A difficult-to- practice virtue - Chetan Parikh

In the great book, "Hedge Hogging", the author, Barton Biggs, writes about the virtues of patience

“Another example of the right way is that of Jeremy Grantham of a Boston investment partnership, Grantham, Mayo, Van Otterloo & Company. Jeremy Grantham, a contrarian, value-oriented, somewhat irascible fellow, has always been regarded as a serious thinker. He is a hungry observer of the investment life around him, a seeker of truth, a man of the mind. He doesn’t care what the world thinks. He is an irregular person. He has a hard glitter to him, if you know what I mean.

In 1995, Morgan Stanley; Grantham, Mayo; and three other firms were each given $1 billion by the Verizon pension fund. We were all paid a small fixed fee but could earn a substantial incentive fee if we beat Verizon’s benchmark global allocation. The program was the brilliant brainchild of John Carroll and Britt Harris. As I recall, Jeremy Grantham became bearish about equity markets in general and tech in particular around 1997. As a result his performance versus the benchmark and the rest of us was lousy. In fact by the spring of 2000, Grantham, Mayo was in last place, 500 basis points a year behind us, and I think at the time we were the leader.

We actually did okay versus the benchmark in the three-year bear market that followed because we also were bearish, but Grantham, who had stuck to his extreme position and was very overweight bonds and underweight stocks, positively soared. He passed all of us like we were standing still. He made up for four years of lousy performance in two years! It was unbelievable! It is to the great credit of Britt Harris, then the chief pension-fund officer of Verizon, that he stuck with Grantham through thick and thin. Britt knew Grantham’s thought process, had confidence in Jeremy’s integrity, and he never wavered. Very impressive! Most pension-fund officers would have fired the consistently worst performer, but not Britt.

But that isn’t the whole story. In the late 1990s, the firm, Grantham, Mayo, had a very rough time. The firm’s assets fell almost 40% as disgusted clients closed their accounts, and his more bullish partners left to form their own firms. Grantham, Mayo went into the red, and Jeremy was mocked as a stopped-clock contrarian. He was undaunted. He kept paying his good investors and spent money on client services and seeding new investment lines like timber and hedge funds. The firm’s headcount actually increased almost 50% even as it was losing money. That’s very hard to do.

Then when the bubble burst, Grantham, Mayo reaped the rewards. Not only was their performance superb during the bear market, when the rally began in 2003 they did well, particularly in emerging markets. Their emerging markets fund soared 70% in 2003 versus 51.5% for the MSCI emerging markets index, and the money poured in. By the end of 2003, assets under management had tripled from the low to $60 billion, and emerging markets alone had $10 billion with a rich fee. So what did Jeremy do? Because he felt that it was just a rally in what was still a secular bear market and that emerging market equities in particular had run far too fast, he closed the strategy to new investors at the end of September 2003.

In the summer of 2005, Grantham described his role as “trying to thrive in a secular bear market.” He believes deeply in “reversion to the mean” as a fundamental tenet of investment life. Markets are shockingly inefficient, he said, and as an investor you should wait for the fat pitch. Big portfolio bets should be tempered until valuations move to extremes. Patience is an investment virtue, but he concedes that it can be difficult to practice because mean reversion can take a long time. These are all adages that most of us give lip service to but have great difficulty following. Jeremy talks about them and rigorously practices them.

Presently he is still cautious on most equity classes. Expectations are still too high, and there are a number of things that could go bump in the night. Equities, particularly in America, remain expensive because valuations and returns have to revert back to equilibrium fair values. Assuming that they will over the next seven years, returns on all asset classes will be meager. He calculates that compound annual real return from large cap U.S. equities will be minus 1%. Treasury bonds are only slightly better, but international equities and emerging market debt will return 2.5% to 2.7% annually. The best asset classes will be emerging market equities and timber, which will earn 6%. Remember these are real returns and are therefore before manager alpha and inflation. Despite his negative outlook, since equity markets turned in the spring of 2003, his asset allocation accounts have performed very well.

What does Jeremy think are the big bets now for a long-term investor? First, move money out of American equities and into international. Emphasize high-quality, lower-volatility stocks and reduce small-cap, high-volatility, more-speculative equities. His specific advice is to move into conservative hedge funds, timberland, commodities, and conservative fixed income.

Jeremy is 66 years old and going strong. He continues to be committed to preserving his firm’s independence and to investors, not businessmen, running the firm. He told Institutional Investor, “What we did when we were losing money, the stance we took, would have been impossible if we were beholden to an owner demanding quick results. The stance we are taking now of closing winning strategies would also have been difficult. I am convinced that independence is in the best interests of the firm and our clients.” Boy, that is integrity!

I suspect that to be truly great, an investment-management firm has to be modeled on Plato’s Academy. Plato wanted to create a fertile atmosphere at his Academy where brilliant young men could be trained to be statesmen, and in this way the future political leadership of Greece would be enhanced. His theory was that the cross-fertilization of profound minds working in different disciplines (historians, artists, mathematicians, philosophers) mingling with each other would enrich the thought processes and insights of all. The intellectual sum of the whole would be far greater than the sum of the parts.”