3Q 2020 GMO Quarterly Letter

Theme and Background

This chapter focuses on investment opportunities in value stocks following their worst relative performance in over a decade. In 2020, value stocks experienced the worst 12-month relative returns on record, driving their relative market valuations to historically extreme lows. The author argues that the current environment resembles the tech bubble period of 2000, with value stocks having entered an extreme undervaluation zone.

Core Thesis

The author makes a clear judgment: value stocks currently trade at the 4th percentile of historical valuations (i.e., cheaper than 96% of historical periods), and this conclusion holds regardless of the definition or screening method used. Counterintuitively, despite value stocks’ prolonged underperformance, analysis shows that over 100% of their underperformance since 2007 is attributable to relative valuation compression rather than fundamental deterioration—meaning the value premium actually still exists. The author believes that if value stocks maintain their current valuation spread and continue their relative fundamental performance of the past 14 years, they are likely to outperform the market.

Key Arguments and Data

1. Multi-Dimensional Valuation Verification: Using 11 different valuation metrics (including GMO’s proprietary "P/Scale") to screen the cheapest half of stocks, the results show:

• Under 10 definitions, value stocks’ relative valuations are at their lowest levels in at least 90% of months since 1971
• The sole exception is the "price/sales" metric, which stands at the 13th percentile, but the author notes that a similar extreme was observed in February 2000 (the cheapest month for value stocks in history)

2. Sector and Size Neutrality Tests:

• After excluding industry, sector, and group effects, value stocks remain exceptionally cheap
• Screening within large-cap and small-cap stocks separately, value stocks are equally cheap
• After excluding FAANGM stocks, value stocks still appear undervalued relative to the ex-FAANGM market

3. Historical Comparison Data (Table format):

Metric	Current Percentile	Most Extreme Historical Month
10 valuation metrics	≤10%	Since 1971
Price/sales metric	13%	February 2000 (similar)
GMO composite valuation metric	4%	Since records began

Companies/Assets Involved

• FAANGM (Facebook, Apple, Amazon, Netflix, Google, Microsoft): Identified as typical representatives of current market overvaluation, whose high valuations may distort overall market valuation judgments. The author re-tests after excluding these stocks and confirms that value stocks remain cheap.
• Energy companies and banks: As typical representatives of current value stocks, they stand in stark contrast to tech giants, but the author argues that such industry differences alone cannot explain the overall undervaluation of value stocks.

Investment Implications

• Clear Long Direction: The author believes the outlook for value stocks over the next 12–18 months is extremely bright, especially against the backdrop of global economic recovery as the pandemic recedes. Investors are advised to position within a long/short framework, enabling profits in both rising and falling markets.
• Strategy Recommendation: GMO’s Equity Dislocation strategy (long undervalued global stocks, short overvalued stocks) is recommended as a complementary tool for value investing, targeting cumulative net returns of over 80%. For investors who still believe in the value factor, this strategy can supplement pure long-only value allocations; for those who no longer believe in the value factor, it can also serve as a hedge against cyclical risks in growth portfolios.

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Theme and Background

This chapter further verifies whether value stocks are historically undervalued across multiple dimensions and explores their future return prospects. The author also points out that growth stock valuations have entered extreme territory similar to the 2000 internet bubble.

Core Thesis

The author's core judgment is that the undervaluation of value stocks is comprehensive and robust, not driven by specific sectors or accounting distortions. Even if the valuation spread no longer narrows, the structural outlook for value stocks—based solely on fundamental growth, dividend yield, and rebalancing effects—is sufficient to outperform the market. Meanwhile, the valuation bubble in growth stocks has become highly pronounced.

Key Arguments and Data

1. Robustness Test of Value Undervaluation: The author verifies the cheapness of value stocks through multiple methods, all of which show them at historically extreme lows.

• Excluding the most expensive IT sector, or excluding the cheapest energy and financial sectors.
• Changing the security weighting method to avoid dominance by large-cap stocks.
• Selecting value stocks only within high-quality or low-quality stocks.
• Conclusion: Without exception, value stocks remain extraordinarily cheap from a historical perspective.

2. Excluding Accounting Distortions and Monopoly Interference:

• Intangible Asset Issue: If traditional accounting significantly distorts valuations for asset-light, R&D-heavy companies, then value stocks should appear particularly cheap in intangible-asset-intensive industries but not in low-intangible-asset industries. Data shows this is not the case; value stocks are equally cheap in low-intangible-asset industries (see Exhibit 5).
• "Superstar Company" Issue: If industry monopolies legitimately depress valuations of smaller companies, then the cheapness of value stocks should be positively correlated with "profit concentration" within the industry. Data shows no relationship, and value stocks are actually cheaper in more competitive industries (see Exhibit 6).

3. Structural Return Prospects for Value Stocks: The author decomposes the relative return of value stocks versus the market into four components:

• Fundamental undergrowth
• Yield advantage
• Rebalancing
• Valuation changes
• Analysis shows that before and after 2006, the first three factors (growth, yield, rebalancing) collectively allowed value stocks to outperform the market. This implies that even if the valuation spread remains unchanged, the structural outlook for value stocks is positive.

4. Global Value Stocks Are Also Cheap: Not only in the U.S., but value stocks in international developed markets and emerging markets are also at historically undervalued levels. In many cases, the valuation spread for cheap stocks is at all-time lows (see Exhibit 8).

5. Growth Stock Valuation Bubble:

• Price-to-Sales (P/S) Ratio: The median P/S ratio for growth stocks has already surpassed that of the 2000 internet bubble period (see Exhibit 9).
• Price-to-Earnings (P/E) Ratio: While the median P/E ratio for growth stocks has not reached the extreme levels of 2000, it is far higher than any period before or after (see Exhibit 10).

Companies/Assets Involved

• Value Stocks: The author is bullish. They are considered historically undervalued in the U.S., international developed markets, and emerging markets, with a favorable structural outlook.
• Growth Stocks: The author is bearish. Their valuations are seen as entering a bubble zone similar to 2000, with P/S ratios even higher.
• Specific Sectors: The analysis excludes mega-cap growth stocks such as Facebook, Apple, Alphabet, Amazon, Netflix, and Microsoft (FAANMG) to prevent them from distorting the overall data.

Investment Implications

• Long Value Stocks, Short Growth Stocks: The author believes the current valuation spread between value and growth stocks has become extreme. The structural return prospects for value stocks are positive, while growth stock valuations have entered bubble territory. This presents an excellent opportunity window for long-short strategies.
• Global Allocation to Value Stocks: Investors should not limit themselves to U.S. value stocks. Value stocks in regions such as Europe, Japan, and emerging markets also offer high appeal and can serve as diversification options.
• Beware of Growth Stock Bubble Risk: The current high valuations of growth stocks (especially P/S ratios) have surpassed historical extreme levels, posing a significant risk of mean reversion in the future.

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Theme and Background

This chapter focuses on whether growth stocks have entered a bubble and the catalysts for mean reversion in value stocks. The author uses extreme speculative behavior in the 2020 market to argue that growth stocks already exhibit bubble characteristics, while also exploring potential triggers for a value stock reversal, but emphasizes that catalysts themselves are not the core of investment decisions.

Core Viewpoint

The author clearly judges that growth stocks are already in a bubble, based not only on high valuations but also on the obvious speculative frenzy seen in 2020. For value stocks, the author believes that while catalysts (such as economic normalization and rising interest rates) exist, they cannot be accurately predicted. The key point is that the current extreme valuation spread has made the risk of "waiting for a clear signal" greater than the risk of "entering early."

Key Arguments and Data

1. Evidence of the Growth Stock Bubble:

• Tesla: Since the fall of 2019, its stock price has risen approximately 800%, while car sales have only increased by 17%. Its market capitalization has surpassed the combined total of all automakers in the United States, Europe, and South Korea (plus Honda, Mazda, and Nissan), yet these companies' 2019 sales were roughly 100 times that of Tesla.
• Nikola: Valued at $3 billion when it went public via a SPAC reverse merger, its market capitalization surged to approximately $30 billion (10x) during the 2020 electric vehicle frenzy. The company is a "pre-revenue" manufacturer—it has never sold or produced any vehicles, nor even built a factory. After the founder was accused of fraud and resigned, its market cap was still more than 3 times its IPO value.
• Other Speculative Cases: Hertz stock rose 10x during bankruptcy as a "high-beta recovery play"; Kodak's stock surged 30x after announcing it would produce chemicals for COVID-19 treatment.

2. Analysis of Value Stock Catalysts:

• Economic Normalization: Vaccine news has already led to a strong short-term rebound in value stocks, as they are more dependent on face-to-face economic activity.
• Rising Interest Rates: Even a modest increase benefits value-stock-heavy sectors like financials; if inflation triggers a significant rise, value stocks could significantly outperform.
• Historical Uncertainty: The triggers for the 1929 crash, 1987 crash, 1989 Japanese market peak, and the 2000 tech bubble remain unclear decades later.

Companies/Assets Involved

Company/Asset	Role	Key Data	Bullish/Bearish
Tesla	Typical representative of growth stock bubble	Stock up 800% vs. sales up 17%; market cap exceeds sum of major global automakers	Bearish (bubble)
Nikola	Extreme speculative case	IPO valuation $3B → peak $30B → still 3x IPO after fraud exposure	Bearish (bubble)
Hertz	Example of speculative behavior	Stock rose 10x during bankruptcy	Bearish (irrational)
Kodak	Example of speculative behavior	Stock surged 30x after announcing COVID-related business	Bearish (irrational)
Financials	Representative of value stocks	Rising interest rates are beneficial	Bullish (potential catalyst)

Investment Implications

1. Growth Stock Bubble Confirmed: The speculative frenzy of 2020 (bankrupt companies surging, zero-revenue companies with tens of billions in market cap), combined with extreme valuations, places growth stocks in a danger zone similar to 2000. Investors should be wary of correction risks.

2. Value Stocks Should Be Positioned Early: Do not wait for clear catalysts (such as full economic normalization or a significant rise in interest rates), as history shows that the triggers for market turning points are often difficult to identify even in hindsight. With current value stock relative valuations at historical extremes, the cost of waiting for a signal (missing early gains) may far outweigh the uncertainty of entering early.

3. Long/Short Framework is Superior: Combined with GMO's Equity Dislocation strategy discussed earlier, going long undervalued value stocks and short overvalued growth stocks can generate profits in both rising and falling markets, making it particularly suitable for the current extreme divergence environment.

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Theme and Background

This chapter, as the report's conclusion, focuses on the investment prospects for value stocks after experiencing their worst 12-month performance in history. The author argues that the current relative valuation of global value stocks is at an extreme historical low, while growth stocks have formed a valuation bubble similar to the 2000 TMT bubble. GMO launched a new long/short strategy in the fall of 2020—the GMO Equity Dislocation Strategy—designed to profit from the bursting of the growth stock bubble.

Core Views

• Value stocks have extremely strong relative return potential: Even if the valuation spread merely holds at current levels and the fundamental performance of value versus growth continues the trend of the past 14 years, value stocks can still outperform the market by a significant margin.
• A growth stock bubble has formed: The current degree of valuation distortion in global growth stocks is comparable to that of the 2000 TMT bubble, creating a historic opportunity for long/short strategies.
• The long/short framework is the optimal execution method: Given the elevated absolute valuation of the overall stock market, a pure long position in value stocks carries significant risk. In contrast, a long/short strategy that buys undervalued value stocks and shorts overvalued growth stocks can generate profits in both rising and falling markets.

Key Arguments and Data

• Relative valuation of value stocks is at an all-time low: Since 2007, more than 100% of value stocks' underperformance relative to the market is attributable to declining relative valuations, not deteriorating fundamentals. If valuations had remained stable, the value effect would have been positive over the past 14 years.
• Historical patterns: The strongest historical performance of value stocks has almost always followed the most painful periods.
• Bubble comparison: The current degree of valuation distortion in growth stocks is similar to that of the 2000 TMT bubble. GMO successfully profited for clients through long/short strategies during the 1992 bubble, the 2000 TMT bubble, and the low-quality stock bubble before the 2008 GFC.
• Potential returns: GMO believes the potential cumulative net return of the GMO Equity Dislocation Strategy could approach 80%+, comparable to the returns of the GMO U.S. Aggressive Long/Short Strategy during the 2000 TMT bubble.

Historical Event	GMO Long/Short Strategy	Cumulative Net Return
2000 TMT Bubble	GMO U.S. Aggressive Long/Short Strategy	80%+
2020 Growth Stock Bubble	GMO Equity Dislocation Strategy	Expected to approach 80%+

• Asymmetric risk-return: If the market is pricing correctly (i.e., growth stock valuations are reasonable), the potential loss of this strategy is far smaller than the potential gain if the market is wrong.

Companies/Assets Involved

• GMO Equity Dislocation Strategy: A new long/short strategy launched by GMO in the fall of 2020, which buys undervalued global stocks and shorts overvalued stocks, targeting a cumulative net return of over 80%. This strategy has been incorporated into the multi-asset and liquid alternative strategies managed by GMO's asset allocation team.
• U.S. Large-Cap Value Stocks: The author notes that the absolute valuation of U.S. large-cap value stocks remains elevated, and their real return prospects are less clear than those of value stocks in other markets.

Investment Implications

• Strongly recommend allocating to long/short value strategies: Against the backdrop of an inflating growth stock bubble and extremely cheap value stock valuations, a pure long position in value stocks faces the systemic risk of an overvalued overall market. In contrast, a long/short framework (long value, short growth) can effectively hedge market volatility and achieve asymmetric risk-return.
• Focus on global value stocks, not just U.S. ones: The absolute valuation of U.S. large-cap value stocks remains high, while value stocks in other global markets are more reasonably priced, offering better real return prospects.
• Bubble identification is key: GMO believes that investment bubbles can be identified before they burst, and the current degree of valuation distortion in growth stocks is comparable to the 2000 TMT bubble. Historical experience shows that such strategies can yield substantial returns when bubbles burst.

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Theme and Background

This chapter discusses how to specifically execute a long-value/short-growth trading strategy. The author points out that simply shorting bubble assets (growth stocks) carries extremely high risk, while a long-short portfolio can not only reduce volatility but also profit when value stocks are undervalued. The current market offers a wide range of ETF tools, but the author believes that directly using style index ETFs is not the optimal choice.

Core Views

• Opposition to pure shorting: Bubble assets are highly volatile, and shorting may lead to losses due to volatility drag. For example, if an asset first rises 50% and then falls 40%, a long position loses 10%, and a short position also loses 10%.
• Opposition to direct use of style ETFs: In growth indices (e.g., Russell 1000 Growth), FAANGM accounts for approximately 40%, while value indices are concentrated in financial stocks, resulting in excessive sector bias (technology stocks account for 40% in growth indices and less than 10% in value indices), leading to concentrated risk.
• Advocacy for refined long-short portfolios: Individual stock weights and net sector/factor exposures should be limited to ensure diversified exposure to the mispricing of growth versus value.

Key Arguments and Data

1. Volatility trap of pure shorting:

• If an asset first rises 50% and then falls 40%, the total return for a long position is -10%, and for a short position, it is also -10%.
• High volatility makes shorting equally difficult to profit from, unless precise timing is achieved.

2. Concentration issues in style ETFs:

• As of September 30, 2020, Apple accounted for approximately 11% of the Russell 1000 Growth Index, with FAANGM collectively accounting for about 40%.
• Technology stocks represent 40% of the growth index and less than 10% of the value index, resulting in a net short sector exposure of 30% dominating risk.
• Value indices are concentrated in financial stocks, but the low-interest-rate environment poses challenges for financials.

3. Historical success cases:

• During the TMT bubble in 2000, GMO used a dividend discount model to construct a long-short strategy, achieving a net return of 80.3% from October 1, 2000, to the end of 2002.

4. Reasons for the failure of traditional valuation metrics:

• The issue with the price-to-book (P/B) ratio primarily stems from companies repurchasing large amounts of stock at prices above book value over the past 25 years, rather than changes in accounting treatment.
• From 1950 to 2000, the S&P 500 had an average ROE of 12.5% and a dividend payout ratio of approximately 50%, but actual EPS growth was only 2.2%, indicating that book value systematically underestimates real assets.

Companies/Assets Involved

Company/Asset	Role	Key Data	View
Apple	Representative growth stock	Accounts for approximately 11% of the Russell 1000 Growth Index	Even if overvalued, it may continue to outperform, making shorting risky
FAANGM	Core growth stocks	Collectively account for about 40% of the growth index	Excessive concentration makes them unsuitable for direct shorting
Financial stocks	Major component of value indices	Concentrated in value indices	Low-interest-rate environment poses challenges, making over-concentration undesirable
GMO U.S. Aggressive Long/Short Strategy	Historically successful strategy	Net return of 80.3% from 2000 to 2002	Demonstrates the effectiveness of long-short strategies during bubble bursts

Investment Implications

• Do not purely short growth stocks: High volatility makes shorting difficult to profit from; instead, construct a long-short portfolio to reduce volatility drag.
• Avoid using style ETFs: Growth/value indices suffer from severe sector and individual stock concentration risks; achieve more diversified exposure through individual stock selection.
• Build refined long-short strategies: Limit individual stock weights and net sector exposures to ensure diversified exposure to value-versus-growth mispricing.
• Redefine value: Traditional P/B metrics are distorted by buybacks and debt financing; adopt more comprehensive valuation models (e.g., dividend discount models) and consider capitalizing R&D, advertising, and other expenditures.

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Theme and Background

This chapter delves into how GMO addresses the fundamental flaws of traditional valuation models—particularly those based on book value—in today’s market. The report argues that due to changes in business models and the rise of share buybacks (especially debt-financed buybacks), book value has become severely distorted as a measure of a company’s true value over the past 25 years. Consequently, GMO’s team has developed a completely new, company-by-company adjusted dividend discount model (DDM), designed to prepare for the impending reversal of value stocks and the bursting of the growth stock bubble.

Core Thesis

The author (Ben Inker) argues that traditional value and momentum models are ineffective at capturing investment opportunities arising from shifts in market leadership. Therefore, GMO has abandoned methods reliant on momentum factors and instead invested significant effort in rebuilding a dividend discount model based on “economically sound” balance sheets and income statements. This model is the key to the success of the “Equity Dislocation Strategy,” with the goal of precisely distinguishing which expensive growth stocks are “worth the price” and which are merely “overpriced.”

Key Arguments and Data

1. Fundamental Flaw of Book Value:

• Over the past 25 years, book value as a measure of a company’s true value has become “far more flawed.”
• Reasons: Changes in business models, but primarily the rise of share buybacks, especially debt-financed buybacks.
• Consequence: Traditional blanket adjustment methods are no longer viable, requiring ongoing, company-by-company adjustments for thousands of firms.

2. Fatal Weakness of Momentum Models in Reversal Strategies:

• The author believes the premise of the Equity Dislocation Strategy is that the growth stock bubble will burst, inevitably leading to a reversal in market leadership.
• Most growth-forecasting models have a “momentum” bias. However, value investing typically has a strong “anti-momentum” tendency, which becomes an obstacle in reversal strategies.
• Key Event Data: On November 9, 2020, value indices experienced one of their best relative performance days in history, while momentum factors suffered one of their worst.
• Russell 1000 Value outperformed Russell 1000 by 3%.
• EAFE Value outperformed EAFE by 1.5%.
• iShares MSCI USA Momentum Factor ETF underperformed the S&P 500 by 4%.
• The author notes that if a strategy favored long positions in high-momentum value stocks and short positions in low-momentum growth stocks, what should have been an excellent day could have been offset or even turned into a loss.

3. Urgency and Workload of Model Reconstruction:

• Simon Harris and his team have spent the past four years correcting all discoverable distortions on a company-by-company basis, rebuilding balance sheets and income statements.
• This work not only corrected input data but also re-examined assumptions about the reversion rate of ROE from 20 years ago, as company-by-company corrections lead to a “completely different” rate of profitability reversion.
• The entire reconstruction effort became a “race” against the bursting of the growth stock bubble this year (2020). The model was ultimately completed early this fall.

Companies/Assets Involved

• Russell 1000 Value / Russell 1000: Used as a benchmark comparing U.S. value stocks to the overall market.
• EAFE Value / EAFE: Used as a benchmark comparing international developed market value stocks to the overall market.
• iShares MSCI USA Momentum Factor ETF: Represents the momentum factor, illustrating its poor performance on a value reversal day.
• Simon Harris: Head of GMO’s global equity team, the central figure in rebuilding the model.
• Carl O’Rourke: A core member involved in the model reconstruction.
• Jeremy Grantham: Has been pushing for the reconstruction of the dividend discount model for years.

Investment Implications

1. Beware of Traditional Value Models: Valuation models relying on book value or simple adjustments may be severely distorted in the current market environment, especially when evaluating growth stocks. Investors need to seek models that can correct accounting data distortions.

2. Momentum Strategies Carry High Risk in Reversal Markets: In the context of an impending shift in market leadership, using momentum models may cause investors to miss the largest gains from a value stock breakout, or even incur losses. For strategies betting on style rotation, momentum factors should be avoided.

3. Focus on GMO’s “Equity Dislocation Strategy”: The core tool of this strategy—the company-by-company adjusted dividend discount model—is now complete. This suggests GMO believes the technical conditions for identifying and shorting overvalued growth stocks while going long on undervalued value stocks are mature, and the execution window for the strategy has opened.

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Theme and Background

This chapter discusses the portfolio construction logic and current holdings characteristics of the GMO Equity Dislocation strategy. The author points out that this strategy does not pursue "all-weather" low volatility, but rather actively takes on controllable risk exposure to capture the most extreme value/growth dislocations in the current market. As of October 31, 2020, the portfolio exhibited extreme valuation divergence, similar to the peak of the TMT bubble in 2000.

Core Views

• Not suppressing all known risks: The author argues that forcibly eliminating all sector and factor risks only exposes the portfolio to unknown risks, and often leads to forced leverage after low volatility, thereby amplifying new risks.
• Diversifying exposure, not eliminating it: The strategy allows moderate sector/factor deviations but limits extreme concentration through penalty mechanisms. For example, shorting the software sector is permitted, but short positions will not dominate portfolio risk.
• Current portfolio valuation divergence has reached historical extremes: The median valuation ratios (e.g., P/E, P/B, P/S) between long and short positions are approximately 1:10, and the dividend discount model (DDM) valuation ratio is approximately 12:1, highly similar to the TMT bubble period.

Key Arguments and Data

• Portfolio construction principles: Through an optimization model, the strategy maximizes value mispricing while controlling exposures to factors such as sector, beta, and size. The author emphasizes that after all model controls are applied, manual review of candidate portfolios is still required to ensure alignment with investment intent.
• Current holdings characteristics (as of October 31, 2020) :

Metric	Long Median	Short Median	Ratio
P/E Ratio	1/10 × Short	—	Approx. 1:10
P/B Ratio	1/10 × Short	—	Approx. 1:10
P/S Ratio	1/10 × Short	—	Approx. 1:10
Cash Flow Yield	Approx. 6× Short	—	Approx. 6:1
Forward Earnings Yield	Approx. 5× Short	—	Approx. 5:1
Dividend Yield	Approx. 3× Short	—	Approx. 3:1
DDM Valuation Discount/Premium	58% Discount	380% Premium	Approx. 12:1

• Historical comparison: The 12:1 DDM valuation ratio is "very similar" to the peak of the TMT bubble.

Companies/Assets Involved

• GMO Equity Dislocation Strategy: The core strategy, going long undervalued global stocks and shorting overvalued stocks, aims to profit from value reversion (whether absolute or relative).
• Multi-asset and liquid alternative strategies: This strategy has been embedded in all GMO asset allocation portfolios that allow low-beta, high-volatility strategies.
• Long-only value stock portfolios: The author suggests combining a pure long value strategy with Equity Dislocation to improve risk/return.

Investment Implications

• For investors who still believe in mean reversion: This strategy can serve as a "turbocharger," enhancing existing value-biased portfolios. GMO predicts that value stock portfolios will deliver solid returns over the next seven years, but absolute returns over the next two to four years depend on whether global high valuations can persist—the author is uncertain about this.
• For investors who do not believe in mean reversion: Even if the value/growth spread does not widen further, the long-short portfolio has a slightly positive expected return; if the spread narrows, it can generate excess returns. It is recommended to allocate a small amount of capital to such strategies to hedge the vulnerability of growth stock/private equity portfolios in an environment where the value spread narrows, without needing to withdraw from excellent growth or venture capital managers.
• Core conclusion: This is the moment when value investment opportunities are best but credibility is lowest. The author believes that through its long-short structure, the strategy can profit in rising, stable, or falling markets, making it a highly attractive asymmetric bet in the current market environment.