Jeremy Grantham - Everything I Know About the Stock Market - 2003

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Text of Jeremy Grantham - Everything I Know About the Stock Market - 2003

Everything I Know about the Stock Market in 30 Minutes

Section 1: A Semi-Efficient Market 1. The investment management business creates no value, but it costs, in round numbers, 1% a year to play the game. In total, we are the market and given the costs we collectively must underperform. It is like a poker game in which the good player must inflict his costs and his profits onto a loser. To win by 2% you must find a volunteer to lose by 4%. Every year. The U.S. stock market is approximately efficient and getting more so. 95% or more of all market moves are unknowable noise and perhaps 5% are manageable (or predictable). Transaction costs and management costs are certain, but anticipated outperformance is problematical. Given all the above, indexing is hard to beat, and relative passivity is not a vice. Therefore, indexing must surely squeeze out active managers until it represents a substantial majority of the business. Remember -- it is the worst players who drop out of the poker game to index. The standard of the remaining players, therefore, rises... and rises... Indexing is held at bay only by the self-interest of the players as opposed to the real investors. The managers want fees and the clients' internal hired guns want influence and a job that looks demanding.



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Section 2: Stocks & Behavioralism: Growth & Value Investing 6. At the stock level in the U.S., equity investors have historically over-paid for comfort (stability, information, size, consensus, market domination, and brand names). Historically, equity investors have over-paid for excitement and sex appeal (growth, profitability, management skills, technological change, cyclicality, volatility, and most of all, acceleration in the above). Paying up for comfort and excitement as growth managers do for example, is not necessarily foolish, for clients also like these characteristics. Conversely, when a value manager is very wrong -- as he will be sooner or later -- he will be fired more quickly than a growth manager. Bodies in motion tend to stay in motion (Newton's First Law). Earnings and stock prices with great yearly momentum tend to keep moving in the same direction for awhile, perhaps because economic cycles are, on average, longer than a year. This is still true but getting weaker and more erratic recently.




Page 2 10. Everything concerning markets and economies (and everything else for that matter) regresses from extremes towards normal faster than people think (e.g., sales growth, profitability, management skill, investment styles, and good fortune). One of the keys to investment management is reducing risk by balancing Newton (Momentum and Growth) and regression (Value). Value investing has benefited from most of the above and has outperformed by about 2% a year. Growth investing has been hurt by most of the above and has been helped only by momentum and has underperformed by about 2% a year.



Section 3: The Death of Value 13. Recently, there are signs that in the U.S. this process of paying up for comfort, quality and growth and being paid to buy 'dogs' has been neutralized by the increasing popularity of quantitative and value techniques. Value stocks have been bid up to a level where they may not even have an appropriate risk premium far less an excess return. For value investing has always had a hidden but serious risk: the 60 year flood. The socalled price/book effect (and the small stock effect) sound like a free lunch, but in 192933 20% of all companies went bankrupt. They were not the large high quality blue chips but small 'cheap stocks' with low price/book ratios. To add insult to injury, the data indicates that the best growth managers add more to growth than the best value managers can add to value, probably because the fundamentals and the prices are more dynamic for growth stocks.



Section 4: The Market & Behavioralism 16. The greatest dangers to a value manager (or contrarian) are '60 year floods' and paradigm shifts. Buying heavily into cheap 1930 prices was to guarantee failure. Similarly, waiting for Japanese real estate and stock evaluations to return to the late 80's level may take infinite patience. There is no size effect or P/E effect or stock vs. bond effect, only a cheap effect. The current price tag is always more important than historical averages. (Stocks don't beat bonds because it is divinely ordained but because they are usually priced to outperform. Today for example they are not). Liquidity is a major advantage for a short-term investor. Because everyone's time horizons are shorter than they should be, liquidity is overpriced. A long-term investor should always try to exploit the other guy's short-term horizon and be paid for taking illiquidity. (And specifically...) The market level does not anticipate future reality. Bull markets do not accurately predict faster growth in dividends for example. In a bull market you are therefore on your own.




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The best long-term predictor of future stock market gains is the current value of the market (yield, price/sales, price to replacement cost). Confidence factors are the primary influences on price levels in the U.S. market not fundamental factors like growth and real interest rates. Confidence is primarily affected by inflation, volatility of the economy and corporate profit margins (not growth) and the importance and make-up of confidence has been remarkably stable for 100 years or more. Stock markets tend to top when inflation and interest rates are low (and vice versa), and responding to low short-term rates by investing in stocks will mostly be painful. Because rising margins drive confidence and p/e's up and sales growth does not, market cycles tend to double count: rising margins x higher p/e's followed by falling margins x lower p/e's. Therefore, the market deviates far more from economic trend than strictly financial logic would allow. Trading noise further adds to this non-economic volatility. When inflation dominates, stock and bonds move together. When inflation is the dominant element in defining comfort and discomfort it feeds through to both stocks and bonds and they move together (1970 - 1995). When profit margins define comfort, stocks and bonds can move independently. (1900 - 1970, 1996?) Size of assets under management is the ultimate barrier to successful investing. No large manager beat the broad market between 1972-85. As assets grow, you are forced to either pick increasing numbers of decreasingly good stocks or to buy larger, indigestible positions of your original holdings. The investment business is the perfect example of the Peter Principal: do well with 500 million, and they'll give you $5 billion.






Section 5: Quantitative vs. Traditional 26. Quantitative investing is stated with apparent greater precision and consequently breeds overconfidence. Because quants can handle more variables they can't resist using them. They can easily end by throwing in the kitchen sink and drowning in detail and data mining. The single most important advantage for traditional investors vs. quants is a tight focus. Quants will never win in U.S. Electric Utilities. For quants, the relative advantages are complexity and speed of price moves. Liquidity problems and risk control are also more easily addressed by quants. Quantitative models tend, like chess models, to get a little better every year. While traditional managers can only handle so much data. (But unlike chess models, we do not have to beat Kasparov but only the average market player).




Page 4 30. Thousands of quant man-hours are sucked into solving intricate math problems, rather than cruder but still effective techniques. On every discussion room wall should hang the motto: "THERE ARE NO POINTS FOR ELEGANCE."

Section 6: Asset Allocation 31. With a 60% hit rate it takes a good manager only 1 1/2 years to prove he can pick stocks because of many decisions a year, but 55 years to prove he can pick stocks vs. bonds (assuming only one decision every 3 years). Therefore an asset allocator must be picked on faith (or by analogy with other skills).

Page 5 32. Asset allocation can increase return and lower risk when the bets are scaled to the manager's skill level. Most good managers have hit rates in the 55 - 60% range which means they make a lot of mistakes and should make small allocation bets. Large bets will cause eventual large losses and the end of the allocation program. Almost all clients and managers want to make bigger bets than their provable skills justify. However big asset class decisions, especially stocks versus bonds are very likely to be the largest and longest lived of all major market inefficiencies because they are dangerous decisions to make and because the industry is not structured to allow free arbitrage as it is between Aetna and Travelers. History is only one of the infinite paths that could have been taken. Therefore future deviations from trend value are frequently larger and longer than history and standard deviations suggested. The future will always have a fat-tailed distribution therefore if you mean to survive, you must 'wait for the fat pitch' before making a big swing.



Section 7: Foreign Markets 35. Correlations therefore follow Murphy's law: they will change when you least need them to. The current potential damage to foreign portfolios from a strong dollar is far greater than clients suppose. When it occurs, it will be the first great trauma of institutional foreign investing and possibly create a sustained reduction in its popularity and a move to currency hedged benchmarks. The U.