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Here’s some fresh news for all of us managing our own retirement accounts.
The Bear of Beacon Hill has spoken — and on one thing specifically, history says he is probably right.
We’re talking about legendary Boston fund manager Jeremy Grantham, the founder of white-shoe fund company GMO and a longtime predictor of doom. As reported by MarketWatch’s Barbara Kollmeyer, Grantham has given an interview to a Bloomberg podcast in which he made three big investment calls.
The first two are that the stock market could fall 50% from here and that investors should steer clear of U.S. stocks altogether because they are overvalued. Maybe he’s right, maybe he isn’t. Both are calls he’s made several times in the past. Subsequent events have not always conformed to the model.
But it’s Grantham’s third call that is most interesting, especially to anyone trying to save enough to retire on someday.
Grantham urged investors to focus on so-called high-quality stocks, which he called “a free lunch.”
“When it comes to quality, they have less risk of every kind, they have less debt, they go bankrupt less, they have less volatility, they have a lower beta. … That is a free lunch,” he said.
Is he right? History says: Almost certainly.
High-quality stocks, typically meaning those of companies with things like high returns on equity, stable earnings and low levels of debt, have persistently been a better investment than the overall stock market for decades.
And that’s been true not only here in the U.S., but also in developed overseas markets like Europe and Japan.
Even more clearly, high-quality stocks have produced their greatest successes during market downturns, crashes, bear markets and slumps. That’s when they’ve held up best, while the weakest stocks have tanked.
Not every financial expert agrees with this, incidentally. Many question whether company quality is really any kind of reliable indicator of stock-market outperformance. There has been a trend in academia to suggest that many of these so-called investment factors are bogus, the product of data mining, p-hacking (don’t ask), publication bias and other sins.
On the other hand, the number crunchers at hedge-fund company AQR have argued that quality is not only a strong source of investment returns, it’s a major source of Warren Buffett’s success — and $120 billion fortune.
As Buffett himself has said, he’d rather buy a wonderful company at a fair price than a fair company at a wonderful price.
The proof of a free lunch, surely — like the proof of a pumpkin pie, an allegedly $5.5 billion fake-meat sandwich or pretty much anything else — is in the eating.
MSCI, the organization that tracks stock-market data around the world, has been monitoring indexes of “quality” stocks on a price basis since the mid-1970s, and on a total return basis — meaning including dividends — since the mid-1990s.
During the average 12-month period since 1975, looking only at the price indexes, quality stocks have beaten the overall stock market by 1.7 percentage points in the U.S., 1.3 percentage points in Europe and 0.4 points in Japan.
Factoring in dividends as well, from 1994, quality stocks have beaten the overall stock market by 1.5 percentage points a year in the U.S., by 1.9 points a year in Japan and by 2 points a year in Europe.
Over time, these have really added up. If you’d invested $100,000 in the broad U.S. stock market in November 1994 (using the MSCI U.S.A. standard index of large and midsize companies as a proxy), reinvesting all dividends, today you’d have $1.6 million before tax.
But if you’d invested in high-quality U.S. stocks alone, you’d have $2.7 million.
If you’d invested that money in European stocks, you’d have about $700,000 today. But if you’d picked high-quality European stocks, you’d have twice as much: $1.4 million.
Japan, which has struggled with lost decades of dismal returns, still sees a similar divergence. According to MSCI data, $100,000 invested in Japan back in late 1994 would be worth just $170,000 today. But the same figure in high-quality Japanese stocks would be worth $250,000.
In MSCI’s data, the outperformance of quality has been persistent, but not consistent. It has lasted over long periods of time. But it has not shown up every month, or every year. There have been several years at a time when quality stocks have done worse than the overall market. Finance is not a natural science like physics, no matter what the professors like to claim. This water does not always boil at 100 degrees Celsius at one atmosphere.
For example, U.S. quality stocks handily beat the rest of the market during the bear market of 2000-03 and during the global financial crisis of 2007-09. European quality stocks outperformed, at certain points by 10 full points a year, during the European debt crisis of 2010-13. Japan’s stock market entered a brutal, long-running bear market at the start of the 1990s. But at the end of the decade, measured in U.S. dollars, Japanese quality stocks were still nearly 50% higher than they had been at the end of 1989.
But quality underperformed the overall stock market during other periods. It did badly from 2004 to 2007, when the stocks you wanted to own tended to be in doomed kamikaze companies like Lehman Brothers, Bear Stearns and Countrywide Financial.
Where are they now? Quality stocks have been beating the broader market index in the U.S. for about a year, but they have been trailing the indexes in Europe and Japan.
If Grantham is correct, we should be investing — especially if we fear a downturn ahead — in funds such as the iShares MSCI U.S.A. Quality Factor exchange-traded fund
QUAL
and the MSCI International Quality Factor ETF
IQLT.
Both have low fees, at 0.15% and 0.3% respectively. And if history is any guide, they will fall less far in a slump and will make us more money in the long term.
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