We value investors have bored momentum investors for decades by trotting out the axiom that the four most dangerous words are, “This time is different.” For 2017 I would like, however, to add to this warning: Conversely, it can be very dangerous indeed to assume that things are never different.
The latest GMO quarterly letter is out. Jeremy Grantham has some stuff to say about the most fascinating topic of the day. I touched on it in my Contra Einhorn piece last week. But Jeremy is a lot smarter than I am, so read this:
When I started following the market in 1965 I could look back at what we might call the Ben Graham training period of 1935-1965. He noticed financial relationships and came to the conclusion that for patient investors the important ratios always went back to their old trends. He unsurprisingly preferred larger safety margins to smaller ones and, most importantly, more assets per dollar of stock price to fewer because he believed margins would tend to mean revert and make underperforming assets more valuable.
You do not have to be an especially frugal Yorkshireman to think, “What’s not to like about that?” So in my training period I adopted the same biases. And they worked! For the next 10 years, the out-of-favor cheap dogs beat the market as their low margins recovered. And the next 10 years, and the next! Not exactly shooting fish in a barrel, but close. Similarly, a group of stocks or even the whole market would shoot up from time to time, but eventually – inconveniently, sometimes a couple of painful years longer than expected – they would come down. Crushed margins would in general recover, and for value managers the world was, for the most part, convenient, and even easy for decades. And then it changed.
Continues on page 9 at the link below: