Successful value investors often work in relative obscurity, delivering steady, market-beating returns over decades.
Jeremy Grantham is an investor that has been following a value approach to the markets since at least 1977, when he co-founded global investment management firm GMO. Over the years, GMO has grown to manage more than $100 billion in assets but is still relatively unknown.
Grantham applies a classic Graham and Dodd value approach to the markets. Benjamin Graham and David Dodd wrote the original textbook on value investing, Security Analysis, in the 1930s. Warren Buffett would later study under Graham. And while countless investors have read the original and revised editions of Security Analysis, only a few have mastered the concepts. The very best value investors, a group that includes Buffett and Grantham, add a unique perspective to their study.
In the case of Grantham, his success is at least partly due to his ability to spot bubbles. He may know more about bubbles than any other investor. In a recent letter to investors, Grantham wrote, “We have studied more or less all assets for as long as we can find data and we have found a remarkable total of 330 ‘bubbles,’ 36 of which we call ‘major, important bubbles,’ which we define as 2-standard-deviation events.”
As an example of what Grantham looks for in a bubble, we can consider the S&P 500 index. According to Standard & Poor’s, the price-to-earnings (P/E) ratio of the stocks in the index is 15.31. Using quarterly data back to 1988, the average P/E ratio has been 18.76.
Standard deviations can be used to measure how much the data varies from average. A high standard deviation will indicate the data often moves far above or below average. A smaller standard deviation will show that the data tends to stay closer to the average. In the case of P/E ratios on the S&P 500 index, the standard deviation since 1988 has been 4.44.
A bubble develops when the price of an asset is unreasonably overvalued. Like Grantham, many analysts consider values that are more than 2 standard deviations greater than average to be bubbles. We would expect values to be this high less than 2.3% of the time. P/E ratios on the S&P 500 index greater than 27.64 would signal a bubble.
Grantham used his knowledge of bubbles to deliver gains to his investors when the Internet bubble was bursting in 2000 and 2001. He also lost less than the market in 2008 as the housing bubble burst.
In addition to studying bubbles, GMO develops forecasts for asset classes based on their studies of long-term value. Right now, Grantham is most bullish on stocks in emerging markets, which he expects to provide average annual gains of 6.8%, after inflation, over the next seven years. In the U.S., Grantham’s firm sees average annual losses of 2.1% in large-cap stocks and 3.5% in small-cap stocks over the next seven years.
In studying Grantham and other great investors, I learned that the biggest stock market winners have solid fundamentals and strong technicals. I combined these factors into a model that finds market-leading stocks with the fastest growth in cash flow. When applying this system to Grantham’s stocks, two buys jumped out.
Given his outlook that emerging markets will provide the largest gains in the long term, it is not surprising to see that two of his largest holdings are in emerging markets. It might be surprising to see an Internet company on the list, but that shows Grantham invests in value no matter what sector he finds it in.
Yandex NV (NASDAQ:YNDX) is Russia’s largest search engine with about 60% of the market. Over the past five years, Yandex NV (NASDAQ:YNDX) has reported average sales growth of 46.6% and an average increase of 39.5% in earnings per share (EPS). Free cash flow turned positive in 2008 and has grown from $0.15 a share to $0.74, an average growth rate of 37.6% a year.