopolitical risk can blow through the entire portfolio. When China was close to 40% of the overall emerging-markets index, that was not possible while owning something that looked like MSCI emerging. And we have seen a bad geopolitical event in China. As you say, the government cracked down on a whole bunch of companies. And that wasn’t unique. We’ve seen that in other emerging markets before. But China was really big. So, it hurt a lot if you had a China-heavy portfolio.
Today, the good news is China is no longer trading at a big premium to the rest of emerging. We still like the rest of emerging better for China for a slightly more subtle reason, which is China has done disastrously over the last couple of years. It has done pretty disastrously from an economic perspective and even more disastrously from an overall stock market perspective. One of the things, though, that has happened is value has been a wonderful thing in China. Value has very strongly outperformed in China. And the spread of value, that discount that value stocks are trading at relative to growth stocks, is now significantly smaller in China than it is in the rest of emerging. So, I still like the rest of emerging better than China because I think I’m getting that bigger value discount and I’m going to get more return from rebalancing. But it is absolutely not the case that I view that China is uninvestable. China has a lot of risk to it. But that risk is probably not something which is a systemic problem for your overall portfolio.
Benz: For our last question, we wanted to ask about environmental, social, and governance investing. ESG has become a lot more controversial since the last time we spoke with you. It has come in for a great deal of criticism from an investment perspective and it has gotten political as well. Jeremy Grantham is a well-known climate advocate and GMO has a climate-focused investment strategy. Has your thinking on ESG changed or evolved over the past few years?
Inker: For us, it really hasn’t. The way we think about ESG considerations in investing in stocks is really around risk and quality. The way we have tried to incorporate ESG characteristics in stocks is to be saying a company that scores poorly is more likely to have something surprising and bad happen to it than the average company. That doesn’t make it uninvestable, but it means all else equal, you would want to pay less for that company just the same way as we’re willing to buy a junkie company, but we better be getting a big discount for that. So, the way we incorporate ESG across everything we do is to say this is a cousin of quality and we want to make sure we’re getting paid for taking the risks associated with the companies that score poorly.
There’s another side which we really do believe in. If you look at the stocks we own in our Climate Change strategy, those are stocks that we think will benefit as the world is forced to adapt to a change in climate and has to change our energy infrastructure and a whole bunch of other things—there are companies that will benefit. I think the market has gone through a couple of cycles on ESG. A lot of people said, hey, ESG is great, you’re going to get a higher return and it’s going to be easy, and this is going to be great, so you can feel better about your portfolio, and you will outperform. That was never going to be something that was sustainably true. The only way you can have a group of stocks outperform in the long run is if they are permanently mispriced. Historically, I don’t know, high-quality stocks have apparently been fairly permanently mispriced, but I don’t know that they will be in future, and I certainly wouldn’t want to assume any group of stocks is going to be fundamentally mispriced forever. That’s what you need to believe in order to think a group of stocks is going to underperform.
I do think there is another thing that is going on and should continue to go on, which is, there is a significant set of investors who say, “I want my portfolio to reflect my moral views, and I don’t want to own companies that don’t align with that.” I think that is fine. I think that is a lovely thing to do. It’s more personal. It’s about what you believe in, and I’m not going to tell you what you should believe in. But I can tell you, in general, excluding a group of companies because you don’t like what they’re doing, normally doesn’t have that much impact on the returns of your portfolio. In the long run, you could have excluded stocks starting with the letter B or companies in certain industries and you’d still get a perfectly good return.
I think people should absolutely be thinking about their portfolios and what kind of stocks they want to own. I do worry that there are people who, again, have overly simplistic narratives and say, well, I think the world needs to change. I think we need to stop burning so much fossil fuels and move to a cleaner grid. But I’m not going to own any copper miners because I don’t like the environmental damage associated with copper mining. The reality is, if we’re going to make the shift that you want the world to make, we need copper. We cannot do that without copper. If we lived in a world where copper miners were starved of capital because people said we don’t like mining and what it does to the environment, we’re never going to get there.
So, what I would say, if you’re going to do ESG investing on a more active basis, you should either be doing it on the aggressive side, that is, what we’re doing in the climate change where we’re looking for companies that we think are going to benefit as the world changes. You can do it on the moral side of saying, hey, I don’t want to own tobacco companies or I don’t want to own coal companies or I don’t want to own companies that create weapons of mass destruction. All of that can make sense. But I think some of the backlash is politically driven. We live in a country where it is more or less impossible to have a statement of values which somebody is not going to violently disagree with. But I think some of the investor backlash against ESG investing came from irresponsible promises. It is not going to be the case that investing will be easy if you do X. And a bunch of people on the ESG side said, investing is easy if you’re going to use ESG.
Lefkovitz: Well, Ben, thanks so much for joining us on The Long View. It’s been great to have you.
Inker: Yeah, this was fun. Thanks so much for having me.
Benz: Thanks so much, Ben.
Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
You can follow us on Twitter @Christine_Benz.
Ptak: And @Syouth1, which is S-Y-O-U-T-H and the number 1.
Benz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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.
(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)