GMO, the investment firm co-founded by Jeremy Grantham, has started running a long-short strategy that is designed to profit from the bursting of the growth bubble the firm sees in the stock market.
The GMO Equity Dislocation Strategy was first put to work in late October across the firm’s liquid alternatives and multi-asset portfolios, Ben Inker, GMO’s head of asset allocation, told Institutional Investor in a phone interview. The firm raced to create the strategy after observing excessive speculation in stocks as the market came roaring back from its Covid-19-induced crash in March.
“By the spring, we had started to see ‘the stupid,’” said Inker. “If you’re not prepared to short the stuff that’s gotten drastically overvalued, you can avoid a lot of the pain — but that’s not going to make you money.”
GMO’s new strategy — which is long cheap stocks and short those that are expensive globally — has the potential to produce cumulative net returns of around 80 percent, according to Inker. That’s similar to the gains reaped from the GMO U.S. Aggressive Long/Short Strategy that the asset manager built to profit from the bursting of the 2000 bubble in technology, media, and telecom stocks.
“We see a very similar spread to what we saw then,” Inker said of the valuation gap between growth and value stocks. “In 2000, buying value stocks was a perfectly decent idea,” he added, “but buying value stocks and shorting growth stocks did a lot better.”
Value stocks have underperformed over the past decade, including a historic meltdown this year. The Russell 1000 Value Index lagged the Russell 1000 Growth Index by more than 40 percentage points during the 12 months through September — the measure’s largest underperformance ever over such a period, according to Inker.
In their enthusiasm for growth stocks, Inker said that investors have at times appeared to give little thought to what they’re buying. That market behavior, which he terms “the stupid,” can signal a bubble.
GMO has long been a student of market bubbles. The Boston-based firm, co-founded by Grantham more than four decades ago, also profited during the 2008 global financial crisis.
“That was quality versus junk,” recalled Inker, who joined GMO in 1992. “We thought low-quality companies had really gotten into kind of crazy levels by the middle 2000s.” The GMO Tactical Opportunities Strategy, which went long high-quality stocks and short low-quality equities, produced a 69 percent return from mid-2007 to February 2009, according to Inker.
GMO began discussing in October 2019 whether the time was right to launch another bubble-related strategy as valuations looked “pretty extreme,” he told II. But drawing on insights his team has gathered from Grantham over the years, Inker said that stock market valuations being stretched beyond historical averages isn’t enough to constitute a bubble.
“It is also necessary to see the evidence of profound speculative excess,” said Inker, who says he has observed that type of mania in 2020.
In his view, ordinary investors have added fuel to the stock market by opening more individual brokerage accounts this year. But he was also alarmed by a jump in short-term call option activity.
Investors buying a three-year call option on Tesla may believe a lot of information may surface in that time that will cause people to recognize that the electric car maker is worth much more than it’s valued now, he said. By contrast, “there is no plausible information that comes out on a three-to-five-day period,” said Inker. “It is pure speculation.”
Inker declined to name the companies that GMO is betting against under the GMO Equity Dislocation Strategy. Shorting is difficult and “scary,” he said, as the potential for losses is unbounded.
[II Deep Dive: ‘The Longest Unprofitable Short I’ve Ever Seen.’]
Short sellers, for example, have racked up massive losses from bets against Elon Musk’s Tesla, which has skyrocketed despite their belief that its stock price has become detached from fundamentals.
Investors have been piling into “go-go names” like Tesla, Inker said. He noted that investors had also driven up shares of Nikola Corp. before short-seller Hindenburg Research’s allegations that the electric truck startup was built on fraud sent its stock price tumbling in September. Nikola had benefited from the “the explosion of SPACs,” said Inker, going public through its merger with a special purpose acquisition company and quickly soaring past the market value of Ford Motor Co.
Nikola climbed to a high market value despite being a “pre-revenue manufacturing company,” Inker said. “It’s a very strange thing.”
While the GMO Equity Dislocation Strategy’s “underlying crucial ingredient is the value model,” Inker said the firm is trying to diversify its risks across regions globally, as well as sectors and style and size factors.
“We’re putting together a diversified portfolio that doesn’t have giant sector or factor bets,” said Inker. “If you just allow yourself to say, ‘Well I just want to be short all of the ‘growth’ companies and long all the ‘value’ companies,’ you’d wind up with a gigantic bet against technology.”
GMO’s portfolio is net short information technology by six points, as opposed to, say, 30 points, according to Inker. While the group of tech-related companies known as FAANGM — or Facebook, Amazon, Apple, Netflix, Google parent Alphabet, and Microsoft — looks somewhat more expensive than the average U.S. stock, their overvaluation is not particularly extreme, according to GMO.
The investment firm plans to provide details on its equity dislocation strategy in a quarterly letter to clients that is expected to be released Tuesday morning.
For the new strategy, GMO had to rebuild companies’ income statements to understand their true profitability as well as their balance sheets, according to Inker. It was a multiyear project that this year became a priority as the firm wanted to wager against companies in the growth bubble.
Inker explained that income statements can be “really flawed” for fast-growing companies whose scale today is “very different” from five or 10 years ago. “It’s only when those growth rates get to be a really big deal that this gets screwed up,” he said.
Before launching the GMO Equity Dislocation Strategy, the firm needed to understand which companies may be only “mildly” overvalued in order to differentiate between the companies GMO should bet against — and which ones it should not, according to Inker.
“I bear many scars” from trying to time bubbles, he said. Still, Inker believes the growth bubble is “well and truly there” in global equities markets.
It has reached “the parabolic stage where maybe it’s got some number of months left, but it’s hard to believe that it’s got years,” said Inker. “This is the kind of opportunity that only comes around once a decade.”
