Quality Investing and Inflation and why Emerging Market equities are at a ‘historical low ratio’
The GMO team articulates – using American data – why in such a climate you need to be invested in high quality stocks: “Several years ago, we extended our database of company accounts all the way back to the 1920s….We identified eight periods in which U.S. CPI remained above 5% for a period of one year or longer and tracked the returns of the highest-quality stocks, the cheaper high-quality stocks, and the S&P 500. The annualized returns laid out in the table are striking.” You will have to read the article to see the table which shows that high quality stocks outperform the S&P500 by around 3% per annum which inflation is above 5%.
So why do high quality stocks have an advantage in a high inflation climate? Here is GMO’s view: “First, we typically invest in relatively high margin businesses. This means that the companies’ exposure to cost inflation is lower per unit of revenues than for the market. If we assume that, like death and taxes, cost increases are more reliable than revenue increases, then quality companies’ margins are less at risk than the average. The reality, however, might be even better, as we would expect the majority of the businesses in which we invest to be able to raise their own sales prices given their entrenched advantages (e.g., in networks, intellectual property). Second, our portfolio companies are typically relatively asset light, meaning that maintenance capex is lower than for the market. The maintenance of physical assets implies exposure to commodity prices one way or another, whereas previously established intangible assets are less immediately exposed. While most intangible assets do require reinvestment, that maintenance investment is largely intangible via technology, IP, and brand equity investments. These are disproportionately delivered via highly qualified and, frankly, relatively expensive personnel, especially in technology and healthcare, meaning that employees are not at the sharp end of household inflation and that any wage/inflation link is less mechanical in nature.” (And yes, this does read very much like a Marcellus newsletter.)
The second insight from GMO comes from their big boss, Jeremy Grantham, who was interviewed recently by John Authers, the famous FT columnist who now works for Bloomberg. We would suggest that you read the entire interview if you are investing in SPACs, bitcoins or US tech stocks. More specifically, after highlighting the bubble in these asset classes, Mr Grantham has this to say about Emerging Market equities: “Asset allocation is particularly difficult today, with all major asset classes overpriced. With interest rates at a 4,000 year-low (see Jim Grant), 60-40 seems particularly dangerous. Two sectors are at historical low ratios however: Emerging-market equities compared the S&P and value stocks vs. growth.
In addition to a cash reserve to take advantage of a future market break, I would recommend as large a position in the intersection of these two relatively cheap sectors — value stocks and emerging market equities — as you can stand. I am confident they will return a decent 10 and 20-year return and perhaps do much better.”