GMO Quarterly Letter April 2010: Playing with Fire (A Possible Race to the Old Highs)
Comment of the Day

April 27 2010

Commentary by Eoin Treacy

GMO Quarterly Letter April 2010: Playing with Fire (A Possible Race to the Old Highs)

Thanks to a number of subscribers for sending through this edition of Jeremy Grantham's unmissable report. Here is a section
A missing ingredient in this critique of Grahamism, or rather Grahamism as usually practiced in the real world, is probably Warren Buffett, whose introduction would conveniently bring up the topic of Quality, which typically is something of a missing ingredient in value investing. It is what he really introduces as an extra emphasis into the world of safety margins and attractive traditional value measures.

If the rare value traps are the bane of Grahamism, then equally they offer an opportunity for quality stocks to show their merits. In Exhibit 5 we show the relative performance in the Great Crash of Quality's close cousin, high return on equity. The high return companies that entered the Crash overpriced still outperformed brilliantly. They had a princely 25% of their money left at the low - whoopee! - whereas the low return firms were left with 5% of theirs so that they had to quintuple just to catch up with their high return brethren! If you had picked up a risk premium of 1% a year for holding low quality -which on average you had not - it would have taken you nearly 165 years to catch up.

In fact, Quality stocks have outperformed the market since 1965 (when our quality data begins) as shown in Exhibit 6. We define "quality" using primarily a high and stable return. I think you would agree that this is a workable definition of a franchise since to be both high and stable means you have the ability to set your own prices. Secondarily, we look at debt. This yields a very uncontroversial list of stocks of the Coca-Cola, Johnson & Johnson, and Microsoft ilk with not even one financial! Even though the "quality" factor is now cheap, it has still outperformed by a decent (maybe you'd say "modest") 40% over almost 50 years. But this 40% is an amazing free lunch. Warren Buffett doesn't really talk much about the fact that he is playing in a superior universe. Why should he? It's like having the Triple A bond outperforming the B+ bond in the long term by 1% a year when, in a reasonable world, it "should" yield, say, 1% less. And how nicely this messes up the Fama and French argument on risk and return.

Eoin Treacy's view In a global economy it seems reasonable to favour globally significant companies, capable of dominating their niches generating reliable cash-flows and offering leverage to the inexorable growth of the global middle class.

The USA has a large number of such companies, not least in the technology sector, and they remain sound medium-term recovery candidates where they are not already leading. (Also see Comment of the Day on April 23rd). However, in the short-term, the risk of a reversion towards the mean, defined by the 200-day moving average, has increased substantially.

Johnson & Johnson rallied impressively from the March 2009 lows but has lost momentum in the reiong of $65. A sustained move below $62 would be be required to mark a significant inconsistency by breaking the progression of higher reaction lows and the 200-day moving average.

Coca Cola, encountered resistance in the region of $60 in December and has pulled back into the previous range by January which signalled a larger inconsistency. It has been ranging mostly below $55 for most of this year and is currently testing the 200-day moving average. An upward dynamic is needed to indicate demand is returning in this area and to offset scope for additional downside.

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