Contrarian Investing with GMO's Ben Inker - FEG Insight Bridge
50:41 Share

Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein, and in this episode, 510, we're going to do something a little different. As many of you know, prior to launching Money for the Rest of Us more than 10 years ago, I was an institutional investment advisor for 17 years. My former firm is FEG Investment Advisors.

I've remained close to many of my former partners and colleagues there. FEG launched a podcast almost five years ago called the FEG Insight Bridge. The host is Greg Dowling, FEG's Chief Investment Officer and Head of Research. Greg and I worked together for years as part of FEG's Investment Committee.

On the FEG Insight Bridge podcast, Greg interviews, in his words, some of the world's leading investment, economic, and philanthropic minds to provide insight on how investors can survive and thrive in a world of markets and finance. This year on the Money for the Rest of Us podcast, we wanted to share some of the standout interviews from FEG's show along with my key takeaways. The first episode I wanted to share was Greg Dowling's conversation with...

with GMO's Ben Inker, released a few weeks ago. GMO is an asset manager co-founded by Jeremy Grantham in 1977. Ben Inker is co-head of asset allocation and a portfolio manager at GMO. I've been impressed with Ben's writings over the years and have been influenced by GMO's approach to asset allocation.

In the interview, Inker says something that should sound familiar if you have listened to Money for the Rest of Us over the years.

Inker said, when you're looking at an asset, it's not enough to be looking at what its returns have been. The really important thing is to decompose those returns into the underlying drivers, because if you understand the underlying drivers, you can understand which pieces of this return are likely to persist, which ones might reverse, and which ones were kind of random.

Helping individual investors understand the underlying drivers of stocks and bonds is why we launched Asset Camp 18 months ago. Those underlying drivers of cash flow, cash flow growth, and valuation changes inform our approach to modeling expected returns.

I also resonated with Ben's thoughts on expensive stock valuations, where the underlying companies are priced, as he said, as if we know what the world is going to be like in five years. We don't, which is why we diversify, including, as Inker says, into the rest of the world that is decently priced and not priced as if the future is going to be amazing.

I think you will also enjoy Greg and Ben's discussion on concentration risk, indexing, and bubbles. Inker also shares why GMO is excited about Japanese small cap stocks. Before we play the episode, I wanted to share a few words from this week's sponsor, Asset Camp.

As a long-term investor, you need long-term insights. You can use AssetCamp to look past speculative market hype and understand past performance, current trends, and expected returns for stock and bond indexes. Markets move in cycles. Don't miss what's next. Get a seven-day free trial of AssetCamp at AssetCamp.com. That's

A-S-S-E-T-C-A-M-P dot com. Here then is Greg Dowling and Ben Inker on FEG's Insight Bridge. Ben, welcome to the FEG Insight Bridge. Well, thanks very much, Greg. I'm very happy to be here.

All right, well, we're going to start a little bit about your career. You've spent the entire time at GMO. So what's it like to be at the same place for so long? It's kind of a hard question to answer because I don't know what it's like not to be. This is the place I really grew up and it's home and GMO is family. And in all of the good and bad ways that family is family.

I don't know what it's like for everybody else with their career, but it's really been a fun trip to be at GMO for as long as I have. Is there some irony in that, right? In that if I understand your career story, they really didn't want you. No, no, they didn't. I was sort of forced upon GMO. At the time, I was an undergraduate. My thesis advisor was Dave Swenson, who managed Yale's endowment. GMO was a very large manager for Yale.

One of the partners at GMO called up David to ask if there was anyone at the Yale School of Management who they thought would be a good fit.

And David said, no, we didn't know anyone at the School of Management, but he had this undergrad that he thought they should talk to. And they said, well, thanks, but no thanks. We're not really interested in hiring someone with no work experience. He said, well, just bring them up, talk to them, see what you think. So I came up, they spoke to me. I favorably impressed no one.

So I went back down and Jeremy ran them, called up Dave and needed to be polite, right? Because you were a really big client and said, you know, thanks, but we really don't want to hire someone without any work experience. And so David said, all right, well, talk to him one more time, because I think after he goes to business school, you'll want to hire him. So I came back up. I went back down.

I was not in the conversation between David and Jeremy, but my impression was Jeremy said, well, he does seem like a bright kid, but we are really worried if we hire someone with no work experience and it doesn't work out. Like now he has other options. He has job offers. And if it doesn't work out in a year, what is he going to do? David kind of cut his legs out from under him by saying, oh, well, that's not an issue.

I tell you what, if you hire him for a year and you don't like him after a year, I'll get him another job. If I can't get him another job, I'll give him a job at the investments office and make sure he gets into business school. So don't worry about that. Big client. Don't want to offend the clients like, oh, OK, I guess we'll give him a job.

And so David was entirely responsible. I cannot take any credit for having gotten the job because I don't think there was anyone at GMO who wanted to hire me. Now, how long has it been at GMO from that point?

To today? 32 years. 32 years. Wow. That is amazing. And in those 32 years, GMO has changed, right? And on a daily active basis, there is no G, M, or O that really is there. I know Jeremy's still involved, but not on a day-to-day basis. How is that?

How do firms have to evolve when the founders move on? Again, I can't speak for other firms, but I think at GMO, you know, one of the things about a firm is its culture, its philosophy, its ethos has to be rebuilt kind of every day and every year. GMO is a place where there are quite a number of us who have been here for a long time and

And what we're trying to do is help bring along the good things about GMO and its history and help slowly change some of the things that have been less good. You know, the people who are attracted to coming here are attracted by some of the important things that...

We really feel we stand for kind of really thinking as long term investors, really worrying about solving problems for clients. And so even though Jeremy is still here because he runs his foundation out of our office here and I still have lunch with him every month or so.

Yes, GMO has changed, but I think at the core, we're really trying to live up to the important things from Jeremy and Dick and Ike brought back in the late 70s. GMO definitely has a brand of philosophy and that probably gets it sort of changes as markets change. But sort of the core principles, I feel like are pretty much bedrock throughout, which is helpful versus other firms maybe that don't have.

What do they do? You kind of know what you're going to get with GMO might change again over time and evolve. But that's probably pretty helpful. I should say we are recording this at the very end of 2024. So we're going to release this in 2025 and we're going to talk about like your views for next year. But before we turn that page, what is a life or investment lesson that Jeremy has given you? And I'm going to add one more to this.

That's one thing that's given you. Let's see. So Jeremy, I mean, man, you work with a guy for 30 years. You're going to learn a lot from him. I would say one life lesson that I learned from him early on, Jeremy Grantham is a lot of things. One of the things he is, is an incredibly compelling speaker. You know, when I got to GMO, public speaking was a scary thing. And, you know, I,

I had kind of the traditional nightmare about public speaking that the worst thing that can possibly happen to you is you're standing up there and you suddenly forget what it is you're supposed to say. Right. That is the nightmare. And then you look down and you're not wearing any clothes or what have you.

But at the 1992 GMO Client Conference, I got to see Jeremy speak to an audience for the first time. He was giving this really wonderful talk. And then somewhere in the middle, he just stops and he looks around and he says, you know,

I'm sorry, I forgot what I was talking about. Can anybody remind me? And someone in the audience reminded him and he went on and he gave the rest of the speech. And it was the best speech I had ever seen a human being give. And it contained the nightmare moment. And it occurred to me, oh, wait a minute. Public speaking is not what I thought it was.

So that was a useful life lesson. Unfortunately, I think one of the things it has done relative to some other colleagues of mine is somehow it took away my fear of public speaking. So I don't prep as much or as well as perhaps I could, but losing that fear.

was very helpful. I'd say from the investment standpoint, the lesson he taught me, the one I make sure when we have a new member of the asset allocation team, I say, hey, this is the thing you need to understand. When you're looking at an asset, it is not enough to be looking at what its returns have been. The really important thing is

is to decompose those returns into the underlying drivers. Because if you understand the underlying drivers, you can understand which pieces of this return are likely to persist, which ones might reverse, which ones were kind of random. And, you know, it's funny. I took a lot of finance in college from really extraordinary teachers. I was incredibly lucky. David Swenson was my thesis advisor.

I took classes from Jim Tobin and Bob Schiller, and I got a lot of good training in finance. But as an undergraduate, they never taught us to really break down the returns. And whenever we're looking at an asset, and if ever we're looking at a new asset or a

That kind of analysis is the bedrock. I remember the day Jeremy came and I was doing some work on small caps for him. And he said, OK, that's great. But where did those returns come from? You have to break it down. And I'm like, what are you talking about? Oh, OK.

That's great. And I totally agree on your first point about communication. So I've had the opportunity to teach for maybe 10 years at our business school here. And, you know, it's funny that you teach some very, very smart people, but if you're in the investment industry and maybe you're a coder and you don't have to communicate, but most times you have to communicate either orally or written. And so if you have a great idea, but you can't convince somebody or communicate with them,

It's probably moot. So I think that's a very kind of overlooked skill in our industry that we teach people how to use, you know, Python or Excel spreadsheet, but we don't tell them how to talk. And so that's I think that's a great point. How about David Swanson? Real quick. You spent some time with David. You basically owe your career to him. What did David teach you?

Again, it's a lot because I took two courses from him. He was my thesis advisor. He was a mentor to me for decades. I would say the most important thing I learned from him in taking the first course I took from him, which was the course affectionately named Stocks for Jocks. It was a big lecture course about investing and finance that was viewed as a pretty easy class. But the thing is,

He made investing seem like so much fun, just this really interesting problem. And I'm someone who has always been really interested in problem solving and puzzles. And he kind of presented investing as this fun, fascinating puzzle and the idea of kind of

His vision of managing the endowment was finding these people and farms to partner with to really try to solve these puzzles. And it just seemed like so much fun. I'm like, that's what I want to do. It's kind of the love of the game, that infectious drive, like, hey, this is something that's noble that you want to do. And it's a great puzzle. So we're going to flip it a little bit and talk a little bit about some of the markets. What's going on now? And

As we transition there, we've been lucky enough to have Jeremy on this podcast a couple of years ago, and it was entitled A Journey Through Bubble Land because I think that's what GMO has probably gotten the most accolades over the years is Jeremy and the firm calling several bubbles, but

You've also been criticized as being like perma bears, right? Like the stop clock that is right twice a day. So looking back at sort of your methodology over the years, what have you gotten right? What have you gotten wrong? And maybe what's changed in the markets that has had you adapt your models? Things we have gotten right.

Certainly, we have been able to recognize on a number of occasions where the markets kind of stopped making sense. And the fact that a market that has stopped making sense is a pretty risky place to be.

We have done a pretty good job after those market breaks, whether it was 2000, 2008 or 2022 of getting back in. Obviously, the thing we have gotten wrong again and again is getting out of the markets too early. Right. We did that. I am taking credit blame for some stuff that happened before I got to GMO. We got out of Japan in 87 and.

That was painfully too early, right? In the 90s, we were slowly getting out of the U.S. market too early. We did it pretty well in 2008. We held on till kind of sometime in 2007. And then kind of in the bull market since the GFC, the biggest mistake has been to be too underweight the U.S. for too long. And...

The blessing and curse of being contrarian by nature is you don't fall for the investing fads, but

You can be too apt to kind of assume the market has something importantly wrong before it does. And the frustrating thing for me, and this is kind of stuff I feel like I got wrong personally, I've written a lot of things over the years. Some of them have proved to be pretty right.

The one that thankfully few people besides me remember that I got profoundly wrong in 2002, I wrote a paper about why profits as a percent of GDP were the most mean reverting series in economics. And I said, look, the reason why is because capitalism is

if the return on capital is high, what you see is a bunch of capital moves in and that competes down the return on capital. And when the return on capital is low, nobody wants to invest. And that brings it back. And then I said something which had the germ of truth, but then I completely destroyed. I said, the only way you can really get out of that pattern is if you see a sustained increase in monopoly power. And then I went on to say the profoundly wrong thing, which was

And I don't think that is likely to happen in a sustained way because monopolies have kind of negative impacts on economies and society. People don't like them. And so governments act against them and corporations aren't people. So one turns out I'm wrong. The Supreme Court says corporations are people and corporations don't vote. So they wind up losing out.

So in terms of things we have gotten wrong, kind of at the asset allocation end is not recognizing the importance of the rise of kind of industry concentration and monopoly power across the global economy, but really most acutely in the U.S. economy and how important that impact could be for aggregate corporate profits. Hardly.

Part of the frustration I have with myself about getting that wrong is on a stock level,

We're pretty good at that, right? The basic idea behind GMO's obsession with quality, starting from the 70s, is that these companies who have market power and have demonstrated an ability to earn an above normal return on capital, man, these companies are pretty special. And that benefit persists for a surprisingly long time.

So kind of on an individual stock basis, we were always on the lookout for companies that were showing the evidence of having monopoly power. And it kind of never occurred to me that they could get so big and this could be so pervasive that rather than this being a good thing for an individual company, this could sort of change the game for a period of time forever.

for an overall market. Interesting. Profit margins tend to be pretty mean reverting and they haven't really been, especially in the tech sector. A lot of what you've written about over the last couple of years has been on this kind of market concentration of those few that have kind of maintained that profit margin, that growth. You know, you can call them Fang or Mag7 or whatever you want to call them. There's

there's been a small group of U.S. tech stocks that have kind of led the way. Can you give us a historical perspective? Isn't there always a bit of concentration in markets? Yes. And I'm going to I'm going to talk about that a couple of ways. One is in a lot of stock markets, there is much more concentration than there is in the U.S. right now. If you think about a small European country, which is relatively open, right, if you are

Denmark and you happen to have Novo Nordisk or 20 years ago if you were Finland and you happen to have Nokia. So you've got a bunch of smaller companies that are more domestic and then you have a big multinational. You can have very concentrated markets. But the reality is there are very few people who ever think about

oh, yeah, you know, I really want to own that Finnish market. Let me just buy the Finnish market. In the case of the U.S., there have been times when the U.S. market was more concentrated and less concentrated. The thing about today that is, as far as we can tell, unique, at least in the period that the S&P composite has existed. One, these companies are really, really big.

They have very high weights and they're also quite volatile.

So, you know, NVIDIA, Apple, Microsoft, they're big. They're about 7% or so of the S&P. You know, back in 62, I think AT&T may have been 10 or 11% of the S&P. So it was bigger than anything is now. But AT&T, you know, they were the phone company. They kind of were the economy. There was not a whole lot of idiosyncratic risk associated with AT&T.

And today we've got these big dominant companies and they are really volatile. So the idiosyncratic risk associated with NVIDIA today in the S&P 500 is as near as we can tell the highest individual stock risk that has ever existed in any company or the history of the S&P composite. And the MAG-7 are big.

big. It's a lot of weight, much higher than it has been on average for, you know, the top seven or top 10. Again, we've seen times in the past where there was some pretty good concentration, but

the risk associated with those aggregate stocks is qualitatively different. And it makes life weird for investment managers. If you were concerned about kind of absolute risk and absolute return, and you looked at these stocks, you would say, well, actually, these stocks are giving me a lot of risk. I would not want to own as much of these stocks as is in the S&P 500.

On the other hand, if your job is to beat the S&P 500, not owning one of these stocks gives you a ton of tracking error. So it is really important for you as an investment manager, for you as an investor to

to be very clear about what problem you are trying to solve. Because today, there is one set of problems I can think of where I would absolutely want to own less of these things, substantially less of these things. And there is another where that is about as risky an activity as it is

as there is at the moment. That is the problem. Yeah, I wonder, and you guys have talked about this as well, if this isn't a confluence of a couple of things, right? In that we have this new technology that is coming up. There are, you could argue, some pretty good moats around this high profit margins. There are some reasons for why they've done well.

We can argue that they are priced too expensively, but these aren't bad companies. They're just probably expensive companies, at least from a historical basis. But is this being exaggerated by the wave of paychecks

passive investing? Like everybody just goes into ETFs and, you know, various types of index funds, levered index funds. Is that creating some of this problem? I don't have the counterfactual, so I can't look at what these things would be without indexing and the rise of indexing. It's far from obvious to me that passive is the driver here. Five,

fundamentally, these companies have done something extraordinary. They have grown in a way that large companies have had real trouble growing historically. And while some of these stocks may be overvalued, and again, I'm holding aside Tesla because Tesla is a different animal than the rest of them. But these companies, maybe they're overvalued.

If they are, it's because their future is going to be less sparkling than their past. But a very common pattern in the stock market is investors assuming the recent past is a good guide to the indefinite future. So you don't need indexing for these companies to have gotten where they are. And if

And if passive has been a driver, it's probably in a somewhat more subtle way. So the thing about passive is they buy the same percentage of every company.

whether they are buying Apple or GM, if the iShares S&P ETF is whatever, 4% of the aggregate of everything, they buy 4% of GM, they buy 4% of Apple. Why should that have a bigger impact on Apple? Well, here's why that might have a bigger impact on Apple. It has nothing to do with the index itself or the passive funds, but it may have something to do with the people they're buying the shares from.

Passive doesn't trade much, really, unless the index changes. It almost doesn't change trade at all. If there's flows in, they got to buy. And so they have to entice someone to sell their shares. And the classic academic finance would say, OK, people own these shares. They are kind of prepared for

to sell an infinite number of the shares as the price goes up slightly because they believe this has gone from fair value to slightly above fair value and they don't want to own it above fair value. The reality is that's not the way investors think or work. Um,

But the people who own GM in general don't own GM because they think, oh, my God, GM is amazing, world beating company. They say, well, this company is really pretty cheap and I think I'm going to get a pretty good return because they're whatever trading at five times earnings and people like to buy trucks and they do a pretty good job of building trucks. And I don't.

need to imagine amazing things to get a pretty good return out of an okay company trading in five times earnings. But if that price goes up a little bit, it's like, well, okay, it's not quite as cool. I am more willing to sell. I am a value investor and value investors tend to be more price sensitive. You know, when we're dealing with Apple or Nvidia,

If the price of NVIDIA goes up a few percent and you are a holder of NVIDIA, you're less likely to say, oh, well, I liked NVIDIA, you know, when it was trading at 36 times earnings, but at 37 or 38, whoa, that's too much. So passive may have this tendency to increase the valuation spread between

Companies, stocks that are held by more price sensitive investors and stocks that are held by less price sensitive investors. So passive might have had an impact, but we got bubbles before we got passive. We got companies that were trading at very high valuations because they had done something extraordinary long before passive.

Passive may have exacerbated this a little bit, but this is not qualitatively different from what we have seen markets do. And particularly in the event of when you think about these companies, it's not just that they have done very well. It's have done really well for quite a long time. And it becomes hard to envision a company that has done nothing but win losing. Yeah.

I hear you. There's no counterfactual. So we can maybe assume that there's some amplification of what may have already occurred, but we don't know. And so it's just sort of a guess. But as we think about these current valuations in the U.S. in particular, and we think about these large tech companies, I started my career in sort of the tech bubble. And gosh, there's a lot of garbage like Pets.com and other companies. There were other...

are others that weren't, that were just overvalued, like a Cisco, right? So that's a real company, still is a real company. It just got overvalued. It seems like that's the issue with most of the Mag7. These are just, these are great companies. They're just perhaps overpriced. And so like, what does an investor do? Because you pointed out the risk, right? There's risk on either side, right? There's risk that you own overvalued stocks. There is risk that if you don't, you have huge tracking error and things can go on longer than you think.

So how do you blend that together? Is quality part of that equation? How do you stay fully invested and participate, but maybe reduce your risk? Well,

I was in New York doing some client meetings earlier this week. I was talking to a CIO. She said something fascinating, which I really loved. And I told her I would steal. So this is me stealing, which is, look, if you know there is a risk, you can try to hedge it. If you know there is uncertainty, you just have to diversify. And what I'd say about the world today is there is a lot of uncertainty.

And so you need to diversify. Now, that is a painful thing, right? The only thing to have owned in the public markets over the last decade is U.S. large cap growth, right? And anything you owned otherwise feels like, well, that was a stupid idea. But I would say today,

Even abstracting away from the MAG-7 and the fact that they're trading pretty expensive for U.S. growth and the fact that it's trading really very expensive relative to history, this is a world that really does feel pretty uncertain. I don't know what the world is going to look like in three years and five years. Now, what I would say is maybe even beyond diversifying...

maybe I want to be a little bit careful about owning stocks whose valuations kind of imply that I do know what the world is going to look like in five years. So my contrarian bent is, man, if whatever, if the AI complex is saying, dude, we know five years from now, it's all AI. Like, well, maybe I want to shade away from that. But

I think you do need to diversify. And the nice thing today is if a slightly worrying thing is the U.S. is trading really very expensive versus history and at all time highs relative to the rest of the world, the rest of the world is pretty decently priced. It is not priced as if the future is going to be amazing. So I would say if you're going to be fully invested, be diversified today.

And look for those areas as potential places to lean a little bit more heavily in where this uncertainty, this potential change may well accrue to their benefit.

Now, I mentioned quality. Is quality screen cheap or not cheap? I mean, because you probably have some tech in quality. That would usually be a source of, hey, I want to kind of have a higher quality portfolio. Would that work? Yeah. So I was going to recommend one bias to have

in your portfolio forever, it would be quality. And the reason why is not because I am utterly confident quality stocks are always going to outperform, but I am really confident that these companies have lower fundamental economic risk.

So they're not guaranteed never to be worse companies than they are today. But in really bad economic times, these are companies that are much less likely to go bankrupt. They are likely to fundamentally outperform in a really bad economic circumstance. And the reason why there's an equity risk premium in the first place is because equities do so badly in really bad economic times. And that's the worst time to lose money.

So I like having a quality bias wherever I can. And the strange thing is they are the group in the market that should underperform in the long run. And they don't. And that's, you know, you can say, yeah, well, is that because of the rise of the mag seven? No, you

You know, quality has outperformed in U.S. large caps for a very long time. It's outperformed within small caps. It's outperformed outside of the U.S. It outperforms in high yield bonds. I mean, one of the strangest things and, you know, I've been talking to people about this for over 20 years is within high yield rate, triple C's are

are much, much riskier than BBs are, right? These are companies that default in a good year, 5% of them default. In a bad year, 35% of them default. If you look at the BBs in a good year, half a percent of them default. In a bad year, 1.5% of them default. So they're both high yield.

but one of them is much riskier than the other. Those triple Cs should outperform. They really should, and they don't. The best performing cohort within high yield for a very long time has been double beats. I don't know why quality is consistently mispriced. The tricky thing for us about trying to value quality

and answer the question, is quality cheap or expensive, is because its growthiness changes, right? If I am trying to figure out whether value is cheap or expensive, well, the thing I know about value is it's not very growthy. And its anti-growthiness doesn't change very much. So its fair value relative to the market doesn't change that much. With quality, there are times when the quality cohort is kind of

fairly dull consumer stock that really do make good profits and reliably so, but grow at about the rate of GDP. And there are times like today where there's a lot of tech there that really does grow faster. So what we've seen historically is most groups, at least over a five, let's say that next five year period,

Valuation is a decent guy. When value is more expensive relative to its history, it tends to underperform. When it is cheap, it tends to outperform if you give it five years. With quality, that doesn't historically happen because in the times when it has looked expensive, it's been because it's actually been growthier. In the times when it's looked cheap, it has been less growthy. And so the performance has been

weirdly stable that didn't happen in the 70s, right? The nifty 50 was uniquely a quality bubble and quality was really very expensive and it really took it on the chin. Today, I wouldn't say quality looks cheap. If we try to take into account the fact that these are high quality firms and they're kind of growthy on our price to fair value model, it looks fine. The group that looks cheap

worrying is junkie growth. So you talked about kind of the pets.com era. And of course, those companies are always more obvious in retrospect than they were at the time. But, you know, we see a bunch of companies who are priced for as if they are going to make a ton of money in the future, but have no history of having made a ton of money in the past.

Those stocks look really kind of scary to us. Quality, I think, is about fair versus the market. And if it's fair versus the market, I like it because I think it's lower risk. But quality has been a tough group for us to try to forecast. Part of time quality. How about value? And I was recently at your client conference and I heard a lot of talk on deep value.

Yeah. So we are big fans of deep value today. So deep value in our definition is when people talk about value, they tend to be talking about the cheap half of the market, kind of the value index versus the growth index. And value globally looks really cheap on that basis. So the discount that the cheap half of the market trades at versus the expensive half is much bigger than normal. That's a good thing for value. But we're

But within that, we do see this bifurcation and it's most striking in the U.S. that the cheapest 20 percent of the market is trading at some of the biggest discounts we have ever seen, whereas the rest of value is actually trading expensive versus its history. So it's cheaper than the market. It is definitionally cheaper than the market because, hey, these are value stocks, but they are cheaper by a smaller margin than they normally are. And

When value is less cheap than it normally is, that gets us quite nervous. So we're not big fans of shallow value today, but deep value to us looks like a really interesting opportunity. And that's true in the U.S. It's at least as true outside the U.S.,

which a lot of people, including me, find a little bit surprising because, you know, you can come up with, of course, here are the names of the U.S. growth stocks that have done so amazingly well. Outside of the U.S., they come less to mind. And yet the deep value cohort is trading at just about, I mean, like first percentile versus history type cheap.

And the growth side is trading well into the 90s. So as we jump around, we talked a lot about large cap earlier and we talked about quality. Let me hear your thoughts on small cap and is small cap the anti-quality factor? There's a lot of junk in small cap, but is it cheap relative to its history?

A thing about small is I have said value is cheap all over the world. Small in different places in the world looks really quite different. For one thing, small in the U.S. has done a lot worse relative to the market than it has elsewhere.

So, you know, the last decade, most of the world, small's done just fine. In the U.S., it has underperformed in a reasonably striking way. And in the U.S., small stocks are trading very cheap versus history against the market. So they are trading at some of the biggest discounts versus large caps that we've ever seen. Normally, that would get us very excited.

Today, we are less excited because we do think some of that relative valuation fall is deserved. And what we have seen with small caps in the U.S., and again, this is not something we have tended to see outside the U.S. to anywhere near the same degree, is decline.

The return on capital for small caps looks much worse than the overall system, than large caps, right? I talked about, hey, in 2002, I said profit margins should be really mean reverting, and they didn't. They did for small. So small's profitability looks the same as it did, you know, it's volatile, it goes up and down with the cycle, but in absolute terms, it's no bigger today than it was in the 80s or the 90s or the 2000s.

For the large caps, it's a lot better than the 80s. It's significantly better than the 90s. You know, it has been on this upward path. As a result, small deserves to trade at a bigger discount than it used to. There's two other things that have happened to small, again, particularly in the U.S. One is they've levered themselves up, so they have more debt than they used to, and that makes them junkier. The other thing that's happened to them is they've gotten old.

There used to be a lot more IPOs in the U.S. than there are now.

And today, even where you have an IPO, in a lot of cases, by the time the company is going public, it's no longer small. So small companies are a lot older than they used to be. And that is an issue because growth is a feature of the young. Younger companies grow more than old companies. If you've got small caps and they're not going to be very growthy and they're not really that profitable, they deserve to trade at a discount. And they do.

If you decompose the returns too small, what you see historically is they've never been all that growthy. Their growth relative to large caps, even in the good times, is maybe a little bit better and is often a little bit worse. They give you less income than large caps because the dividend yield is smaller and they're more apt to issue more shares as opposed to buy back shares. So you get less income from them.

So if you get less income and you don't get any more growth, they must underperform. Well, no, they haven't underperformed. And the big reason is the fact that small is not a static group of stocks. Some small caps graduate to large cap land or maybe mid cap, depending on how you're defining your cohort. And.

A small cap that leaves small to become large, good things have happened to it. It has almost certainly grown. And if it hasn't fundamentally grown, then its valuation has certainly gone up. So the companies in small that leave small almost always give you a pretty good return.

And the large cap universe is also not a static group of stocks. Some of them become small and a large cap firm becoming small is not a good thing. Fundamentally bad things have happened. And of course, their valuation has fallen. So this rebalancing has been positive for small and is basically entirely responsible for the historic outperformance of small cap firms.

And so it's not that we are confident small is going to lose from here. I think small is probably cheap relative to its fair value. It's not as cheap as it looks. And they are junkier and riskier than they used to be. So where we own small in the U.S., we are...

particularly focused on the higher quality names because we don't want to be in a situation where if we do wind up in a recession, these guys are going to go bust on us. From an asset allocation perspective, is there anything else that we haven't hit? We've talked about diversification. We've talked about kind of deep value versus just value. What else as we kind of try to put a bow on the investment side? Is it EM? Is it international?

One place we have been really pretty excited about and have owned for a while, and the returns have been decent, but we think there's more to come, is not so much U.S. small caps, but Japanese small caps. Japan is, to us, a really interesting market. Actually, it is the only other market besides the U.S. that over the last decade

has fundamentally done really well. So the underlying earnings growth in Japan has actually been better than the earnings growth in the U.S. Now, the return hasn't been as good because Japan has derated over that period, whereas the U.S. has gotten a lot more expensive. So the returns have certainly favored the U.S., but the fundamentals have been very good in Japan. And

we think it's sustainable because what Japan did was go from having the worst return on capital in the world to

to okay. And they've done that the hard way. They did that by really increasing their sales margin. So in order to increase your sales margin, you need to become more efficient. You need to fire people. You need to shut down underperforming divisions. You need to do unpleasant things that kind of suck. They've got some more work to do, but a lot of that work is not so hard.

I talked about how in the U.S. small caps have been levering themselves up. That's been going on for about 15 years. In Japan, small caps have been paying down their debt for 30. And it is frustrating as a shareholder, right? Over the last 20 years, the interest rates in Japan have been zero and

And to take your retained earnings and use them to pay off debt that costs nothing, that's not a really good return on capital investment. But the good news is they have no debt. It's really hard to drive them into bankruptcy.

And if they start doing some of the things to rationalize their balance sheets, they're hugely overcapitalized. That can lead to really pretty good returns. And the thing is, you know, why? What's the catalyst? How to have hope? Well, the Japanese government is putting pressure on them to do this. Right. Japan is a market which nobody wants to be the first one to do something, but nobody wants to be the last one either. Right.

And in Japan, you know, if you can't get your price to book above one, and there's a bunch of companies trading at a price to book below one, you get demoted on the stock exchange. If you can't get your ROE above eight, you will not get bought by the big Japanese public pension funds. And it's shameful. And so companies are looking, asking kind of, well, what can we do to improve these things? We've never really worried that much about our ROE, but how

help us understand what we can do to improve it. And the good news is the stuff you need to do to improve it isn't that hard. Just stop paying down debt. Buy back some stock. Pay a dividend. We see cheap valuations. We see really pretty straightforward ways for these companies to improve. And

from an underlying perspective, there's a bunch of these companies, you know, they're not Microsoft, they're not Apple, but in their little niche, like these are companies with really good moats. They know how to make marine paint that nobody else makes as good a marine paint or, you know, the ceramics that cover semiconductors or these things that are just amazingly good at and have very little competition. They're

They're pretty good companies. They haven't been managed well from a shareholder perspective, and we're seeing that change. So the other thing that's really cool as a foreigner investing in Japan is the yen is just stupid cheap.

You hear about people going to Tokyo for vacation because it's cheap. And, you know, anybody who's old enough to remember the 80s, like that's impossible. But the yen is really cheap and that makes these companies really competitive. So it is a place we are quite excited about and a place we warmly recommend people giving an eye to. It's an easy place to overlook, but we actually we're pretty excited about it.

All right. Excited, warm recommendation. There you have it. Japanese small cap. Hey, let's finish with just a couple quick kind of lightning round personal questions. This might be a tough one for you, but what is one interesting fact that nobody else knows about you?

One of my former hobbies that some of the longtime people at GMO always pester me about having left behind, I used to write something called fun facts. I would sort of discover some weird thing about the world and give a write-up about that. I did that for about 20 years. And then life got too busy and I had kids and it was hard to do that in the evenings. But that was something I used to do that I really liked. So...

here we go. A fun fact about you is that you wrote fun facts. I like that. I like that. What's your current hobbies? So you gave that up. What do you do other than like being dad taxi? I am disturbingly addicted to the New York Times little games every morning. We have an email chain for Wordle and connections. And so that is something I do every day in terms of

things I really enjoy doing. One thing I'm very excited about, I used to do a fair bit of scuba diving that was harder when the kids were little. My kids are now old enough. They are going to get certified this winter and we're going to go scuba diving as a family for the first time in March. So that's something I'm quite excited about. It is something I have loved to do and I've wanted to share it with my kids and they're finally old enough that they can do it. Fantastic. Fantastic.

Final, final question. You've been around all of these luminaries, got to rub shoulders with lots of smart people. If you could recommend just one investment book to someone, what would it be?

Oh, this is such a horrible question. Hey, you're not supposed to tell me these are horrible questions. Because it's so much depends on what you're looking for, right? I was a huge fan of Peter Bernstein. I thought he was just about the clearest thinker and writer about investing in a very long time. And I loved Capital Ideas.

It's from a long time ago, but just understanding how this all came to be. That's great. It doesn't tell you that much about how to invest now. So there's other books I could give you on that. But if it was going to be one thing, it would be Capital Ideas.

to see whether, hey, this seems like an interesting area that you want to learn more about or not. Maybe it was a bad question, but that was a great answer and a great response. So thank you very much. And thanks for sharing all this great wisdom with us. And we're hoping we need it. We need it in 2025. So hopefully this leads to some positive returns for our listeners. Hope so.

If you are interested in more information on FEG, check out our website at www.feg.com. And don't forget to subscribe to our communications so you don't miss the next episode. Please keep in mind that this information is intended to be general education that needs to be framed within the unique risk and return objectives of each client.

Therefore, nobody should consider these to be FEG recommendations. This podcast was prepared by FEG. Neither the information nor any opinion expressed in this podcast constitutes an offer or an invitation to make an offer to buy or sell any securities. The views and opinions expressed by guest speakers are solely their own and do not necessarily represent the views or opinions of their firm or of FEG.