The transcript from this week’s, MiB: Tom Hancock, GMO Focused Equity, is below.
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This is Masters in business with Barry Ritholtz on Bloomberg Radio.
00:00:10 [Barry Ritholtz] This week on the podcast, I have an extra special guest. I love finding these people who are just absolute rock stars within their space that most of the investing public probably is not familiar with, haven’t heard about them. Maybe they’re a little below the radar or institutionally facing. And so the average investor is unaware of them. You certainly are familiar with GMO, Jeremy Grantham shop with Mayo and Ulu, his, his partners that that shop was founded in 1977. The person who heads their focus and quality strategies, this gentleman named Tom Hancock. He also helped run some of their mutual funds and helped put together their first ETF, and he has really quite an astonishing track record. The Quality fund mutual fund that GMO runs that symbol G-Q-E-T-X, it’s just crushed it over the past decade. 13.6% a year, way over both. Its index and its benchmark.
It’s in the top 1% of its peers. Morningstar five star gold rated. Just really, really interesting. And Tom has helped with the introduction of GMO’s first retail product, the quality ETF stock symbol Q-L-T-Y-G-M-O has been institutional since they launched in 1977. This is the first time they’re putting out a product for retail. And Tom explains what goes into quality stock selection, why they went to the ETF. You wouldn’t be surprised to learn the tax consequences of owning a mutual fund is a part of it. Really fascinating guy. Tremendous track record, unusual background comes from computer science and software and, and pivoted into quantitative investing. I found this conversation to be really fascinating. If you’re at all interested in focused portfolios, the concept of quality as a sub-sector under value and just how you build a portfolio and a track record, that’s tough to beat. I, I think you’ll find this conversation as fascinating as I did. With no further ado my discussion with GMOs, Tom Hancock. Thanks,
00:02:40 [Tom Hancock] Barry. It’s great to be here.
00:02:41 [Barry Ritholtz] So, so you have a really interesting and unusual background. Let, let, let’s start there. Computer science bachelor’s from, from RPI in 85, PhD in computer science from Harvard in 92. What, what was the career plan?
00:02:57 [Tom Hancock]] Yeah, well it wasn’t doing, investing in quality stocks in the early days, that’s for sure. I actually come from a very academic family. My father was a university professor. My mother worked as an editor. Her father had been a university professor. We have doctors in the family. I actually don’t know that anyone in my family actually had a job at a private for-
profit traditional company ever. I’m the first, I’m kind of the black sheep. So that’s where I started from. In fact, the fact that I actually went into computer science rather than the more liberal arts discipline was a little bit non-traditional, let’s say. And I think that was kind of an early wise decision that I give myself credit for is back in high school. Like, you know, I was really interested in history and stuff, but I didn’t really wanna be a historian. So it’s like, what do I actually like to do as opposed to think was interesting. And that’s where at the time, you know, computer programming was becoming a thing. I really loved it. That led me down that track and really well, I had a software engineering job. I was always sort of pointing toward a research career. And then at some point after my PhD school studies, we could get into that if you like, but I kind of decided to switch and finance was kind of what was available for me at that point. Yeah. Let,
00:04:08 [Speaker Changed] Let’s lead up to that transition software engineer at IBM, then you get your PhD, then research at Siemens, which seems to be more of a technological position than a finance position. What was your focus within tech?
00:04:24 [Speaker Changed] I worked the area in which I studied in, in graduate school and then worked at Siemens, which as you say, it’s a, a research lab. Think like Bell Labs, IBM Watson, that kind of think tank environment. I worked on machine learning, which is a subfield of, of course artificial intelligence.
00:04:41 [Speaker Changed] Back in the nineties.
00:04:41 [Speaker Changed] Yeah, that was the nineties. So artificial intelligence is a, it’s an area that’s been around for a long time. I think the term was coined in the 1950s, but I was doing it, or I should say working on a, a small part of it back in the nineties of, in graduate school is at a, at a fairly theoretical way at Siemens it was with more applications in mind.
00:05:02 [Speaker Changed] So, so how does the transition to finance take place? It seems like maybe you’re gonna attack into research or academia. How did you, how did you find your way to both finance and GMO?
00:05:14 [Speaker Changed] Yeah, so there’s two parts to that. One is just sort of why not the academic track and then the why the finance part. So the, the why not the academic track was in academia. I was doing very theoretical stuff that was very maybe intellectually interesting, but understood by increasingly few people in the world. So I just sort of wanted to be something that was a little more relevant. And I thought maybe the research lab would provide that. And for various reasons it still didn’t feel like that. So I was, I was basically looking for something that was relevant. I, you know, I wanna be loved like everyone, right? So I wanna do something that I can talk to people about and they don’t realize, well, you
00:05:49 [Speaker Changed] Be loved or you wanna go into finance, it’s one or the other.
00:05:51 [Speaker Changed] Well that, so that leads to the other with finance, which wasn’t certainly an opportunistic element to that. Like what kind of industry hires people that values fancy academic degrees that don’t have necessarily a lot of developed specific skills and finance. I’d say management consulting is any of the other thing that least at that time was the other career trajectory, just my personality, more of a math oriented introvert. Finance was the natural fit for GMO. Particularly, I got really lucky when I was in graduate school. So I was at Harvard. Harvard has a smaller computer science department. We do a lot down the river at MIT, right? And I went to a, a research group there. I was headed by Ron ve, who’s perhaps known to some as the R behind RSA cryptography. But he also worked, oh, for Billy in machine learning in this area.
00:06:39 And he ran this research group of scruffy grad students and postdocs that I would go to. But there’s this one guy who came from downtown who wore a suit and no one quite knew who he was. I asked who’s that guy? Like, I think he’s a banker. And he was a very smart guy. My mental image was that he worked in the bank of, back of a bank approving mortgage applications. He was really frustrated and this was his intellectual outlook. It turns out that was not what he, he was, he was a guy named Chris Darnell who was the, started of the quantitative research effort at GMO. He was Chris Jeremy Grantham’s right hand man in the, in the early eighties. But he’s just, he also came from an academic family. He had broad interests. He came to this group. I’m not even quite sure how he found it, honestly. But in any case, when I was sort of casting around at places to look, that connection was rekindled and that was my entree into GMO. Really,
00:07:28 [Speaker Changed] Really interesting. And you joined GMO in 1995. You’ve been there ever since. That’s kind of unusual these days in finance to stay with one firm for, gee, it’s almost 30 years. What makes GMO so special? What’s kept you there for three decades?
00:07:45 [Speaker Changed] It’s been a great place to work, obviously. I’ve, I’ve thought so. I think GMO felt very familiar when, to me, when I joined as a smaller firm, I think maybe 60 people at the time. It’s very much of a intellectual debate, academic kind of vibe. It felt very comfortable to me. And the firm’s grown. I’ve kind of grown with it. I think one of the things that’s kept me engaged is I’ve actually done different things. So kind of as we’re alluding to, as you’d think, my background is very much on the
quantitative side. Now I do fundamental side research portfolio management, which I just,
00:08:20 [Speaker Changed] So, so you joined GMO, there’s 60 people, 30 years. They’ve grown tremendously. How big is GMO today versus when you joined and what was that process like to experience all that growth?
00:08:33 [Speaker Changed] Yeah, I think it’s about 500 people today. Wow. The bulk are in Boston, which is where I sit. But we have investment offices in San Francisco, in London, and in Singapore and Sydney, Australia. So it’s a, it’s a global firm. The, you know, one of the things I think when, when I started at GMO, it was really just investment people almost. And ev all the sort of compliance, client service, legal, kind of, everything was done sort of on the side by investment people. And gradually we
hire, we professionalized over time, right? So it’s,
00:09:11 [Speaker Changed] You’ve become an enterprise, it’s 10 x what it once was in terms of headcount, it’s much bigger in terms of assets. And I can tell you from personal experience, us finance people, we’re not great at accounting, legal, compliance, all the detail and stuff that, that keeps the firm running. Yeah. The
00:09:30 [Speaker Changed] Trick is we’re not great, but we think we are. So that’s where we get into trouble.
00:09:33 [Speaker Changed] That that’s, that’s a lot. That’s really true. We hear a lot about Jeremy Grantham thoughts on markets, but much less on how the firm is managed, how this growth came about and the culture as a business. Tell us a little bit about GMO as as a cultural enclave up in Boston.
00:09:55 [Speaker Changed] Yeah, well one thing to start with, there is the name GM and O. And it’s three people. And people know Jeremy Grantham, I think very well, but that Dick Mayo and Ike Van Loo are the other two. And that’s relevant to your question because from the very early days before I was there, they kind of operated separate investment teams. Dick Mayo was a traditional, I’d say portfolio, strong portfolio manager focused on US stocks. Ike was similarly international stocks. And Jeremy was kind of the go everywhere, top down, big ideas guy. And that a bit of that cult, Dick and Ike are both retired now. But a lot of that culture of different investment teams that do things a little bit differently is very much part of GMO. There is not one central view to the firm. Jeremy is a very strong, powerful persona and very deep thinker. Jeremy’s never really been a portfolio manager. His role has always been, in my experience at least, he’s always been much more of a gad flaw. He makes you think about things, he makes suggestions, he pushes you to come to your own conclusion. He leads you to water, but he’s not a hands on the, on the portfolio person. Huh.
00:11:04 [Speaker Changed] Really interesting. We, we had him down sometime last year, came by our offices and, and spoke. And I very much get the sense he has no interest in retiring. He loves what he does, he is very plugged into everything that’s going on. He, he’s gonna do this forever, isn’t he?
00:11:23 [Speaker Changed] That would be my guess. Yeah. I think he probably will outlast me in, in the industry. He’s, he is one of the smartest people I’ve ever met and one of the most driven people I’ve ever met. He has a, I think, I hope along professional lifespan ahead of him, I would say he is a little bit less focused on what you might call the day-to-day of investing at GMO. And he does a lot of stuff outside. He’s very involved with the Grantham Foundation, right? His charitable organization both on the, their mission, but also on the investing side of managing their portfolio too.
00:11:53 [Speaker Changed] So, so that raises a really interesting question. He’s a big picture guy. He’s always looking for what risks and what black swans might be coming at us that the investment community either hasn’t found yet or isn’t paying attention to. How do you translate that 30,000 foot view as to what’s going on in the world to something like quality and focused investing? Or is it really just there to sort of help you create a framework for looking at the universe? Yeah.
00:12:23 [Speaker Changed] Well, when I say he’s a big picture guy, I don’t necessarily mean just that he’s investing as to make macro calls. I mean more that he steps back from the fray a bit and thinks about the big ideas and what really matters. And that whole idea around quality investing that’s kind of Jeremy from the 1980s, early eighties and saying, bang, say, hey, you know, I cut my teeth as, as he and Dick Mayo did on VA traditional deep value investing, but we’re missing something here with these higher quality companies. How should we think about that? How can we invest about that? How can we improve our process? So that’s sort of philosophical outside and around the box thinking is kind of what really led to us having a quality oriented strategy today.
00:13:06 [Speaker Changed] And, and, and quality is really a subsection of value. Is that, is that what you’re suggesting?
00:13:13 [Speaker Changed] It’s an improvement of value or refinement on the definition of value. And people use these terms loosely, of course, and these all fall under the, the rubric of fundamental investing and buying companies that are great over the long term at great prices. But the idea that, you know, companies that can compound at high rates of return deserve premium multiples, you should be willing to pay for them, is the root of it.
00:13:35 [Speaker Changed] The quality funds ticker, GQ ETX has returned 13.6% a year over the past decade, putting it in the top 1% of its peers. So let’s talk a little bit about what goes into that sort of performance. What are the core themes at GMO around focus and quality? Tell us a little bit about what differentiates GMO from the way other value investors invest.
00:14:05 [Speaker Changed] If you think about value investors, value investors traditionally are people who kind of know the price of everything and the value of nothing, right? They’re much too focused on ratios around trailing fundamentals and not on the, on the plus side future growth opportunities. On the negative side, maybe competitive threat. So bringing the quality idea into that, thinking about what companies have a long trajectory to grow and to grow at high return on capital. That’s the key thing. Also, differentiating between growth, that’s just sort of throwing money at the wall and seeing a little bit come back to you versus very efficient growth. That’s the key to quality investing. I could maybe flip that around a little bit since I think particularly post 2008, 2009, the quality style of investing has become a lot more popular. People, certainly some people talk a lot about the difference between our approach and a lot of quality managers is that they’re really quality growth managers. So the quality but at a reasonable price. Or you could interpret that as not just chasing the companies everybody knows are high quality, but finding a few, maybe more neglected names, that quality to reasonable price is a little bit of a different style than I see most people practicing out there.
00:15:17 [Speaker Changed] So let’s get into some of the definitions of this. How does GMO define quality?
00:15:23 [Speaker Changed] Yeah, so we think about quality, first off, the ability to deliver high returns on investment going forward. Then what enables that you have to have some asset ability capability that competitors can’t equally duplicate. I mean, traditionally it could have been like a physical asset or brand. Of course these days in an IT world it’s much more about network effects of of platform companies and such. But you have to have that special sauce that’s not re reproducible. It has to be doing something that’s relevant. Like you would wanna avoid the trap of companies that do one thing well and that thing’s not growing. So they just try to do other stuff. And then management quality does also come into play. I do keep a strong balance sheet. Are you prudent? Do you invest when you should return capital when you shouldn’t? So as those assets, the relevance and then capital discipline are the key components for us.
00:16:11 [Speaker Changed] Given that definition of quality, has that evolved or changed over time? Or has that been pretty much the definition going back to the eighties or nineties? That’s,
0:16:20 [Speaker Changed] That’s been pretty much the definition. Going back to the eighties and nineties, I told you kind of the fundamental definition. There’s also quantitative metrics that we look at Those have evolved, but always within that capa, that cluster of high returns on investment stability across the economic cycle are consistent and strong balance sheets. What has changed over that period too is what kinds of companies best meet that threshold. So if you go back to the eighties and nineties,
you really we’re talking about like the Cokes and Proctor and Gambles, right? And Johnson Johnson type
00:16:50 [Speaker Changed] Consumer companies,
00:16:51 [Speaker Changed] Right? And big consumer and healthcare. And now those are still there, but a lot more of the big tech companies, the, the FANG companies, more growth companies, frankly.
00:17:00 [Speaker Changed] So, so for a long time it looked like Apple was a value stock even as it became big and bigger than giant. But when we look at what people call the magnificent seven, are you seeing any real value there? Companies like Microsoft and Nvidia, Netflix, I assume are quality companies by your definition, but are they quality at a reasonable price?
00:17:24 [Speaker Changed] All the names you mentioned are quality companies. We believe, we don’t all, we don’t hold all of ’em. It’s the, the prices vary. If you think about meta and alphabet, those are kind of the value stocks in the bin, right? Those,
00:17:35 [Speaker Changed] Well, they got your lack over the past couple of years before last year’s recovery.
00:17:40 [Speaker Changed] Yeah. And we also hold Microsoft and, and Apple apple’s actually an interesting case study. ’cause we used that as an example of our investment at our investment conference 15 years ago about what a high quality company isn’t. And then Steve Jobs turned around in the iPhone and so forth. And of course the rest is history. The point is we were very wrong about them and we were late to the party, but the party had such long, such a long party that it’s okay to be late to it. You see, we still had a really good time with that company, which I think is a little bit of a lesson to, for quality investing, you don’t have to be the first one in the door there. These th these themes run for a long time and if you’re willing to admit you’re wrong and, and change your stripes, these, you can still make money.
00:18:20 [Speaker Changed] So there were a few come GMO Warren Buffet were quote unquote late to Apple, but did exceedingly well with that. So you don’t have to be at the there at the IPO, you don’t have to be there when they crash in the.com implosion. As long as the growth rate is there and the the value is reasonable, there’s an opportunity.
00:18:41 [Speaker Changed] Yep. And speaking of the.com implosion, like Microsoft via a case study where we, in previous strategies, we held Microsoft for a very long time, that’s where the valuation could help us in the.com bus. So Microsoft now is on 30 times earnings. It was over 50 right? In 2000, right. And I don’t think it was a much better company than, it’s a pretty good company now, right? Yeah, yeah. So there’s, you know, great company, you have to at some point be willing not to hold the stock. And yes, actually Microsoft by this point is outperformed since the peak of the cycle, but it took a long, long time for that to happen. So,
00:19:10 [Speaker Changed] Well the, the buler era was not where they really shined new CEO seems to have done a great job over the past, what is it, five years Nadal’s been there for? Yeah,
00:19:20 [Speaker Changed] Yeah. At least that I think at this point we held through the, and actually added in the Bombay era. So that would be up our taking the view that, at least in this case turned out to be right, that is something companies can fix if the core assets there, you know, the core network effects of everybody using their products, they’re being so entrenched in IT systems departments around the world that was still there. The easiest thing almost to fix as a CEO. So if a stock’s training at 13 times earnings and has all these great characteristics and you think the CEO can change, that can be a great time to invest,
00:19:53 [Speaker Changed] Throw the bum out, bring someone else in, and the rest is history. So I love this quote of yours on the backwardation of risk quote, the expectation is that achieving higher returns requires taking more risk, but higher quality stocks have outperformed lower quality stocks by a considerable margin despite being less risky. Explain
00:20:17 [Speaker Changed] Yeah, and that’s, that’s a point that Jeremy Grantham kind of observed very long time ago and is emphasizing for a long time. And actually Ben Inker is the head of our asset allocation group. Just wrote a, a very interesting piece on that too. This idea that at the big picture level, stocks versus bonds, things kind of behave what you’d expect. You get more return, but there’s more risk associated with it. Sure. But if you look within asset classes, that hasn’t been true just empirically. Like why is it, it’s perplexing, right? That high quality companies, which have been safer, right? They do better in recessions and such have, you’ve not had to pay for that with lower return. And that’s, that was really the core of Jeremy’s observation about quality stocks and why it’s not just that quality’s this silver bullet that just beats the market all the time. And I’m sure we necessarily believe that’s true, but it, it does improve your portfolio with lower risk without having to give up return.
00:21:10 [Speaker Changed] So the obvious answer is value makes a big difference within quality stocks. Is that what leads to the lower downside in, in a market dislocation, if you’re buying it right, there’s less room to fall, right?
00:21:26 [Speaker Changed] In isolation quality on average gives you downside protection, certainly did in 2007, eight for example. But then it didn’t in the, when the tech bubble burst, it didn’t last year in 2022. Right? Then the reason for that is a lot of the quality stocks were really expensive. So as the trade off compromise or combination of value and quality is what we think gives you that best downside protection, but without having to give up too much on the upside too.
00:21:50 [Speaker Changed] Huh. So let’s dive into the details of GMO’s. Quality strategies in 2022. Core quality and quality value outperformed the s and p 500 by a wide margin. 2022 was a a down 19% I think in the s and p 500, but last year, 2023 core quality and quality value slowed, but quality growth boomed somewhat different. Environment and quality growth was where all the gains were, were had. Is this a purposeful style diversification within quality? How, how do you think about core quality, quality value
and quality growth?
00:22:32 [Speaker Changed] Yeah, when we think about the opportunity set for us of high quality companies, there are, as you say, really different kinds of companies within that quality is neither growth nor value. You can find both within it. And so when we talk about quality growth or think tech stocks, qua core quality, think defensive coke, consumer staples, value, think some of the more cyclical names. We like the fact that there are high quality companies in all these areas and generally we find them attractive. And we like the fact that as you point out, they tend to work at different parts of the market cycle. And so yes, it is deliberate that we have exposure across these, not that, you know, if it’s 1999, we’re probably not gonna have much quality growth. So it’s not a fixed allocation, but it does give us diversification. And because we’re familiar with stocks across this spectrum, it also gives us the ability
to rebalance. And that’s one of the things that we’ve been quite successful with over the last few years, is not just that we hold both these kind of companies, but we’ve been leaning against the wind to buy the growth stocks at the end of 2022. The value stocks more recently just rebalancing has had a lot of value.
00:23:38 [Speaker Changed] Really interesting. You, you mentioned Ben Inker, who I know publishes pretty regularly. You publish on a, on a regular basis also not too long ago you put something out quality for the long run, A little play on Professor Siegel’s stocks for the long run. Tell us a little bit about the valuation discipline, quality investing offers and and why that’s so important when so many stocks have had such great run up over the past couple of quarters.
00:24:05 [Speaker Changed] Yeah, I think that’s maybe a mistake I’ve made in my, my career has been too rooted in looking at what did well over the last few quarters if a stock did really well thinking, oh, it must be expensive. Whereas the reality of IT markets are efficient enough that the vast majority of outperformance is driven by truly improved fundamental results. So we have to be with that level of humility. I think the other thing to think about is that if you’re a long-term investor, getting the valuation exactly right matters less, you know, the finessing, the entry exit point is less important if you’re gonna hold for five plus years, which is kind of what our ambition is to do with our stocks. But in extremis, which is the Microsoft and the Tonight 2000 example and maybe some other AI related stocks today, it really does matter. You really like the long time where you have to hold to make up that valuation whole is so long that you just really shouldn’t be involved. It’s kinda our basic philosophy. 00:25:03 [Speaker Changed] Another research piece you put out, I found kind of intriguing quality investing for greed and fear. Explain that.
00:25:10 [Speaker Changed] I mean, the fear part is kind of what we’ve been talking about. Like if you’re worried about market downturns, quality is a good sleep at night investment. And thing I laugh about is every time we think about writing an annual letter or something like that, someone wants to write in these uncertain times that we are now in today, it’s like, it’s always uncertain times. When has that not ever been the case? Right? Right. So people are always worried and so quality is always good for, for that constituency. The only thing I’d say is if when those worries come to pass, if you hold quality stocks that you really believe in, you’re less likely to sell at the wrong moment. So there’s that psychological advantage to them that goes beyond just statistical analysis of return periods over time. And the greed is the quality is not just a defensive portfolio, then the market’s going down, you hold cash, right? You don’t hold high quality stock. So the greed part is that high quality companies do participate in the upmarket. And so if you think, you know, AI is a great thing. If you think GLP ones are fantastic, if you think there’s innovation going on all around the world and you wanna participate in it, we think high quality companies are a great way to do that.
00:26:14 [Speaker Changed] I have a, a recollection, and I think it was the Onion, our long national nightmare of peace and prosperity is finally over was a 2000 headline. And it’s true. How often, how often can you say, well thank goodness we live in times where there’s no uncertainty and, and everything is rational
00:26:33 [Speaker Changed] When we say that run for the hills that
00:26:35 [Speaker Changed] That’s exactly right. GMO has released last quarter their first retail product an ETFI love the symbol QLTY. Let, let’s talk a little bit about the ETF and the thinking behind it. GMO has almost exclusively had institutional investors, very high net worth family offices. I mentioned the quality mutual fund, that’s a $5 million minimum. What was the thinking behind, hey, let’s do an ETF that anyone could buy for 50 bips? No minimum.
00:27:10 [Speaker Changed] Yeah, you’re exactly right. GMO has been an institutional in manager. We started in the endowments and foundations space and have gone from then. But as you also said, institutional includes increasingly family offices and wealthy individuals who pay taxes. And so just structurally the ETF is such a better vehicle. Yes, to pool clients and GMO’s always been an advocate of pooled investing. You get the, we think it’s be good a solution and allows more portfolio manager focus not to have separate accounts. And so really the launch, the genesis of having an ETF for us was less about entering the retail market or accessing different clients and more about better servicing the institutional tax paying clients. That said, we have a lot of respect for individual investors. I think they get a bum wrap among institutional managers. Institu individual investors can be very sophisticated, discerning, thoughtful. And it’s not a segment of the market we wanna shy away from other than just the operational complexity of having lots of small clients. And there the ETF market has matured to a point where we don’t really face that complexity. And so we’re glad to be able to be a lot more accessible. The only thing I’d say about ETFs, and they’ve been on our radar screen for a while of course, but in originally they were for no particular reason, but kind of associated with passive or more commoditized quantitative factor strategies. And it’s really over the last few years that an active strategy in an ETF has been something people would pay any attention to.
00:28:43 [Speaker Changed] So I mentioned previously the GMO Quality Mutual fund, top 1% of its peers, 13.6% a year for the past decade. How does the quality ETF strategy differ from the mutual fund strategy?
00:28:57 [Speaker Changed] Not very much. It’s the same investment process philosophy team and everything. The one simplification we’ve made for the ETF is it only, we only invest in US companies. So the quality fund is global and its opportunity set has had up to 20% in non-US domiciled multinationals, think like the Nestle’s of the world, that kind of company, right? Whereas the ETF is designed to be a more straightforward s and p 500 US only equity strategy
00:29:26 [Speaker Changed] And it’s concentrated 35 large cap stocks. Is it limited to what’s in the S&P 500 or is it any US stock?
00:29:34 [Speaker Changed] It’s not limited to the S&P500. What we’d like tends to be large cap established great businesses. So I think it is in fact all stocks are in the S&P500.
00:29:44 [Speaker Changed] And and 50 bips is not an unreasonable fee structure for an actively managed fund. Tell us the thinking behind this. Why go, I wouldn’t call it low cost, but it’s not a high cost etf. Some of the other active ETFs are a hundred bips or more. What was the thinking there? Yeah,
00:30:03 [Speaker Changed] Well we’re pricing it similarly to how we price our institutional accounts. As I mentioned, a lot of our, I think initial funds have come from tax paying investment advisors and such who might have a choice which to use. We wanted to make that a not fee driven choice, right? But just picking the right vehicle. Another reason why we can keep the costs low is these are very liquid stocks. There’s not really a capacity constraint around these. So it’s not like we have to charge an exceedingly high rate to be a profitable
00:30:33 [Speaker Changed] Business. And how often do those 35 stocks turn over? Is there any, hey, we’re gonna rebalance this once a year or once a quarter, or is it driven on whatever opportunities the quality stock team you work with decides we’re going to get rid of accident, replace it with them?
00:30:49 [Speaker Changed] Yeah, there’s no calendar to it. It’s driven by the opportunities as we see them. If we think about the mutual fund, and I don’t think this would be any different here. We’ve run been running turnover about 20% a year for the last few years. Which consistent with my remarks earlier, when we buy a company, we’re thinking about holding it for quite some time. In fact, probably about half that turnover is not so much new stocks entering or stocks exiting as more rebalancing around valuation moves in the portfolio.
00:31:16 [Speaker Changed] I love the ticker QLTY. It’s amazing that was even available this late in the ETF world. How did you guys start first thinking about we have clients paying all this phantom tax on the mutual fund side. ETFs really seem to be much more efficient from a tax perspective. Tell us a little bit about the, the discussions that led up to let’s create an ETF.
00:31:42 [Speaker Changed] I’m acutely aware of the tax issues as I put the bulk of my investing in our, our own strategies too, including the mutual fund now, now I’m invested in the ETF. I think it would go back to over a decade. Like we were well aware of ETFs for a very, very long time. And while we got the best ticker out there, there are other quality ETFs out there, which, you know, advisors were talking to us as competitors. So we were kind of looking at the competitive landscape and seeing, hey, what do they do that’s different from what we do? Why do we think our approach is better? You know, we’re more fundamental, we have the valuation, et cetera. There are a lot of differences. Felt like now was the time, I think largely because of the rise of active ETFs versus pure passive ones.
00:32:21 [Speaker Changed] Now, now this obviously isn’t the exact same holdings as the quality funds mutual fund, but I’m gonna assume they’ll track pretty closely over time. It’s the same process. It’s some of the favorite ideas from quality go into the ETF. Can, can we expect similar performance from this?
00:32:39 [Speaker Changed] Yeah. My, my expectation is they won’t differ is that we’ve never held more than 20% in non-US stocks and all the non-US, all the US stocks we hold in the fund. We also hold in the ETF at similar weights, there are a couple new names. So it’s not just a carve out, but it’s very, very similar in characteristics.
00:32:56 [Speaker Changed] So, so I know GMO has a variety of offerings. You do equities, alts, fixed income. How does the quality screen work with other asset classes besides equities? Can you do that with alts? Can you do that with fixed income or is it just specific to value stock investing?
00:33:17 [Speaker Changed] Focusing on quality characteristics as well as valuation and sort of quality at a reasonable price, sort of big picture is an idea that cuts pretty much across all of GMO’s strategies and the different asset classes in which we invest. Of course it means different things if you’re running a merger arb strategy, right, with a short horizon, then long term buy and hold investing like quote we do. But that’s, that’s there. Another thing to think about that sort of unites GMO as a firm is that a lot of our clients come sort of through the door, if you will, in our multi-asset class solutions. We, we call asset allocation at GMO. So a lot of the strategies that we’ve developed over the years at GMO, including originally the quality strategy derived from us, Jeremy and team Ben Inker and others, seeing a top-down opportunity in the market, us forming a strategy if that’s a conventional asset class or at the time a new asset or sub-asset class, like quality investing. That’s how a lot of what we do get started, it’s why we kind of have a complicated lineup for a firm our size. But that does impose a certain, I think, intellectual consistency on how we think about the world.
00:34:26 [Speaker Changed] So, so given the success of this first ETF and given this expertise in all these different areas, the obvious question is what’s the next ETF that’s gonna come out of GMO? Or are you guys good with quality and you’re not looking for any other retail products? Yeah,
00:34:44 [Speaker Changed] Well I’m not gonna break news on your podcast, but I think, you know, we do one with the idea certainly that we might do more and
00:34:52 [Speaker Changed] If this is continues to be successful, all these other asset classes that GMO plays in some of them are really ripe for an E
00:35:00 [Speaker Changed] Yeah, some, some were ripe than others. But I think there’s a lot of opportunity out there. If you maybe another way of asking that crisis, why did we start with this one? I think there are, there are a couple obvious reasons. One, it is our largest strategy, but another it is US equities, which are kind of the simplest, most liquid asset class. They fit well for the transparency of an ETF structure. It’s most easiest to do the market making around them. So it was a very obvious place for us to start.
00:35:23 [Speaker Changed] So the mutual fund is about $8 billion or so. Is there any limitation on how big the CTF can get? I mean, assuming it’s all large cap US stocks doesn’t seem like there are a lot of constraints on how large this can scale.
00:35:38 [Speaker Changed] Yeah. Not practical constraints, of course there is a constraint for everything, but we’d be talking about tens of billions of dollars where capacity would be, huh.
00:35:46 [Speaker Changed] Really interesting. So let’s talk a little bit about what’s going on in, in value today. I I, I’m impressed by this quote of yours and really curious if it’s still true. US deep value stocks are unusually cheap in the US market in particular, the cheapest 20% look cheaper than they ever have in 98% of the time through history. That’s really surprising. I keep hearing about how expensive stocks are. The bottom quintile of value is as cheap essentially as it ever gets.
00:36:20 [Speaker Changed] Yeah, that’s a quote that’s coming up from our asked allocation team about how they think about positioning equity portfolios to be maybe nuanced about that, where we’re talking about is the valuation that relative to the overall market. So it’s kind of two sides of the same coin. It’s not so much that cheap stocks are really, really cheap. It’s that the spread of valuation ratios is very wide.
00:36:41 [Speaker Changed] So the non-value stocks are very expensive.
00:36:43 [Speaker Changed] Yeah. And frankly I think that is where most of the action is. It’s that the non-value stocks are trading at much higher multiples than they normally have. And when we say deep value, it’s almost like, you know, two people talk about index because they divide the world 50 50. Right? There’s no magic to that. I think right now, just in a market cap sense, market concentration, there are a lot more growth stocks. So to find the true value stocks and making air quotes, you kind of have to go a little bit deeper into the percentiles of market cap than you would typically.
00:37:11 [Speaker Changed] And when we’re talking about value, you’re still discussing with the quality overlay. So you could have quality stocks and, and the least expensive quality stocks on a valuation basis. Yeah.
00:37:23 [Speaker Changed] Relatively
00:37:23 [Speaker Changed] Attractive, but maybe not absolutely attractive. I I don’t wanna put words in your mouth.
00:37:27 [Speaker Changed] Yeah, maybe apologize for confusing terminology on our part because when we say deep value, I think people often think just the lowest price to book stocks out there, right. In the GMO terminology, that’s deep value on a measure of what we’d call intrinsic value that blends a hefty ver version of quality into that. So, you know, that will include some stocks we hold in the quality and I think the metas of the world, companies like that.
00:37:49 [Speaker Changed] Gotcha. So I get the sense you guys don’t pay a whole lot of attention to the macro economy or geopolitics or what the fed’s doing. How, how important are these other aspects to the way you manage assets?
00:38:05 [Speaker Changed] Not that important. I think the thought experiment for us is if this is something that feels cyclical that isn’t going to affect where the world’s gonna be five years from now, then we’re only gonna pay attention to it. To the extent that if something happens, we react to it. Like it can create a dislocation, right? People might overreact to an interest rate move in our opinion, but we’re not gonna try to forecast it or pick stocks based on that. You did mention geopolitics in that list. Sure. Geopolitics is, in my mind a little bit different. And the reason that’s a little bit different is I’m not sure that’s gonna be solved five years from now, right? That could get worse or the trends that we’re on are different from where we’ve been in the last 20 or 30 years. So that is, I’d say, of those things, the one where we scratch our head a little bit more, not that I’m gonna claim we have the answers there, but it is front of mind for us.
00:38:52 [Speaker Changed] How, how do you think about interest rate risk or inflation or the whole transitory versus sticky debate? Does that become a key part of the asset allocation discussion or is it just kind of background noise that everybody has to deal with
00:39:10 [Speaker Changed] More background noise? GMO is kind of famous for doing seven year forecasts, right? And the reasons we do seven year forecast is that’s sort of the horizon where we feel like whatever the noise is that’s going on now, that that’ll kind of all be gone. So the philosophy behind those is, eh, seven years from now things will be kind of normal and I’m not sure what the path is to get there, but if that’s where they’re going, this is what that would imply about returns over that horizon. And,
00:39:34 [Speaker Changed] And one of your recent notes, you, you mentioned Jeremy Grantham’s super bubble thesis. How do you work in quality as a core equity allocation within the concept that, hey, maybe there’s a super bubble going on out there. Is that, is that consistent?
00:39:49 [Speaker Changed] Yeah, I’m a a humble portfolio manager who works from the bottom up. So I’m not really thinking about super bubbles very much. Honestly. I’m thinking about are these stocks that we’re investing in good quality business price to deliver a good return and good, I mean, sort of double digit type return over the next five ish years. So if it turns out that this is a super bubble and I think Jeremy’s technical definition of that is a very, very big bubble, then quality stocks are gonna go down. We will have been wrong to invest in them. The silver lining is at least we’ll have done better than pretty much anything else out there.
00:40:22 [Speaker Changed] The quality will go down less than, than the rest of the indices out
00:40:27 [Speaker Changed] There. Particularly quality with a sense of valuation. Huh.
00:40:30 [Speaker Changed] Alright, so let me jump to my favorite questions that I ask all of my guests. Starting with what have you been streaming these days? What’s been keeping you entertained either video or audio?
00:40:43 [Speaker Changed] Well, I have a 12-year-old daughter and she runs the family with an iron fist and she likes to still watch TV together. So I’ve been watching a lot of survivor episodes, although unfortunately I actually like those. She’s moving on to something else now that I like less well, but I won’t call it out in terms of, I, I listen to a lot of podcasts too. That’s where I get a little more sort of, I am sort of embarrassed to say this, but professionally it takes a little bit of the place of reading. I, I love Econ Talk, which is sort of theoretical economics debate podcast for fun. I love Judge John Hodgman. There’s all kinds of things out there. It’s a great world.
00:41:19 [Speaker Changed] Yeah, no, it really is. So let’s talk a little bit about your career. Who, who were your early mentors who helped shape the path you’ve taken professionally?
00:41:30 [Speaker Changed] I think in my case, a lot of the mentors come through kind of my academic career and teachers and, and professors going back. And my high high school math teacher, Mr. Hyde, he was the one who taught the computer programming course. He’s the one who sort of encouraged me to take college courses when I was in high school. He also taught me bridge, which is, I don’t really play that much anymore, but he is a great game. And let you think a lot about things in a, in a great way. My PhD advisor at Harvard, Les Valiant. I’d also pick out, I mentioned Chris Darnell at GMO. Rob EY was the name of my first manager there. He was a very wise, wise man. He, if I think about one of the things I’ve gained from these people too, particularly the professional ones, it’s kind of when to be willing to say no to stuff too. My colleagues now wouldn’t believe it, but I used to be like probably over
accommodating. And maybe I’ve learned that lesson a bit over. Learned it.
00:42:23 [Speaker Changed] What are some of your favorite books? What are you reading currently?
00:42:27 [Speaker Changed] Well, this is the holiday time. I just came back from a long plane flight and I read this really fun detective book that my wife gave me for Christmas. But then I was reading a biography of Samuel Sewell, who’s one of the judges at the Salem Witch Trials actually. So a colonial era figure. It’s an interesting book to learn about that era. My favorite book of all time, and it’s not even close, is a children’s book called The Land of Green Ginger. Huh. Which is written by the screenwriter of the original Wizard of Oz movies. It is a satirical, clever take on kind of the postscript, the Aladdin myth from the Arabian Knights and I Rec, I recommend all of your listeners if they can find it, which is easy. Read that book,
00:43:11 [Speaker Changed] Really interesting. What sort of advice would you give to a recent college grad interested in a career in investment and finance?
00:43:20 [Speaker Changed] So investment finance is actually a very broad area. So the first advice is kind of narrow that down. And the best way to narrow it down is to get exposure to lots of different things. And I think the best way to enable yourself to get exposure is don’t focus so much on finance investing. Just figure out about learning, learn all sorts of things. Learn math, learn history. You can
always learn a trade after that. Don’t think, oh, I’m interested in finance, so I’m just gonna spend all my time listening to investment podcasts. No offense or, or none. Taken, gonna read 10 Ks.
00:43:55 [Speaker Changed] I, I don’t, I don’t imagine that anyone’s gonna listen to a couple of dozen podcasts and suddenly begin to outperform the benchmark. It’s a little more nuanced than that, isn’t it?
00:44:05 [Speaker Changed] I think all the great investors talk about reading and how much they, of their time they spend reading and just learning. And I think that is one of the things I like about the investment industry is you just spend so much of your time just learning about how businesses work, how the world works. You’re kind of an observer. You’re kind of a miserable critic, rather an actual creator of value, but an analyzer of others’ work
00:44:26 [Speaker Changed] It, it’s, it’s almost academic adjacent, given how much reading there is. And our final question, what do you know about the world of investing today? You wish you knew 30 years or so ago when you were first getting started,
00:44:38 [Speaker Changed] That appreciation of quality businesses and the value to pay for them. I come, my mindset is a little bit more contrarian and I think I, from an investing perspective, that manifest itself much more in a, a value orientation or value, meaning low multiple underperforming stocks, cigar butt of philosophy. And I think realizing the value of time and compounding and you know, just, it’s just worth paying up for a higher quality business
00:45:03 [Barry Rtholtz To say the very least. Thank you, Tom, for being so generous with your time. We have been speaking with Tom Hancock, head of the focus equity team at GMO. If you enjoy this conversation, well check out any of the previous 500 interviews we’ve conducted over the past nine years. You can find those at iTunes, Spotify, YouTube, wherever you find your favorite podcasts. Sign up for my daily reading [email protected]. Follow me on Twitter at ritholtz. I would be remiss if I did not thank the crack team who helps us put these conversations together each week. My audio engineer is Kaylee Ro Tika. Val Run is my project manager. Shorten Russo is my head of research. Anna Luke is our producer. I’m Barry Rtholtz. You’ve been listening to Masters in Business on Bloomberg Radio.
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