- Value stocks have become extremely cheap relative to growth stocks, creating a valuation disparity last seen during the tech bubble, according to Ben Inker, head of asset allocation at GMO.
- To profit from the growth “bubble,” GMO launched a new long/short equity strategy that aims to sell overvalued stocks while loading up on cheap stocks around the world.
- Inker also breaks down why he believes the strategy has the potential to achieve similar returns that another GMO long/short strategy delivered as the tech bubble burst.
As the tech bubble burst, GMO, the investment firm co-founded by Jeremy Grantham, exploited the extraordinary valuation disparity between value stocks and growth stocks by launching the GMO US Aggressive Long/Short strategy. It returned 80.3%, net of fees, from October 1, 2000 through December 31, 2002.
That kind of opportunity has resurfaced as the stock market rebounded from the coronavirus-induced crash in March and the “the speculative footprints of a bubble” materialized into “the stupid,” according to GMO’s head of asset allocation, Ben Inker.
“Whether it was Hertz stock rising 10-fold in the spring as a high-beta recovery play despite the fact that the company was bankrupt and shareholders wouldn’t have benefitted from a recovery even if it happened, or Kodak stock rising 30-fold after announcing it was going to start making chemicals to enable the production of COVID-19 treatments, very odd and speculative things have been going on,” Inker wrote in a third-quarter GMO quarterly letter.
“And it was the spring where we started seeing the stupid,” he said in a Friday interview. “We are very confident that the stupid is currently alive and well in this market. And sooner or later, the stupid has to be paid for.”
Amid the speculative frenzy in the market, the valuation spread between value and growth stocks has reached a level similar to that of the tech bubble, Inker observed.
This time, GMO, which also reaped gains from the 2008 housing bubble, has launched a new long/short equity strategy - the GMO Equity Dislocation Strategy - to profit from the growth bubble.
The market-neutral strategy is based on a proprietary quantitative model that comes up with a valuation for every company across the universe of about 15,000 companies, which then filters out to about 200 names to bet on or against respectively.
"We are building a portfolio that wants to be short really overvalued company and long undervalued company, but cares about risk control in a number of ways," he said. "It cares about stock-specific risks so it wants to be diversified; our maximum position size on any individual stock is less than 1%."
What to long, and what to short
While the strategy is straightforwardly long value and short growth, it is by no means expressed as a concentrated bet against the tech giants in FAANGM in favor of traditional value stocks in the energy and financial sectors.
Inker, who admits to having agonized over the best way to play the mispricing between value and growth, pointed to the fallacy in this approach.
"Tech is probably overvalued, so you don't necessarily want to avoid having a net short position in tech. On the other hand, this is about the fact that value looks cheap, this is not about tech itself," he said. "We don't want to have this just be a bet on one or two factors. We want this to be as pure an expression of value as we can, in a platonic sense."
Another approach that Inker and his team considered is to avoid taking any industry bets in the portfolio.
"You can say I have a zero net weight in autos, but you're going to be long a lot of traditional auto companies, you're going to be long Volkswagen, GM, and Honda and short Tesla, Nio, and Nikola, " he explained. "And whatever you want to say about the advisability of that trade, that trade isn't neutral on autos."
As Inker and his team went about constructing the portfolio, they realized that as they pressed hard on one type of risk, it tended to increase the dimension of another kind of risk.
"So in terms of the portfolio construction, this was really not about taking every other risk besides value out of the portfolio," he said, "but trying to make sure that the factor exposures you need to have in order to believe your portfolio is a value portfolio, trying to have a diversified package."
The portfolio is currently long some of the financial, industrial, and traditional auto names while shorting some information technology companies.
"We see within the IT sector, it's often the case that the companies that actually make physical things in IT look much cheaper than those that are kind of more purely virtual," Inker said.
He declines to name individual stocks they are shorting, but admits to finding Tesla "profoundly overvalued."
"It's that class of companies, so companies that aren't particularly profitable, they don't have a really good profit margin and have been growing by virtue of raising a lot of capital, those tend to be the companies that if they had done very well, which Lord knows Tesla has, are going to look pretty expensive to us," Inker said.
He added: "Because the underlying profitability of the business doesn't look that exciting. And we're not that interested in how fast it's been growing if it hasn't demonstrated a high return on capital, so a company like that will not appear to have a large intrinsic value."
Waiting for the bubble to burst
Tesla has run up 635% this year, but Inker said that has not affected the portfolio thanks to its built-in individual position-size cap and diversification.
On the long side, value stocks, which staged a fierce comeback since Pfizer announced its positive vaccine efficacy news in November, continue to make strides.
"The thing we feel most strongly about is that the discount that value stocks are trading at relative to growth stocks is too wide," Inker said. "My belief is that the growth stocks, a lot of them are really so overvalued, that the price is going to have to come down."
As for when the eventual bursting of this growth bubble will take place, Inker gives what he calls a "better than a 50/50 shot."
"Within the next 12 to 18 months, the growth stocks, particularly the ones that have really zoomed higher this year, are going to start falling," he said. "But it's not crazy to believe, and a number of people have come out saying that they think the overall P/E of the market could really rise higher from here. My guess is they're probably wrong, but I'm not 100% sure of that."
What he is quite sure about is the scale of the opportunity here.
"If I wanted to paint the most bullish case, it would be if the gap [between growth and value] closes sequentially, then we can make even more money than we did in 2000," he said. "On the other hand, if it all happens quickly or if it turns out that there's more truth behind the speculative names than it immediately appears, then maybe we'll make less."