The second part of Grantham’s latest quarterly letter has some interesting insight into the source of his diverging views with Fama-French on risk and reward - and it deserves some attention from investors IMO.
On what they agree on: P/B and size are risk factors
Grantham wrote:I think P/B and yield and price-to-earnings (P/E) are risk factors. They have less fundamental quality and are therefore more prone to failure in rare crashes. I think this is the one thing Fama and French got right – for the wrong reasons.
Exhibit 3 in Grantham’s letter shows both low p/b and small caps to be ‘lower quality’ companies (lower levels and stability of profits and higher levels of debt).
On what they disagree on: The reliability of the relationship between risk and reward
As Grantham doesn’t seem to believe risk and reward are reliably related he seems to think it was sheer luck that Fama-French came to the conclusion that P/B and size were risk factors based solely on analysis explaining the past variability of returns. As Grantham says:
Grantham wrote:“The real behavioral market is perfectly happy not rewarding “risk” when it feels like it, as is shown by the 70-year underperformance of high beta stocks. But this time it worked.”
This is where Grantham looses me. Data shows a long-term premium for low p/b and small cap stock portfolios for US and international markets as far back as data is available. This suggests to me risk and reward are related. And the Fama-French research show this to be the case by the fact that the variability in past returns can be explained by P/B (HmL) and size (SmB), which Grantham shows in his quarterly letter to be risk factors (?).
To supplement Grantham's arguments he points to the ‘alpha’ on GMOs intrinsic value series (returns not due to exposure to p/B and size risk).
Gantham wrote:“What this means is that any outperformance on our intrinsic value is pure alpha, where for P/B, etc., and for small cap it is a risk premium, and a risk that definitely comes to bite you every so often.”
But if we look at the FF3F regression on the GMO Intrinsic Value, alpha disappears after accounting for exposure to the risk factors.
- Code: Select all
August 1999 - March 2010
Alpha (t-stat) Beta Size Value R^2
GMO Intrinsic value -0.06 (-0.47) 0.86 -0.17 0.37 0.91
Finally, and more specifically on quality. Grantham says:
Grantham wrote:But what about “Quality?” This factor has outperformed forever. (The S&P had a High Grade Index that started in 1925 and handsomely outperformed the S&P 500 to the end of 1965 when our data starts.) Since the market is efficient, to Fama and French quality must be a risk factor!
On ‘quality outperforming forever”:
- - From 1966 to 1993 (from Exhibit 6 in the article) – that’s 27 years – its cumulative performance was slightly below the S&P500.
- From 2004 to date, since inception of the GMO Quality fund, it has underperformed the S&P 500 by about 0.5% per year.
So as investors what should we focus on?
The reasonably strong relationship between risk and reward (as reflected in the historical data across countries, for which there are reasonable explanations), or the ‘small set’ of apparently anomalous relationships for which there is little explanation? Personally, I go with the former over the long-term.