For Jeremy Grantham, a master of identifying asset class bubbles, it pays to wait. His study of financial history reveals mean reversion as an inevitability. In short, bubbles, high valuations, unusual valuation multiples, exceptional profit margins do not last forever. They inevitably return to their average values. Grantham made a career out of avoiding macro-economic bubbles that have made suckers out of the rest of us.
Grantham’s track record is remarkable, with predictions that include the credit crisis and the tech bubble. His ability to detect and avoid investment bubbles had led to enviable professional success. He is a founder and Chief Investment Strategist of Grantham Mayo Van Otterloo (GMO), an asset management firm with over $107 billion in assets under management. GMO’s holdings show where Grantham feels valuations are reasonable, away from bubbles. Today, he views low-quality companies as overvalued, and he sees significant risk in the broader stock market. Currently, Grantham is underweight equities at $29.2 billion of the fund, and is focusing on high quality, large cap companies with low valuations.
Grantham has maintained his conviction in Google (GOOG), which accounts for $881.6 million or 3.02% of the portfolio. Google currently sells at a 3.27 price to book ratio, a 5.10 price to sales ratio, and a 19.45 price to earnings ratio (trailing twelve months). Today Google is not a value company, but does offer growth prospects at a reasonable price. In a sense, buying Google at sensible prices represents a victory for Grantham over past speculators who participated in the tech bubble.
Just as the tech bubble burst at the turn of the millennium, the 2008 commodities bubble burst spectacularly. Most energy commodities are lower than their prices at the height of the bubble, and today companies that produce commodities have reasonable valuations. However, Suncor Energy Inc. (SU), a new position worth $214.9 million or 0.74% of Grantham’s equity portfolio, sells at a 1.27 price to book ratio, a 1.25 price to sales ratio, and a 12.46 price to earnings ratio (trailing twelve months).
Grantham also added $36.2 million of the energy company Canadian Natural Resources Limited (CNQ), which now accounts for 0.124% of the equity portfolio. CNQ trades at a 1.78 price to book ratio, a 3.01 price to sales ratio, and a 30.93 price to earnings ratio (trailing twelve months). This stock is expensive for an energy company, so this is not a valuation play. Instead, Grantham might be betting that gross margins will increase from 50.5% to a historical average above 60%. This would lead to a return on equity three times higher than today’s 6.1%, and a price to earnings ratio between seven and eight.
However, not all the changes to Grantham’s portfolio seem consistent with mean reversion to historical averages. Holdings in industrial metal producer Vale S.A. (VALE) were increased by 300% to $90.1 million or 0.31% of the equity portfolio. It currently sells at a 1.73 price to book ratio, a 2.25 price to sales ratio, and a 5.59 price to earnings ratio (trailing twelve months). Despite these attractive valuations, this company is benefiting from demand due to China’s real estate boom, a trend which might be a bubble that is about to burst. Building in the People’s Republic of China accounts for more than 60% of GDP, a fraction that has no historical precedent. If this building subsides, VALE’s revenues will drop as the demand from iron ore and other industrial metals drop.
Equally perplexing is Grantham’s 479% increase in Intuitive Surgical, Inc. (ISRG) to $30.1 million of the portfolio. ISRG is highly valued, selling at a 6.10 price to book ratio, a 9.01 price to sales ratio, and a 35.22 price to earnings ratio (trailing twelve months). Worse yet, ISRG is enjoying record margins and revenues, and if it is to experience reversion to historical means, its performance would drop precipitously.
Most of Grantham’s holdings show patience to buy the right companies, at the right time, at reasonable prices. However, some holdings might be made in error or could be components of other investment strategies. Only time will tell whether VALE will suffer from a slump in Chinese construction, or if ISRG is a savvy investment.