Mon, 12 Sep 2011
GMO's Ben Inker says high-quality stocks are the only domestic-equity assets currently priced to deliver a decent real return.
Christine Benz: Hi, I'm Christine Benz.
I'm here at the Morningstar Investment Conference with Ben Inker. Ben heads up asset allocation at Grantham, Mayo, Van Otterloo. He also runs a number of GMO funds, as well as Wells Fargo Advantage Asset Allocation.
Ben, thanks so much for being here.
Ben Inker: Thanks for having me.
Benz: So, Ben, we've all heard a lot about Bill Gross talking down Treasuries recently, I'm wondering if GMO shares that view, shares that pessimism about Treasuries?
Inker: Yes, I think we really do these days. We are pretty simple, when it comes to bonds; we look for two things. We'd like in a government bond to get paid expected inflation plus at least 2%, and we'd like the government to have policies, which if sustained, would allow them to continue to service the debt. On that front, the U.S. looks to be 0 for 2, and so it's hard for us to like Treasuries much here.
Benz: How about TIPS?
Inker: The TIPS--we like the TIPS in one way, that for most investors what they care about is not returns, but returns over inflation. So, we think the TIPS make a lovely base-case investment--that you start off from the TIPS and then make your decisions. The trouble is, they've got the same problem that Treasuries do right now, which is they just don't yield enough.
So, a 10-year TIP is yielding inflation plus less than 70 basis points, a 5-year TIP has a negative real yield. So whereas 10 years ago when they were yielding 4%, that was a great place to stick your money and then look for something better. Today, 60 or 70 basis points or something negative in real terms, it's just not enough. We have a real hard time recommending them.
Benz: So, I know GMO for some time has been pretty positive on high-quality developed markets large caps. Does that continue to be the case?
Inker: Absolutely. We think that high-quality stocks are the only things worth owning in the U.S. equity space. They are probably not cheap in absolute terms anymore, but they are priced to deliver a decent real return, and the rest of U.S. equities doesn't look priced to deliver much of a return.
If we look outside of the U.S., quality is probably a little bit cheap in the developed world, maybe not cheap in emerging, but what we see all around the world, the larger cap the stock, the better the value.
So, small caps look expensive in the U.S. and in Europe and in Japan and in emerging. As you get bigger and bigger over to the mega-caps, the mega-caps look cheap everywhere, and that's weird. It doesn't happen very often, but right now they look like the best risk-reward play out there.
Benz: So I guess one thing you want to think about anytime you hear a lot of people saying the same things, and one recurrent theme for the past several months--and for you guys longer than that--has been that large caps are cheap. Should we be questioning what has gotten to be sort of conventional wisdom right now?
Inker: Well, it's funny. It seems like conventional wisdom, but unless we are looking at the past seven or eight weeks, it's not reflected in the markets. I think you've got to be very careful when everybody loves an asset class that has been doing really well.
But if it's an asset class that has been lagging, which large caps have for the last couple of years, that's a different case. Everybody loved credit in late 2008 and early 2009, and they were right. I think if everybody loves large caps right now, they may well be right. The valuations are a lot better.
Benz: I know GMO for a while has been enthusiastic about what you have been broadly calling "stuff in the ground," so energy and other resources, but you made an interesting point that you think a lot of the futures-based strategies that allow one to invest in commodities are sub-optimal, and you prefer actually natural resources equities. Can you talk about your reasoning there?
Inker: There are certain vehicles which are very effective if what you want to do is speculate, and there are others that are very few effective if what you want to do is invest. Buying a commodity future we think is inherently a speculative activity, and it's not clear that there is a long-term return to owning commodity futures.
You need not merely for commodity prices to go up, you need for them to be going up at a faster rate than the market is pricing in. And for the last decade now, commodity markets in general have been in contango, which means that future prices are expected to be higher than spot. And so, even if commodity prices are going to rise, which we think over the next 20 years they are likely to do in real terms, you won't necessarily make much money.
The nice thing about commodity companies is they are concerned with earning a decent return on capital, and by buying equity in a commodity company, you are supplying them with the capital they need to operate their business. You're doing a service which the company needs. There is a reason why the company should be interested in giving you a return, and we think that's a much better way if you want to make a long-term play than owning the commodity future.
If you think silver is going to go up in the next week, the silver future is the best place to play in. If you want to bet that natural gas prices are going to be higher 10 years from now, you're better off owning the companies that have natural gas reserves.
Benz: A last question, Ben: GMO at various points in time has been very bullish on emerging markets. You have been right about a lot of those calls. I'd be curious to get your take on emerging markets, given the tremendous runup we've had in those regions over the past decade.
Inker: Emerging markets is little bit tricky. A lot of people say they have done very well over the last decade, because growth has been good. I expect growth is going to continue to do well. So these guys are going to do as well as they did the last decade. We think the key reason why they have done so well over the last decade is they started off really cheap. They were trading at maybe six or seven times normalized earnings. Today, they are trading at 14 or 15 times normalized earnings. Now that's not enough to scare us. That's an OK valuation.
But it means there is no way that they can deliver the kind of returns--or at least they don't deserve to deliver the kind of returns--that they have over the last decade. But the valuations seems OK, and we are happy to hold them. We are a little bit nervous about the overheating we are seeing in some emerging economies, and we are a bit nervous about what's gone on with fixed asset investment in real estate in China, but we still own emerging, we're still overweight where we have got a benchmark that includes emerging. And in the long run, we think from these levels they are priced to deliver a decent real return.
Benz: Okay. Well, Ben, thanks so much for sharing your insights. We appreciate it.
Inker: Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.