GMO recently released a white paper titled The S&P 500: Just Say No, by Matt Kadnar and James Montier.
The paper questions the validity of throwing in the towel and simply indexing all of our equity exposure to the S&P 500. Of particular interest to us here at The Acquirer’s Multiple is Montier’s deep value screen, which he has regularly run over time to assess the potential opportunity set from a bottom-up perspective. The paper makes the point that today’s lack of undervalued opportunities may be an indication that the market is now overvalued saying:
As Graham noted, “True bargains have repeatedly become scarce in bull markets…Perhaps one could even have determined whether the market level was getting too high or too low by counting the number of issues selling below working capital value. When such opportunities have virtually disappeared, past experience indicates that investors should have taken themselves out of the stock market and plunged up to their necks in US Treasury bills.”
Here’s an excerpt from the paper:
Pension Trustee Smith: I recommend to the committee that we liquidate our International equity assets and index our equity exposure to the S&P 500. US stocks have outperformed for the last 20 years, and I see no reason why that should not continue. Everyone knows that the US is the strongest economy and market in the world.
This is a somewhat fictionalized version of a comment or conversation that has gone on in many committee discussions over the last several years in one form or another. And why wouldn’t it?
Being a US equity investor over the past several years has felt glorious. The S&P 500 has trounced the competition provided by other major developed and emerging equity markets. Over the last 7 years, the S&P is up 173% (15% annualized in nominal terms) versus MSCI EAFE (in USD terms), which is up 71% (8% annualized), and poor MSCI Emerging, which is up only 30% (4% annualized). Every dollar invested in the S&P has compounded into $2.72 versus MSCI EAFE’s $1.70 and MSCI Emerging’s $1.30. Diversification theoretically sounds good, but as Yogi Berra said, “In theory there is no difference between theory and practice, in practice there is.” Diversification in this particular
instance seems good in theory but not so much in practice.
So, shouldn’t we agree with Trustee Smith and throw in the towel, index all of our equity exposure to the S&P 500, and call it a day? If our goal is compounding capital for the long term, which it is, we would not just say “No,” but something akin to “Hell no!”
On Deep Value Screening Today
An alternative measure of the scale of the opportunity set is afforded by using a screen developed by Ben Graham.3
He suggested a deep value screen based on four criteria: 1) the stock’s earnings yield should be at least twice the AAA bond yield; 2) the stock’s dividend yield should be at least two-thirds of the AAA bond yield; 3) the issue should have total debt of less than two-thirds the tangible book value; and 4) the stock should have a Graham and Dodd P/E (price divided by 10-year earnings) of less than 16x.
Exhibit 7 shows the results of running this screen across a variety of markets at two points in time: late 2008 and today. In late 2008, the screen was finding lots of cheap stocks – 20% of Japan and the Asian markets were passing the screen; 10% of stocks in the UK and Europe were “deep value” cheap; and, even in the US, 5% of stocks were being thrown up as deep value (including the likes of Microsoft!).
Now, fast forward to today. In Japan and Asia only around 5% of stocks are showing up as extremely cheap; in Europe and the UK the number drops to 1% to 2%; in the US not a single stock passes the screen. Not one single solitary stock can be called deep value.
As Graham noted, “True bargains have repeatedly become scarce in bull markets…Perhaps one could even have determined whether the market level was getting too high or too low by counting the number of issues selling below working capital value. When such opportunities have virtually disappeared, past experience indicates that investors should have taken themselves out of the stock market and plunged up to their necks in US Treasury bills.”
3. One of the authors (Montier) has regularly run this screen over time to assess the potential opportunity set from a
bottom-up perspective.
You can read the complete paper here.
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