British investor Jeremy Grantham may not be as well known as Warren Buffett to the general public, but he is considered a giant in the investing world.
A co-founder of Boston-based asset management firm GMO, with more than $118 billion under management, Grantham is known for his breadth of knowledge on just about every market topic -- especially asset bubbles.
His quarterly shareholder letters are definitely worth a read, so I thought I'd feature a few snippets from his latest.
When I started following the market in 1965 I could look back at what we might call the Ben Graham training period of 1935-1965. He noticed financial relationships and came to the conclusion that for patient investors the important ratios always went back to their old trends. He unsurprisingly preferred larger safety margins to smaller ones and, most importantly, more assets per dollar of stock price to fewer because he believed margins would tend to mean revert and make underperforming assets more valuable.
You do not have to be an especially frugal Yorkshireman to think, "What's not to like about that?" So in my training period I adopted the same biases. And they worked! For the next 10 years, the out-of-favor cheap dogs beat the market as their low margins recovered. And the next 10 years, and the next! Not exactly shooting fish in a barrel, but close. Similarly, a group of stocks or even the whole market would shoot up from time to time, but eventually -- inconveniently, sometimes a couple of painful years longer than expected -- they would come down. Crushed margins would in general recover, and for value managers the world was, for the most part, convenient, and even easy for decades. And then it changed.
What Grantham says here is important. You see, most everyday investors are told or believe that value investing is the way to go. Buy and hold never fails.
Rubbish. It's a gross oversimplification. Even Buffett himself is no longer a "value" investor in the old-school Ben Graham sense. Yes, studies show that this strategy does work over the long-term, but there is mounting evidence that we're in a "new normal." And Grantham agrees.
As evidence, Grantham cites the price-to-earnings (P/E) ratio of the S&P 500. From 1996-2006, he says, the S&P's average P/E of 23.36 was abnormally high by 1935-1995 standards -- by as much as 65-70%. And even after the bursting of the tech bubble, stock valuations only returned to "normal" temporarily. (Forget about the Financial Crisis -- valuations dipped within the blink of an eye and then quickly resumed upward, as we have witnessed over the past several years.)
Here's what Grantham had to say:
Indeed, a trend is by definition a level below which half the time is spent. Almost all the time spent below trend in the US was following the breaking of the two previous bubbles of 1929 and 1972. After the bursting of the tech bubble, the failure of the market in 2002 to go below trend even for a minute should have whispered that something was different. Although I noted the point at the time, I missed the full significance. Even in 2009, with the whole commercial world wobbling, the market went below trend for only six months.
Here are Grantham's closing thoughts:
In conclusion, there are two important things to carry in your mind: First, the market now and in the past acts as if it believes the current higher levels of profitability are permanent; and second, a regular bear market of 15% to 20% can always occur for any one of many reasons. What I am interested in here is quite different: a more or less permanent move back to, or at least close to, the pre-1997 trends of profitability, interest rates, and pricing. And for that it seems likely that we will have a longer wait than any value manager would like (including me).
So what's an investor to do then?
In short, get used to the "new normal." Don't wait for a major dip before deploying cash into the market. You may wind up waiting a lot longer than you think. To paraphrase the economist John Maynard Keynes, the market can stay "wrong" a lot longer than you can afford.
This is the exact same situation potential investors in Amazon (Nasdaq: AMZN) have faced over the past few years. As my colleague Jimmy Butts pointed out, those paying attention to conventional measures of value completely missed out on what would have been life-changing gains.
This Controversial Stock Is A 'Buy'
This sets up the discussion for another, far more controversial stock-- one that defies conventional thinking about valuation. But thanks to Jimmy's Maximum Profit system, which uses proven metrics to trigger buy and sell signals for subscribers, it's been flagged at a time when most "value" investors wouldn't touch it with a ten foot pole.
Could the story end up similar to Amazon? Or will it crash and burn as more than a few would relish to see? Tomorrow, Jimmy will explain why this company's "impossible" valuation actually makes sense, why you should ignore the doubters and add this industry trailblazer to your portfolio right away.
If you can't wait until tomorrow, or don't need any more convincing, I invite you to click here for the name of this pick and access to the rest of Jimmy's market-crushing portfolio.
This article originally appeared on Street Authority.