Wednesday, February 2, 2011

Grantham: Weak Force Becomes a Monster

From Jeremy Grantham's latest quarterly letter:

"...quality stocks were not only the least expensive, they were also the least risky, often a formidable combination."

He later added...

"Our sustained heavy overweight in quality stocks in 2009 was painful, intellectually and otherwise. Our pain in 2010 was more 'business as usual,' waiting for the virtues of value to be revealed. The saving grace is that, although value is a weak force in any single year, it becomes a monster over several years. Like gravity, it slowly wears down the opposition."

Examples of what Jeremy Grantham probably means by "quality stocks" can be found in one of his asset management firm's mutual funds conveniently named GMO Quality III (GQETX).
Clearly, a professional money manager like Mr. Grantham has to worry about yearly performance since clients may leave before the long-term strategy even gets a chance to work.*

A long-term oriented investor that manages his/her own money doesn't have this problem. For those who are in a situation with no short term pressure for returns, it's actually better if the quality stuff continues to underperform since:

Excess capital can be used by the company's management to reduce share count whenever the share sell below intrinsic value (to the benefit of remaining owners...a cheaper stock means less capital needed for each share bought back). It also allows the true long-term owners to buy more of the business on the cheap over time.

The result for the owners that hang in there is a bigger portion of an economic pie. If it's more than a decent business that economic pie should increase in size as it compounds in value. The stock price will take care of itself as the strong force of long run economics take hold. 

"I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years." - Warren Buffett

Today's investment culture is obsessed with short-term price movements by "renters". As far as I'm concerned, the only time one should care what the "renters" are doing is when they gain enough influence on the price of a stock to push it to extremes in either direction. In other words, it's time to sell even a very good business at, let's say, something like 80x earnings -- a 1.25% earnings yield -- as odds are capital can be deployed at higher returns/lower risk elsewhere.

At the other extreme, even a decent business bought at 8x earnings -- a 12.5% earnings yield -- can produce a good result.

For me, investing in stocks comes down to:

1) owning, with a margin of safety, a portion or all of an understandable business that has durable economics (high return on capital, a wide economic moat etc),

2) monitoring those factors that could cause the economic moat to shrink or get permanently damaged (regulations, technology shifts etc),

3) evaluating whether widening the moat is a priority for the management team that's in place (and whether they have the competence to widen it).

"We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year." - Warren Buffett at the 2000 Berkshire Hathaway (BRKa) Annual Meeting

and

4) judging how wisely capital is being allocated over time.

Otherwise, allow the magic of compounding to work.

Adam

Long BRKb

* Jeremy Grantham talks about what he calls "career risk" in part 2 of the latest letter. From the letter: "Career risk drives the institutional world. Basically, everyone behaves as if their job description is 'keep it.' [John Maynard] Keynes explains perfectly how to keep your job: never, ever be wrong on your own. You can be wrong in company; that's okay." This tends to drive market prices well above and below reasonable valuations. Mr. Grantham and other investment professionals had to deal with this dynamic head on during the dot-com bubble. At that time, some pros rightly resisted the herd but were "rewarded" by client redemptions. They just didn't "get" the "new paradigm" or at least that's what much of the herd seemed to be thinking. Only after the fact is it usually clear who "gets it".
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