(PUB) Investing 2015

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GMO Forecast Calls for Pain Portfolio Matters | Christine Benz

Today, we actually see something of the reverse. U.S. stocks look expensive to us, more or less across the board. But if forced to own U.S. stocks, we’d rather own the big ones. Smaller-cap stocks are trading at higher valuations than we’ve really ever seen. Again, they’re not as silly as the Internet stocks were in 2000 , but we’ve seen a period of time where the U.S. economy has been outgrowing the rest of the world by a significant margin. U.S. small caps tend to be much more domestically focused. They tend to be more leveraged than large-cap names, and they’ve been big beneficiaries of very low interest rates. A lot of things have gone their way. We don’t think that things will continually go their way. And they’re priced as if small caps are growth stocks, and the reality is that the vast majority of small caps are not growth. Benz: Again, U.S. stocks are not attractive overall to you. But when you take a few different cuts of the U.S. market, a couple of pieces look slightly better. Quality looks better to you. Let’s talk about how you define quality. Inker: For us, quality stocks are companies that have shown an ability to earn a high return on capital across the economic cycle, where that return on capital has been stable, and where the company has been able to do that with low debt. Those are the three key factors for us for quality. Now, those compa- nies have some nice characteristics. They are much less likely to go bust than the average company because they are profitable and they don’t have debt. They don’t outperform in the long run; there is no particular reason why they should. They are probably less risky; but today, in one of the few times in history, they’re not trading at a premium. These guys are actually trading at slightly lower P/Es than the average stock, which is interesting because we think they deserve a premium. And particularly today, we think they would deserve a premium because when we look at U.S. stocks today, the most striking thing is that U.S. corporations have almost never been more profitable. Profits, as a percent of GDP , are near all-time highs. Returns on invested capital look very good. We think they are

The forecast from investment firm Grantham Mayo Van Otterloo for projected asset-class returns is widely anticipated within the investment industry, even though it’s rarely sunny. At the Morningstar Institutional Conference in early March, I sat down with Ben Inker, co-head of the firm’s asset-allo- cation team, to delve into the firm’s latest forecast. Christine Benz: Let’s start with U.S. equity today. Generally speaking, it’s not a particularly optimistic picture for U.S. equity. Ben Inker: We don’t much like U.S. stocks today, and that’s because their valuations are trading at the very high end of what we’ve seen historically. U.S. large-cap stocks don’t look as expensive as they did in 2000 , but we’re trading at valuations today that are higher than we saw at the market peak in 1929 or 1965 . We are trading at what we think of as upper- 20 s in terms of normalized earnings, which is really quite expensive. If valuations are going to come back to long-term averages — which is, let’s say, 16 or 17 times normalized earnings — that means, over the next seven years, you’re unlikely to make money rela- tive to inflation in U.S. stocks. So, we really don’t much like them. They have been worse, but they’ve spent most of their history much better.

Benz: Are small caps particularly unattractive to you today?

Inker: Yeah, it’s one of the interesting things. Most of the times in history when the S & P 500 has been at its most expensive, it’s been a large-cap phenomenon. 2000 was an extreme example of that. It was only a handful of stocks that were driving the very high valu- ations in the S & P 500 , and so if you just looked at the average stock in the U.S. , it was much less bad.