James Montier, the outspoken value investor and member of the asset allocation team of Boston-based GMO, talks about dangerously high valuations and the virtues of holding dry powder.
Four words seem to define the current mood in financial markets: There Is No Alternative. Yes, equity markets might be somewhat expensive, but considering the alternatives – bonds and cash –, they are still the best investment. The correction in October turned out to be a mere hickup in a solid bull market. But James Montier remains skeptical. The value investor and member of the asset allocation team at Boston-based asset manager GMO sees the stock market in a near-bubble and warns investors from being complacent. "To think that central banks will always be there to bail out equity investors is incredibly dangerous", says the outspoken Brit. His source of wisdom in current markets comes from none other than Winnie the Pooh: "Never underestimate the value of doing nothing."
James, when you screen global equity markets today: Do you still find any value?
It’s getting really tough now. It’s getting harder and harder to find really good sources of value these days. There are maybe one or two pockets out there, in Europe and in some emerging markets.
Emerging markets are really bifurcated into stocks you don’t want to own at all, because they are really expensive, and stocks that are outright cheap, but they are also pretty damn scary. In that field, I talk about Russian energy or Chinese banks. I personally don’t like the latter but one can make the argument that they are at least optically cheap. There are a lot of reasons why these stocks are cheap. The good news is that everybody knows why they’re cheap, which means it’s all in the price already. But apart from that, it’s really hard to find anything that is reasonably cheap out there.
So in a simple beauty contest between Russian energy versus Chinese banks you’d go for the former?
Yes, I’d go for Russian energy. The problem with the Chinese banks is that they are optically cheap, i.e. they trade on high dividend yields and low PEs. But they are financials, and the credit cycle in China is pretty extended. We’ve been looking at the market-implied levels of non-performing loans in the Chinese banking system, and we came out with 9%. Which is ok, but if you look at a serious, big banking crisis, you get NPL way in excess of 9%. In Thailand in 1997 we saw a NPL level of 45%. I’m not sure there is a big margin of safety in Chinese banks. It certainly is not big enough for my taste.
And you get that margin of safety in Russia?
Yes, certaily more so. Gazprom tradex at a PE of 2, Lukoil at 3, Surgutneftegaz as well. You don’t want to necessarily target one particular company, in order not to maximise your single stock risk. But if you own the group of them, and one is being taken out by the government, which is not impossible in Russia, you are partly protected. They are cheap. A lot of bad news is in the price. The whole Russian market trades on a Shiller-PE of 5. It’s hard think that the world has not priced in the risks that are associated with Russia. Mind you, they are real risks, I think the problem in some ways is the outcomes are almost binary. Expropriation is the thing you worry about when investing in Russia, and there is no way of telling if it happens or not. Either it will or it won’t. Investing in Russia has option-like characteristics. It’s either worth nothing or a lot more than what it is trading on now.
Any other examples of screaming value?
I’d say Samsung Electronics and generally the Korean chaebols. The government of Korea has been a big shareholder in the chaebols, and they are pushing them for reform now: Breaking up businesses, sell non-core assets, pay out higher dividends. So unlike in Russia, where the government is scary, in Korea the government is on your side as a shareholder. The big issue for Korea right now of course is what’s happening in Japan. The Yen weakness is really hurting Korea, the exporters are screaming for a weaker Won. At some stage it can easily be seen that the Korean government will want to weaken the Won and push their exports.
Where do you find value in Europe?
There was a lot in the periphery two years ago, but that has faded. Today, the periphery is okay, but not outright cheap. There are some stocks in the cyclical and industrial field that still can be considered value in Europe. Again, I would not go for financials in Europe, even though they appear cheap. The big question for European value is how you deal with the reality of deflation. Deflation is a clear risk for any value investor.
Why is that?
When you’re a value investor, you focus on the intrinsic worth or asset value, i.e. what is this company worth if I break it up tomorrow and sell its assets. That’s the fallback value of the company. The problem with deflation is it destroys the value of assets every day. Every day that goes by with deflation, your assets are worth less than the day before in real terms. That is a real problem, because it effectively undermines the core essence of value.
But didn’t the value approach work well in Japan?
True. In Japan we saw zero inflation for twenty years, and value as an investment approach has done remarkably well. So to the extent that Japan is a template, then value should work fine in Europe. But one has to be mindful of the effects that a more severe deflation causes for value investors.
And how do you deal with that risk?
Ask for an even bigger margin of safety. The value investor Seth Klarman has spelled this out nicely: One, you have to be much more conservative in your assumptions and demand a much larger margin of safety. Or two: you simply don’t get involved at all.
Is there any value left in the U.S. stock market?
Not really. We’ve been selling out some of our high quality names, you know, the Microsofts, J&Js, Pfizers and Procter & Gambles of this world. We still own a little bit, but we are selling them down. Fundamentally we still think they are a very low risk business;they offer high profitability and low leverage. Their valuation support simply has come down. Our seven year forecast for U.S. high quality is about 2% real per annum. That’s a long way from the 6% we think is fair value. They are not cheap anymore.
What’s your overall equity allocation at GMO now?
We are at 36% in straight equities. We started last year at 54% and have been selling down steadily. What we did instead is increase our exposure in alternatives to the equity market, like selling at the money puts at the index level. That has a very different payout than long equities. You sell one month puts rather than hold something for seven years. But put selling is only attractive when volatility is reasonably high. We’re not doing much put selling now, because volatility has collapsed again. Another alternative is merger arbitrage. They add up to short duration equity exposure. They share the same risks as equities, but offer a much shorter time horizon.
The stock market just keeps zooming up. A low equity allocation must be hurting you now.
That is the problem. This is the first central bank sponsored near-bubble. There is just nowhere to hide.
Why do you call it a near-bubble? After all, the S&P 500 trades on a Shiller-PE or more than 26.
I fully agree with you. One shouldn’t dwell too much on the semantics of a bubble. We at GMO define bubbles as a two standard deviation move away from the long term trend. And we are not quite there yet. We’d need another 10 to 15%. But let’s say it in simple terms: For all purposes, this is a hideously expensive market. I don’t care if it’s a bubble or not. It’s too expensive, and I don’t need to own it. But because this is a central bank sponsored near bubble, it hurts to stay away.
So central banks are pushing investors into riskier assets?
Yes. Cash rates are zero in nominal terms, and negative in real terms, bond yields are not going up anytime soon. In 2000, you could stay away from equities, sit in cash and get paid almost 3% in real terms. Or you could buy TIPS, emerging market equities, old economy small caps, and so on. There were cheap opportunities out there. And again in 2007, cash still gave you 2,5% real. Today, cash gives you minus 2% in real terms. That’s the big difference. The question for every investor is how much do you let this negative cash rate influence your behaviour. Some of us are willing to own more equities, because the alternatives are just appalling. Others like me are saying cash is negative, but the danger of owning equities that are way too expensive is just much worse. In cash, I know my downside, but equities can fall precipitously from a wildly overvalued level. I am not being compensated for that risk. The path for equities will not be nice and smooth and linear over the next seven years.
Whenever we have a small correction, it only lasts for a couple of weeks before markets head up again. Doesnt’ that convince investors that you can always buy the dip?
Yes, absolutely. That kind of mentality will lead to a bubble, when fear is removed and is being replaced with the fear of missing the upside, i.e. greed. Once you get that mentality, you enter a bubble. The narrative is simple: We are all protected, underwritten by central banks. That’s a very tempting thought in the short term, but incredibly dangerous. The central banks will protect us up until they don’t anymore. And you don’t know when that will be.
Are there any investment opportunities left in fixed income?
There is some stuff you can do. The forward curve offers some opportunity: They are pricing in a fair amount of rate normalization in the US and UK. The market implies a reasonable amount of tightening. If you take a three year bond four years forward, it yields about 3%. I’d take that. You can own that belly of the curve area of the forward market. If rates don’t rise as much as implied, then you make some more money. You only lose money in that field if rates go up faster than the market implies, and I don’t think that looks like a particularly serious risk today. Also, we are short Japanese government bonds.
Even though that’s considered a widowmaker trade?
Yes, and I know that from painful personal experience. I wrote a paper in 1997 when JGB yields were at 3%, saying they could not possibly get any lower. And I watched them halve and halve again. But now the view of our fixed income guys is they just can’t gothat much lower. And unlike in 1997, they are probably right. What’s the worst that can happen? The yields won’t go to zero, so the loss is limited. I’m not sure shorting JGBs is going to be a hugely positive investment either, though. I am a skeptic of prime minister Shinzo Abe and his plans. To me, there is no evidence that inflation is actually coming back in Japan. The sequencing that Abe has to achieve in order to get inflation back is so difficult. He starts by devaluing the Yen, okay, but what that does is raise import prices, which means the average Japanese person just had a wage cut. That’s deflationary, not inflationary. You may raise the CPI headline, but you are stripping out the ability of the consumer to spend. Abe’s next phase would have to be to get wage inflation going. There’s no sign of that at all yet. And until he gets that sequencing order right, it won’t work. A CPI headline of 3% is useless, you just have to strip out the consumption tax increase and the price of imported energy. Core Japanese inflation is 60 basis points. So I don’t think you’ll get a riotous rout in JGB yields, because the Bank of Japan is buying them. The BoJ can control the market. When you issue bonds in your own currency, as the Japanese can do, you have the luxury of owning your own printing press. That means you don’t have to fear the bond vigilantes, they just don’t exist. They are a myth, an invention by economists to scare governments. A central bank, if it chooses, can have any interest rate at the long and short end of the curve. If they buy bonds ad nauseam, no one can stop them.
What do you think of high yield bonds?
In a world that is yield starved, people forget that it is not yield one should worry about, but total return. The problem with low-yielding high yield bonds is when we get a default cycle, you know you will get hit. We all creep out of the yield curve, but we forget that we are not getting compensated for the risk of default. The total return expectation for owning high yield bonds today is negative. Why on Earth would I want to own that stuff? People are blinded by zero returns in cash, so they pile into high yield. The only way it would only be about the yield is if you think that you can get out before all the others. Which of course is impossible in aggregate and therefore not a viable strategy.
So what’s your most impoartant advice to investors now?
Be patient. Don’t take it from me, take it from Winnie the Pooh: Never underestimate the value of doing nothing. Never forget: You can’t know the future. Hold a lot of dry powder now. 50% of our portfolio today is in cash or some form of short term bond holdings. If we do get a dislocation in equity markets, we will have the ability and deploy that dry powder. That’s the time to buy.