How Grantham Defines "High Quality"

Pat Dorsey: In looking at your most recent asset class forecasts, the one that sort of sticks out - especially since it has really under-performed during this recent rally - is U.S. High Quality. That sort of being at the top of your list right now.

Jeremy Grantham: Yeah.

Pat: You've been fans of that for a while, and I've always wanted to ask you, how do define high quality? If you could unpack that a little bit, I think it would be very helpful.

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Jeremy: It's unbelievably ordinary, like most of what we do. It's high return, stable return, and low debt. The way we do, it has a fractional difference between a Moody's rating or an S&P rating, but very similar. Quality is quality; we kind of know what it is. It's a great franchise company. If you have high stable returns, you're fixing the price. You're a price-setter. [laughs]

Pat: Of course.

Jeremy: And you can only do that if you're a great franchise company. And if you can do that, you don't need any debt, and so they don't have it. So it tends to go as a package. Our high quality companies, whether we own them or not, whether they're cheap or not, are always Coca-Cola (KO), Microsoft (MSFT), Merck (MRK), and Lilly (LLY) and so on.

Pat: It's interesting to hear, because we do a lot at Morningstar on kind of competitive advantage. Again, I've just always been curious as to how you define it, and as you put it, simplest is always the best.

Jeremy: Yeah, it's almost always the best. When we try to get too clever, we almost always mess up. They worked brilliantly last year. They were the only game in town. We should have perhaps expected that this rally would hurt them. And we did half-expect it. And I kind of warned about it internally. [laughs] But what stopped us from doing enough was the fact that they were still cheaper than the competition. And for us, that value discipline is the bedrock, the seven-year forecast. It went into April with the cheapest numbers, the highest imputed seven-year turn, and then of course it was flat for April more or less.

Bad guys were roaring outwards, as everyone tried catch up and play the volatile stocks. And now, of course, the gap is immense again. And most of our fears about the future bear heavily on the junky companies.

I think the seven lean year hypothesis of all the kinds of things that will take some considerable time to work out of bear very heavily on the junk. They don't touch, materially, the high quality companies.

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