Might Makes Right

Jeremy Grantham has been pounding the table for high-quality stocks since at least 2006. That was the year when his firm, Grantham, Mayo, Van Otterloo & Co., estimated that large-cap companies such as Coca-Cola KO and Johnson & Johnson JNJ would beat the S&P 500 by more than 3% per year during the next seven years.

No one paid much attention, as high-quality stocks (defined by GMO as companies that have low debt and stable, above-average returns on capital) lagged over the next two years. But investors took notice when 2008's results were tallied: The S&P 500 dropped 37% while GMO Quality GQETX, a fully invested mutual fund stocked with high-quality firms, lost 24% and the Morningstar Wide Moat Index, a market-cap-weighted index of high-quality companies, lost 30%.

Grantham and GMO still think the future is bright for these strong businesses. According to GMO's research, mega-cap high-quality stocks trade at their biggest discount to the S&P 500 in recent history--a 10% discount today compared with a 40% premium in the mid-1970s (otherwise known as the Nifty-Fifty era).

Unlike GMO, other go-anywhere managers had not made much of a fuss about high-quality names. That changed when Steven Romick, manager of the Los Angeles-based FPA Crescent Fund FPACX, announced during his second-quarter conference call that he and his team had been spending "an inordinate amount of time studying high-quality companies." This was big news because Romick, one of the five finalists for Morningstar's Manager of the Decade award, has a history of buying primarily small- and mid-cap companies.

When we see managers such as Romick and those at GMO get on the same page in regard to an investment theme, we want to learn more. We invited Romick and Ben Inker, GMO's head of asset allocation and manager of GMO Global Balanced Asset Allocation Fund GMWAX, to discuss this subset of the equity market. Our conversation took place Aug. 24 and has been edited for clarity and length.

Defining High Quality
Ryan Leggio: Both of you have been talking a lot recently about high-quality stocks. Steve, what's your definition of a high-quality company?

Steven Romick: Are we talking about high-quality stocks or high-quality companies?

Leggio: Both.