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Grantham: Value Matters in Everything

Pat Dorsey, CFA

Pat Dorsey: There's sort of large demographic trends like this that are, to some extent, forecastable. You know, not easily reversible. How do those factor into some of your asset class forecasts for, say, developed markets versus emerging markets?

Jeremy Grantham: Mostly they don't.

Pat: OK.

Jeremy: Because in the end, returns to the stock market are overwhelmingly to do with the return on capital. It isn't about top line growth. Nobody believes this, but it's true. In other words, growth stock simply don't beat value stocks. Growth countries, for the record, have no history of reliably beating slower growth countries, although everyone thinks that's the case. It won't stand the test of analysis.

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Pat: You had a question about China in the session this morning. That might be sort of a key underpinning of your- I don't want to say bearish - but perhaps more moderate thinking on China, that the returns on capital aren't going to be there to support good equity returns.

Jeremy: Yeah. I'm very bullish that China will grow fast. I'm very confident it will have a lot environmental problems.

Pat: [laughs] That's a high-confidence bet.

Jeremy: A very high-confidence bet. I'm very confident they'll put pressure on raw material prices. But I'm not very confident that their earnings per share will be exceptional. And therefore you have to be careful. When you run an analysis of growth rate by country, you find no correlation between growth and return on the market. But when you run a correlation on a country based on starting PE, there is of course a very handsome correlation.

Pat: A very big one, yes.

Jeremy: So without getting too simplified, value matters in everything, including country selection. When China looks cheap, I can stand a little bit of the problems they might have. When it looks more expensive, the longer term problems bear down more heavily. But overwhelmingly, everything comes down to starting point value. And the only thing ordinary investors, everyday investors, have to realize is you must - when you're looking at PEs - you must normalize for profit margins.

And there are several ways of doing this. But if you don't do it, you'll be very badly led astray. Robert Schiller, a professor at Yale, recommends a 10-year smoothed average, as did Ben Graham back in the time.

We try to normalize for profit margins and PEs, both of which are very easy. And I think a little bit easier and more accurate than a 10-year number. Because for 10 years you can have above-average PEs and above-average profits margins. And I can prove it, because we just did.

Pat: Yes. [laughs]

Jeremy: We had 20 years that averaged above. So you were constantly normalizing, but coming out with a number that was moderately higher, I think, than it should have been. But in any case, you have to do that.

Pat: Tying those two things together, do you see any kind of long run pressure, perhaps greater than mean reversion, on global profit margins, given sort of the entry of all this massive Chinese capacity into the global market? Does that have any kind of, perhaps, discontinuous affect on margins?

Jeremy: No, I don't think so. But then I hero-worship the ordinary and the normal. Let's put it this way, China just went through the greatest growth in the history of mankind, and we had, for a long chunk time, surprisingly above-average margins. And you could make many, many cases that they would have competed everybody down. But the global profit margins, records were set in emerging, in developed, and it didn't happen. And of course a lot of that, I must admit with hindsight anyway, a bit of an illusion. Some of those profits were padded by the banking system and padded by the growth of dept, and padded by this, and padded by that.

And padded by simply the surprise on top line growth, which was always a little bit more than people budgeted for. It's like Charles Dickens, budget a pound and your income is one pound and sixpence of happiness, and it's 19 shillings and sixpence misery. And that works for corporate profits in spades.

So the fact that they always budgeted for 3.5% global growth and got 4.25%, that was, for the world, a massive plus. And that's the kind of thing that's going into reverse now. We're going to live in a world with minor league unpleasant surprises being much more common than they were in the last 15 years.