Ben Inker & Tom Hancock, GMO – The Value and Quality Opportunity | #486

Episode Summary

Executive Summary: Ben Inker and Tom Hancock argue that the post-2022 market shift has made quality and value attractive, but only selectively. They see deep value as unusually cheap, quality as still defensible but not broadly cheap, and growth as vulnerable to “traps.” They also highlight Japan, parts of EM, and AI supply-chain enablers as notable opportunities, while warning that higher rates, recession risk, and AI disruption create real dispersion across stocks and sectors.

Main Topics: 2023 market backdrop: rates, recession risk, and AI (Priority: 5/5): The guests frame 2023 as a year of rising rates, a market that appears to be ignoring recession risk, and an AI-driven rally that may have bubble-like characteristics but rests on a real technological shift. Why quality investing still works (Priority: 5/5): They define quality as strong, durable return on capital, low leverage, and businesses that can withstand shocks. Quality may look “less risky,” yet historically it has still outperformed, likely due to market inefficiency and career-risk dynamics. Deep value vs. shallow value (Priority: 5/5): GMO splits value into deep value and shallow value, arguing the cheapest segment is exceptionally attractive while the rest of the value universe is much less compelling, especially in the U.S. Growth traps and value traps (Priority: 4/5): The conversation introduces a framework for identifying stocks whose fundamentals deteriorate beyond current-year disappointment. Growth traps are especially dangerous and were unusually prevalent in 2022. Japan and emerging markets as opportunities (Priority: 4/5): They see cheap currencies, improving returns on capital, shareholder-friendly reforms in Japan, and broad valuation discounts in EM as reasons these markets may offer compelling opportunities. AI winners, losers, and the supply chain (Priority: 4/5): Rather than chase headline AI names alone, they suggest looking at enabling companies in the semiconductor and data-center supply chains. They also emphasize that some firms may be profoundly disrupted by AI. Investor process and career-risk awareness (Priority: 3/5): Both guests stress pre-mortems, battle plans, rebalancing discipline, and caution against firing managers or abandoning strategies based only on recent underperformance.

Key Arguments: The market in 2023 is pricing in AI excitement but not fully pricing in recession risk, creating a disconnect across asset classes. Quality investing should be grounded in return on capital, leverage, and durable business economics—not just low volatility or stable earnings. Quality stocks can outperform despite being less risky because markets may not fully price their defensive characteristics. Value should be decomposed further: the cheapest stocks (“deep value”) are far more attractive than the broader cheap half of the market. In GMO’s framework, the cheapest 20% of the U.S. market is historically extremely cheap, while the next 30% of “shallow value” is relatively expensive. Value traps are hard to forecast, but they are costly; growth traps are at least as common and are even more damaging to returns. 2022 was a particularly bad year for growth traps, not just because of rates but because many growth firms disappointed on both current and future expectations. Japan looks attractive due to a cheap yen, improving returns on capital, net cash balance sheets, and governance reforms encouraging shareholder friendliness. EM looks cheap versus history and the developed world, but China and geopolitical decoupling remain the main risks. AI may create both obvious winners and hidden losers; investors should consider suppliers and enablers, not just the most obvious large-cap beneficiaries.

Data Points: Apple Podcast reviews: 849 - Number of Apple reviews mentioned by the host during the intro. Spotify reviews: 74 - Number of Spotify reviews mentioned by the host during the intro. Cheapness percentile of deep value: 2nd percentile - The cheapest 20% of the U.S. market is described as cheaper than it has been 98% of the time relative to the market. Time periods when deep value was cheaper: A few months in 2000 and a couple months in fall 2020 - Historical windows when the cheapest 20% of stocks were even cheaper relative to the market than today. Value trap share of value universe: Almost one-third - Their quantitative definition suggests nearly a third of value stocks become value traps in a given year. Value trap underperformance: About 15% per year - Value traps underperform the rest of the value universe by this margin. Growth trap underperformance: Almost 23% per year - Growth traps underperform the rest of the growth universe by this margin. Growth trap share in 2022: Over 70% - More than 70% of growth companies qualified as growth traps in 2022 under their framework. Japan currency level: Almost $140 per dollar - The yen’s weakness is cited as making Japan a cheap place to produce goods and services. Emerging markets valuation: About half the valuation of developed markets - They argue EM is trading at a large discount versus developed markets. Quality premium: About 10% PE premium - They note quality can trade at roughly a 10% price-to-earnings premium depending on whether it is more growthy or value-like.

Pivotal Quotes: "A glancing punch can knock a junk company to the mat. Quality companies absorb body blows like Rocky Balboa and come back for more." — Host quoting Tom Hancock: Used to illustrate the difference between fragile low-quality businesses and resilient quality firms. "The weird thing to me about quality is if there is any group of stocks on earth that has a good fundamental reason to underperform, it's quality." — Ben Inker: Ben explains why quality’s historical outperformance is surprising from a risk/return perspective. "The market does not seem to be at all pricing in a recession, and other markets are pricing in the idea that a recession is going to happen." — Ben Inker: Ben highlights a disconnect between equity pricing and broader macro signals.

Implications: Listeners should think more granularly about factors: buy deep value, not just generic value; favor quality with reasonable valuations; beware growth traps; and look beyond headline AI names to enablers and disrupted firms. Japan and selected EM exposures may offer better risk-adjusted opportunities than U.S. large caps.