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GMO Pitches a Curveball

At a firm famous for bearish value investing, fund manager Tom Hancock argues for a surprising strategy.

GMO fund manager Tom Hancock is betting big on U.S. equities and technology, which in a tumultuous market lets him sleep well at night, he says.

Hancock, head of GMO’s focused equity team, wrote in a recent research note that 45 percent of the firm’s “quality strategy” is invested in technology, with Google parent Alphabet being its largest holding. He sees Alphabet trading at a high — but justifiable — price-to-earnings multiple.

“While we are very careful to not overpay for a stock, we do not manage according to traditional “‘value’ metrics,” Hancock said in the note. “Our portfolio trades at a premium, albeit a modest one.”

In an expensive market, quality companies tend to trade at higher P/E ratios than most “value” investors would like, wrote Hancock, saying he does fundamental analysis to find those with strong and resilient businesses. More than 80 percent of assets in GMO’s quality strategy are in U.S. equities, according to the note.

GMO, co-founded by legendary value investor Jeremy Grantham, is known for identifying and avoiding bubbles. Yet when screening for quality, there may be room for an active stock picker to shine at time when bearish sentiment is on the rise, according to Hancock, who says Alphabet looks even more attractive after the broad market selloff.

The tech giant’s shares tumbled 13 percent in the fourth quarter to $1035.61 at the end of December. Still, the stock was down just 1 percent for all of 2018 thanks to a strong rally earlier in the year.

Hancock expects Alphabet’s research and development will translate into higher future revenues and he likes that the company has a lot of cash and strong growth prospects. 

“Today’s R&D is taken out of today’s earnings as an immediate expense, whereas in reality current earnings are driven by the R&D of several years ago,” he said in the note. According to his view, capitalizing the expense and amortizing it over time “paints a more accurate picture of Alphabet’s true valuation, in which current earnings power is significantly higher.”  

[II Deep Dive: Top Tech Stocks Have Retreated — But Short Sellers Are Struggling to Post Gains]

While FAANG stocks — Facebook, Apple, Amazon.com, Netflix and Google — were popular picks last year, some investors worry these high-flying tech giants have become overvalued in the aging bull market. 

GMO holds three FAANG companies, including Facebook and Apple, according to Hancock. 

“A technology-heavy portfolio can still be defensive if it is comprised of the right companies that meet our quality standards and trade at reasonable valuations,” he said.

Jittery investors are looking for cracks in a bull market that has run for almost ten years. As part of their concern, fund managers often point to rich valuations in U.S. stocks compared to equities in emerging markets.

The S&P 500 was trading at 20.9 times trailing earnings at the end of November, compared to an average multiple of 15.7 going as far back as 1880, according to Hancock. But when filtering for high-quality stocks, Hancock finds U.S. companies that look less expensive than peers in developing economies. 

For example, he said that Walmart de Mexico is trading at more than twice the multiple of Walmart, the giant retailer based in Bentonville, Arkansas.

“At today’s prices, we believe that our buy-and-hold portfolio of quality equities can generate a return in the order of 5 percent above inflation based on our discounted cash flow analysis,” Hancock wrote.

He calculated that GMO’s quality strategy trades at a P/E ratio of 18.2, a premium compared to 17.2 for the S&P 500.

“While GMO generally sees opportunity in emerging markets, we find that valuations in the U.S. and emerging markets stocks have converged when we filter the indices through our quality screen,” Hancock said.

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