Secrets Of Success: Learn from a maverick and a master

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The Independent Online

It comes as no surprise that co-founder of the firm Jeremy Grantham seems to have a reputation as a maverick in the business. But his firm has not grown to its current size, with some $80 billion under management, without having a strong track record in justifying its active management fees. Grantham is generous in how much information he is willing to share with visitors to the website.

I would highlight the regular asset allocation and asset class forecasts the firm's team provides, and its letters to investors, commenting on current developments in the markets. These cover US and international stocks, as well as bonds and cash, and give two values for each class: one the firm's central forecast of seven-year returns, and the second its estimate of how much value it expects to add as an active money-management firm.

The latter is an implied marketing message, but the firm has been around long enough to have earned a reputation for making realistic forecasts, rather than, as many brokerages and fund managers do, simply giving its investor clients rosy forecasts that make them feel good.

There is a lot more meat to be found in the archive material as well. Two items are well worth reading. One is an interview with Outstanding Investor Digest, a specialist US publication, from July 2000. Grantham describes why he was so confident that the internet-led stock market bubble was over and why it was sure to usher in a period of poor subsequent market returns. He also explains why Keynes' s comments on stock market behaviour, likening it to a beauty contest in which the object is not to pick the most beautiful contestant, but the one that you think the other judges will deem to be the winner, still hold true.

The second piece is a talk that Grantham likes to give, entitled "Everything I Know About the Stock Market in 30 Minutes". It starts: "The investment management business creates no value, but it costs 1 per cent 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 per cent, you must find a volunteer to lose by 4 per cent. Every year."

There are another 48 one-, two- or three-sentence comments in this vein. Longstanding readers of this column will surely have some sympathy with number 38: "90 per cent of what passes for brilliance or incompetence in investing is the ebb and flow of investment style" (that is, periods when growth stocks do better than value, or vice versa, and ditto for small capitalisation shares versus large cap equivalents); and its corollorary, number 39: "Since opportunities by style regress, past performance tends to be negatively correlated with future relative performance."

Perhaps the most important observation is: "Getting the big picture right is everything. One or two good ideas a year are enough." Given that most of us don't have the time or skills to pick all the stocks for our portfolios ourselves, it follows that we ought to devote most of our effort to trying to get the big decisions that will have the most impact on our long-term performance right.

That means being clear about the risks we are prepared to take. We must also try to form some view about where we are in the market cycle at any one time and then pick funds that will benefit from that viewpoint and are managed by individuals or firms whose primary motivation is making your money, and not just their income, grow.

This is not easy. One of the strongest themes coming out of Grantham's firm's research is that mean reversion is a powerful guiding principle: when particular asset classes or markets move significantly away from long-term trendlines, it is a near certainty they will in time move back towards those trendlines. In an exhaustive survey of major past financial market bubbles, Grantham Mayo could not find one that did not revert to the mean once it had moved two standard deviations above or below its trendline.

In any bubble, there is an element of excitement that allows exceptionally strong performance by an asset class to be rationalised away, as property seems to be being treated now.

There is a global real estate bubble developing that has taken prices in most leading countries way above the levels at which you would expect mean reversion to become inevitable. It would be easier to deal with this kind of big issue if there were any certainty about the exact point at which the bubble starts to burst. But bubbles typically last a lot longer than most people expect at the time. Grantham's observation on the stock market seems to be that current valuations are not difficult to explain. His firm's model of what drives price-earnings ratios holds that the conditions that most excite investors are when inflation rates and GDP growth are stable, coupled with high profit margins. This pretty well describes the current market, in which volatility is at low levels and profit margins are at, or near, record highs.

Unfortunately, just because these conditions please investors, it does not mean that they will continue. In Grantham's view, real returns from mainstream equities over his seven-year forecasting horizon are likely to be poor or even negative, though offset in part by stronger performances by non-US equities and emerging markets. That, in turn, may have implications for the way that style factors are likely to rotate. Grantham thinks that the five-year period of small cap outperformance is due to come to an end, and (as do I) that there is also a case for considering high-quality growth stocks once more as an alternative to conventional value.

The risk to this positioning is that if markets are going to fall, growth stocks may do even worse in the short term. The painful lesson from history, he says, is the contrarian one that investors do worst when investors are in a comfort zone, as they are today, and best when they are most worried.

jd@intelligent-investor.co.uk

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