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GMO North America | Europe | Asia-Pacific
Ten Lessons (Not?) Learnt
Asset AllocationJames Montier
1GMO
Lesson I: Markets aren’t efficient
A long litany of bad ideas:CAPMAlpha and BetaBlack and ScholesRisk management Mark-to marketM&M dividend and capital structure irrelevanceShareholder ValueRegulatory regime
Most insidious aspects of EMH are the advice on sources of outperformanceInside information (illegal in most places)If you can see the future better than everyone elseAlso tells us that opportunities will be fleeting
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Not a drop of evidence that we can forecast anything at all
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1982
1983
1984
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1989
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1998
1999
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2001
2002
2003
2004
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2006
2007
2008
2009
Economist forecast
Actual result
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Forecast error over time: US and European markets 2001-2006, %
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Analyst expected returns (via target prices) and actual returns (US, %)
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-40
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-20
-10
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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Analysts’ forecastActual outturn
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-40
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-20
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0
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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Analysts’ forecastActual outturn
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Lesson II: Relative Performance is a dangerous game
Homo Ovinus
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Institutional investors vs. US market (weight difference)
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Sm
all
Larg
e
Val
ue
Gro
wth
Hig
h M
omo
Low
Mom
o
Hig
hA
ccru
als
Low
Acc
rual
s
Hig
h is
sue
Low
issu
e
Source: Lewellen (2009)
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Many active managers aren’t even trying!
Lewellen concludes:“Quite simply, institutions overall seem to do little more than hold the market portfolio. Their aggregate portfolio almost perfectly mimics the value-weighted index... Institutions overall take essentially no bet on any of the most important stock characteristics known to predict returns, like B/M, momentum, or accruals. The implication is that, to the extent that institutions’ holdings deviate from the market portfolio, they seem to bet primarily on idiosyncratic returns – bets that aren’t particularly successful. Another implication is that institutions, in aggregate, don’t exploit anomalies in the way they should.”
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Why not? Career and Business risk (Homo Ovinus rides again)
Cohen et al ‘Best Ideas’
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B e s t Id e a s M a r k e t
Cohen et al conclude“The poor overall performance of
mutual fund managers… is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to overdiversify.”
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Performance around hiring and firing decisions (%)
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Lesson III: This time is never different
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1 12 23 34 45 56 67 78 89 100 111 122Months
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Mill/Minsky/Kindleberger framework for bubbles
Displacement
Credit Creation
Euphoria
Critical Stage/Financial Distress
Revulsion
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Why don’t we see bubbles?
Black Swans– Unpredictable– Massive Impact– Ex-post rationalization
Predictable Surprise– At least some where aware of the
problem– The problem gets worse over time– Eventually explodes into crisis
Five impediments to recognising predictable surprises:(i) Over-optimism(ii) The illusion of control(iii) Self-serving bias(iv) Myopia(v) Inattentional blindness
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Lesson IV: Valuation Matters (in the long run)
Source: GMO
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Buy when it’s cheap: if not then, when?
Buying at 10x G&D PE
124-19Average64-11982.0331-41942.03
218-531931.10183-161917.09
Months before mkt return to purchase levelMonths to market trough% decline from purchase to market troughDate of Purchase
US market 1881-2008
1001001001001008524212510213187243126112134510010010010083818515-168293524134995100909282-383-72-11-249380433726109294919280-38-11-18-26-241016741342113
10 Yr5 Yr3 Yr2 Yr1 Yr10 Yr5 Yr3 Yr2 Yr1 Yr10 Yr5 Yr3 Yr2 Yr1 Yr
% of times subsequent return positiveWorst Subsequent ReturnSubsequent Average Return
Source: GMO
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Graham and Dodd PE (S&P500)
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1881
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1936
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1958
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1981
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2000
2004
2009
Source: GMO
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Bottom up valuation: What would Ben think?
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UK Europe US Japan Asia
Now Mar-09 Nov-08
% of stocks passing BG conditions
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Lesson V: Wait for the “fat pitch”
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1 2 3 4 5 6 7 8 9 10 11 12Source: Plottt et al
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ADHD and stock holding periods
Source: NYSE
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1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
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Lesson VI: Sentiment matters
Source: GMO
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Low PE High PE
Low SentimentHigh Sentiment
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Exploiting sentiment (US 1962-2000)
Source: Baker and Wurgler
-1.5
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Age (old vs young) Volatility (high vs low) Profitability (high vs low)
Sentiment LowSentiment High
When sentiment is low: Buy young, volatile, unprofitable firmsWhen sentiment is high: Buy old, stable, profitable firms
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Sentiment suggests need for caution
96 97 98 99 00 01 02 03 04 05 06 07 08 0915
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ADVISORS SENTIMENT BEARISH Source: DATASTREAM
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Lesson VII: Leverage can’t turn a bad investment good
• Leverage can’t turn a bad investment good, but it can turn a good one bad
• Limits staying power
• Can turn a temporary impairment (i.e. price volatility) into a permanent impairment of capital
• Beware of financial innovation…often just leverage in a thinly veiled disguise
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Lesson VIII: Beware of over-quantification
Ben Graham: “Mathematics is ordinarily considered as producing precise and dependable results; but in the
stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from…Whenever calculus is brought in, or higher algebra, you could take it as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.”
Keynes:“With a free hand to choose coefficients and time lag, one can, with enough industry, always
cook a formula to fit moderately well a limited range of past facts.I think it all hocus - but everyone else is greatly impressed, it seems, by such a mess of
unintelligible figures.”
Munger: “It seems like higher mathematics with false precision should help you, but it doesn’t. They teach
that in business schools because, well, they’ve got to do something!”
There are no points for elegance in the real world.
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Risk isn’t a number
Risk isn’t volatility, it is the permanent impairment of capital
Volatility creates the opportunity.
Keynes again:“It is largely fluctuations which throw up the bargains and the uncertainty due to
fluctuations which prevents other people from taking advantage of them.”
Think about risk as a trinity:Valuation riskBusiness riskFinancing risk
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Lesson IX: There is no substitute for skepticism
Santayana: “Skepticism is the chastity of the intellect, and it is shameful to surrender it too soon or
to the first comer: there is nobility in preserving it coolly and proudly.”
We are in the rejection game.
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Lesson X: Benefits of cheap insurance
Insurance is often disliked in investing, because of the nature of the cash flows, but that often makes it cheap!
Examples:Inflation insuranceMoral hazard/market melt up insurance
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Long-term volatility
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28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09
Source: SG, Bloomberg
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Lessons (not) learnt
I. Markets aren’t efficientII. Relative performance is a fool’s gameIII. This time is never differentIV. Valuation mattersV. Wait for the fat pitchVI. Sentiment mattersVII. Leverage can’t make a bad investment goodVIII. Beware of over-quantificationIX. There is no substitute for skepticismX. Don’t underestimate the use of cheap insurance
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