Tom Hancock on Quality Stocks and Launching ETFs

Episode Summary

Executive Summary: This episode of Masters in Business features Tom Hancock of GMO, who discusses quality investing, the firm's history, and its first ETF QLTY. Hancock explains GMO's definition of quality (high returns on investment, competitive advantages, capital discipline) and how it combines with valuation. The conversation covers the GMO Quality Fund's top-decade performance, the appeal of quality stocks as both defensive and growth-oriented, and the benefits of the new ETF for tax-paying investors.

Main Topics: GMO's Quality Investing Philosophy (Priority: 5/5): Definition of quality as high returns on investment, sustainable competitive advantages, and capital discipline. Contrast with traditional value investing. Performance of GMO Quality Fund (Priority: 5/5): 13.6% annual return over the past decade (top 1% of peers). Explanation of how quality + value drives outperformance with less risk. Launch of GMO's First ETF (QLTY) (Priority: 4/5): Motivation: better tax efficiency for institutional clients and retail accessibility. Strategy: 35 large-cap U.S. quality stocks, 0.50% expense ratio, low turnover (~20%). Tom Hancock's Unusual Background (Priority: 3/5): From computer science PhD (Harvard, machine learning) to quantitative finance at GMO. Impact of academic rigor on investment approach. Quality vs. Value Spectrum (Priority: 4/5): Quality growth, core quality, quality value strategies. Cyclical performance differences (2022 vs. 2023) and rebalancing benefits. Current Market Valuation Extremes (Priority: 4/5): Deep value stocks are unusually cheap relative to growth stocks. No super bubble concern for quality portfolios due to valuation discipline. GMO's Firm Culture and Structure (Priority: 2/5): Independent investment teams (Jeremy Grantham as big-picture thinker, not portfolio manager). Multi-asset class solutions and seven-year forecasting approach.

Key Arguments: Quality stocks have outperformed lower-quality stocks with less risk, contradicting traditional risk-return tradeoff. Quality at a reasonable price combines defensive characteristics with growth participation. Valuation discipline prevents buying 'wonderful companies at wonderful prices' that take decades to pay off. The ETF structure is superior for tax-paying investors vs. mutual funds. Geopolitical trends (unlike cyclical macro) may be more persistent and deserve more attention. Deep value stocks are at near-historic cheapness relative to the overall market. Individual investors can be sophisticated; the barrier to entry for GMO was operational complexity, not a belief they are unsophisticated.

Data Points: GMO Quality Fund return (10-year): 13.6% - Annual return past decade, top 1% of peers per Morningstar GMO employee headcount (now vs. 1995): 500 vs. 60 - Firm growth over ~30 years QLTY ETF expense ratio: 0.50% - 50 basis points vs. some active ETFs at 1%+ Portfolio turnover (mutual fund): 20% - Annual turnover, consistent with long holding periods Non-U.S. exposure in global quality fund (max): 20% - Difference between global fund and U.S.-only ETF Deep value relative cheapness: 98th percentile - Cheapest 20% of U.S. stocks are cheaper than 98% of historical observations relative to the market ETF number of holdings: 35 - Concentrated large-cap U.S. quality stocks

Pivotal Quotes: "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." — Tom Hancock: Explaining the core paradox of quality investing observed by Jeremy Grantham "Individual investors can be very sophisticated, discerning, thoughtful, and it's not a segment of the market we want to shy away from, other than just the operational complexity of having lots of small clients." — Tom Hancock: On why GMO launched a retail ETF after decades of institutional focus "If you're a long-term investor, getting the valuation exactly right matters less. Finessing the entry-exit point is less important if you're going to hold for five plus years." — Tom Hancock: On the importance of long holding periods for quality stocks

Implications: The podcast underscores that quality investing with valuation discipline can offer superior risk-adjusted returns. GMO's move to ETFs signals a broader trend of institutional managers offering tax-efficient retail products. For investors, quality at a reasonable price remains relevant amid extreme market dispersion between growth and value stocks.