One of the doyens of Value Investing is Jeremy Grantham from GMO. He is most famous in Australia for declaring we have a housing bubble. He’s probably right, but I suspect it will take a while longer yet for that particular thesis to be proven correct!
He is also an accomplished investor with decades of experience in most markets and a pretty good track record with, importantly, much less volatility than your average fund manager. Every quarter, GMO put out a market commentary piece by Jeremy, and it’s usually compulsory reading for me. But this quarter, it was another article that caught my eye – a piece by Ben Inker from GMO on the rise of the “price insensitive investor”. And if you’re interested, you can subscribe to receive future quarterly updates.
The article explained just how many of the world’s largest investors no longer care what they pay for assets, or what their returns might be. This is an extraordinary turn of events, but goes some way to explaining why most mainstream markets continue to be overvalued. Investors such as central banks, large defined benefit pension plans and financial institutions must, through complicated regulatory requirements, hold certain types of assets (for example high grade credit-rated bonds) in certain proportions. They must, therefore, buy these assets almost regardless of the price they pay.
If we assume a continuing rational market, and that the marginal buyer will continue to be there, it will lead to returns that are, based on historical averages, well below normal. That cuts down options for investors such as us, who seek returns more in line with historical averages.
The real risk in all this, poses Ben Inker, is that these marginal buyers may one day become price insensitive sellers. Each group of investors has circumstances which might cause them to no longer be able to hold those assets. And in that case, poses Inker, “if circumstances cause these price-insensitive buyers to turn around and become price-insensitive sellers, there are not a lot of candidates to take the other side.”
Traditional providers of liquidity in these circumstances, brokers and major investment banks, have had these activities curtailed in recent years due to more stringent rules implemented since 2009. This, quite naturally, could exacerbate the problem and lead to circumstances where we see severe corrections in some markets, or submarkets. That’s not our expectation, but who knows what could transpire in a financial world in which regulators, politicians and central banks are constantly doing things never before attempted in the hope of engineering economic recovery.
Regardless of whether we see violent market corrections or not, price insensitive behaviour makes it much harder to make an acceptable return from the largest and most active asset classes, such as sovereign bonds and shares in large listed companies.
Our method of avoiding this problem is to maintain flexibility through three key principles:
- Stay small enough to essentially invest in whatever we like;
- Prefer strategies which can outperform either because they are operating in a niche market, or where the manager has a competitive advantage, or both; and finally
- Pursue true diversification – preferring a combination of assets which we believe are both uncorrelated with each other and can deliver the required returns.