Description

What if I told you that an investment was available that featured the following:

• Some of the best brands, assets, and management in the world
• Revenue, income, cash flow, and book value growth consistently higher than the S&P 500
• An incredibly strong balance sheet and low debt levels
• A diversified revenue stream with 50% of sales outside of the U.S.
• Historical and expected return on equity far in excess of the overall market
• Strong pricing power which should act as an inflation hedge

Now what if I added that you could have all of that for a lower valuation than the S&P 500? 

So what's the catch?  Well, the specific recommendation is a mutual fund, GMO Quality (GQETX).  For those of you who get a little queasy at the thought of buying a mutual fund, this write-up is really about the broad opportunity in the space and is easy to implement in a number of different ways.  The Fund is not available to retail investors either (as far as I know), but the performance, holdings, and many of GMO's letters are public so I thought writing about the fund as a whole made sense as readers can re-create or customize (or ignore!) the investment to their own liking. 

Most of you are probably familiar with GMO, a respected Boston-based investment manager run by Jeremy Grantham with over $100 B in assets and a number of strategies across asset classes.  GMO launched this particular strategy in 2004 which focuses exclusively on high quality companies, meaning those with high historical and expected returns on equity, consistent earnings, and strong balance sheets.  From that universe GMO looks for the most attractive valuations and avoids certain industries where the method is less applicable, such as financials due to their inherent leverage which can inflate ROEs.  The resulting portfolio consists of many of the best and largest companies in the world, particularly those in the technology, healthcare, and consumer staples sectors. While I doubt many of you are interested in the actual fund, the fees are reasonable as well (as low as 48 Bps but depends on the type and size of the client).            

Grantham has been pounding the table for quality stocks for a while now and said the following in his most recent letter (http://www.gmo.com/websitecontent/JGLetter_ALL_3Q09.pdf):

"Quality stocks (high, stable return and low debt) simply look cheap and have gotten painfully cheaper ...In our seven-year forecast the quality segment has a full   seven-percentage-point lead per year over the whole S&P 500, or 9% over the balance ex-quality. This is now at genuine outlier levels...In the long run, quality stocks have proven to be the one free lunch: you simply have not had to pay for the privilege of owning the great safe companies, as plain logic and established theory would both suggest."

While Grantham is certainly talking his own book, the numbers and logic of this investment do appear quite compelling.  To first get a sense for what is in the fund, here are the top 25 holdings (~80% of the portfolio) with some basic valuation metrics.  The last public disclosure of holdings was 8/31/09 but given the strategy I don't expect there to be too many material changes to the underlying holdings:

The entire portfolio has 62 holdings and in aggregate appears more attractive than the S&P:

Taking an in-depth look at the growth of these companies over the past decade shows just how "quality" these businesses truly are.  As a result of their dominant market positions, world class brands, and strong balance sheets they have compounded sales, income, and cash flow at significantly higher rates than the S&P 500.  For the table below I pulled historical #'s for each company and took the weighted average of the growth rates for each metric.  All data is from 1999-2008 unless the company didn't report for the entire period, so a few of the start dates vary.  Growth rates for the Quality Portfolio are on a per share basis to account for share buybacks and there are various sources for the S&P 500 data (for earnings I used as reported earnings as reported by S&P, which is admittedly unfair given the massive effect of non-recurring write downs on 2008 earnings): 

To be clear there is some element of data mining in this analysis.  By definition to become a "quality" company you likely grew at higher than average rates and GMO certainly didn't own all of these stocks the whole way up.  While the historical numbers should be taken with a grain of salt, I do believe that most of these companies remain world class and in aggregate have better than average prospects.  50% of their sales come from outside of the U.S. (vs 36% for the S&P 500 as a whole) so they should benefit from global growth and enjoy a natural hedge against long-term US dollar depreciation. 

Another key feature is the strong pricing power that these companies maintain which should protect against inflation.  In a recent addition of Value Investor Insight a manager cited a study they performed of the inflationary environment between 1973 and 1981.  While they found that most stocks and bonds lost tremendous value after accounting for inflation and taxes, they also found that the 25 companies in the Fortune 500 with the highest ROE compounded their book value at 15% over the period vs 10% for the entire group.          

Consensus growth estimates also act as a sanity check that these companies have not lost their "quality".  Calculated on a bottoms-up basis and using consensus estimates for both the portfolio and S&P 500, the  weighted average book value per share growth for GMO Quality is higher than the S&P 500 for both 2009 (15% vs 13%) and 2010 (21% vs 15%).  In addition, consider the following about the GMO portfolio:

• 35 of the 62 holdings grew their book value per share in 2008 and the weighted average growth was slightly positive
• Weighted average EPS growth was also positive in 2008
• 40 of the 62 companies grew their EPS in 2008 and 43 are expected to in 2009
• Weighted average book value per share growth was positive every year since 2000, while the S&P's book value fell in 2002 and 2008

Overall I believe this investment offers both above average return potential and below average risk, with inflation protection thrown in as a free kicker.  The fund itself or any significant subset of its holdings should do better than the S&P over the next 10 years and is a great place to either park cash or replace broad market exposure given the defensive characteristics of the underlying companies.  GMO's holdings could also act as a simple screen for potentially attractive individual names - in fact 22 of the 62 have been written up as longs on VIC in recent years if you want more specifics (MSFT, ORCL, WMT, KO, GOOG, NVS, NSRGY, UNH, WAG, HD, NKE, MCD, EBAY, KMB, HPQ, DCM, AAPL, WLP, LOW, DELL, KFT, and UPS).  While not quite as defensive, purchasing Magic Formula stocks could also make sense as part of this theme, particularly if you are looking for an inflation hedge given their high ROIC's, which is in the same ballpark as GMO's use of ROE since GMO excludes highly levered companies (shameless plug for our VIC hosts - you can also check out http://formulainvesting.com).         

While it's not as exciting as a small, overlooked situation with a clear reason for its mispricing, I do believe that broad asset classes such as this can become dramatically mispriced from time to time (tech stocks, real estate, credit, treasuries, etc.).  The nice part about this case is that I personally don't care very much about having a specific catalyst - while the stocks could certainly underperform somewhat over the short to medium term, their ability to compound book value over time and withstand just about anything thrown at them (financial crisis, inflation, dollar panic, etc.) should ultimately be rewarded with a higher than average multiple, and they will continue to compound at attractive rates in the meantime.   

Catalyst

• Continued earnings and book value growth
• Inflation, dollar panic, or some other crisis leads to relative outperformance versus market
• Investors realize that the best, safest companies should have above market multiples