Case GMO

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Case Analysis
Title of Case: GMO- The Value versus Growth Dilemma
Submission date: 04/24/2018
CERTIFICATION OF AUTHORSHIP: I certify that I am the author of this report and that any
assistance I received in its preparation is fully acknowledged and disclosed in the paper. I have
also cited any sources from which I used data, ideas or words; either quoted directly or
paraphrased I also certify that this paper was prepared by me (my team) specifically for this
course.
Team member
Team member 1
Team member 2
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Last name, First name/ ID/ Sign
2
Table of Contents
Question
#
Title
Page
1
What is value investing and growth investing? What are the
differences and relative merits?
3-4
2
What are GMO’s main arguments in favor of value investing?
3
Estimate the Real risk-adjusted long-term expected return for
CVS, RR Donnelley, and Manor Care
4-7
4
Why wouldn’t GMO include Cisco Systems, an otherwise
excellent company, in its portfolio at this time?
7-8
5
In 1999, the P/E ratio of Cisco was 171.47……Assume that the
GMO makes decision based on the expected return
8-9
6
Now assume that the P/E ratio of Cisco Systems…… Assume that
the GMO makes decision based on the expected returns
9-10
4
3
1. What is value investing and growth investing? What are the differences and relative
merits?
Value investing and growth investing are various trend of investment that stakeholders
have been applying over the years. Value investment is an investment style employed by
investors through buying undervalued stocks in the market. In this case, the investor is certain
about the company’s supposed stock value. The purchase of the stock is considered positive in
the event that the stocks undervalue is due to temporary market reasons and the company in
question is financially sound. On the other hand, growth investment is the investment style based
on the appreciation of capital. The companies that growth investors invest in are those that show
signs growth that is above average. In this case, the investor analyzes the market trends of the
stock and predicts that the stock will appreciate.
The two investment styles however have several differences in their operation which
include the objectives of the investors, nature of stock, investment philosophy, strategy as well as
risk. In the case of value investment, the investors’ objective is to find a financially sound
company, with undervalued stock great potential. The growth investors on the other hand focus
on finding stock that has been showing considerable appreciation above the normal market rates.
Through this, the two investment styles differ in investment philosophy.
Considering the amount of risk involved, the risk in value investment is less compared to
that in growth investment. This is because, the market conditions causing the falling stocks can
be determined and a prediction made on whether they will improve or not. On the other hand,
this is not possible in the case of growth investment. There is a relatively higher risk in growth
investment because; the market may tend to stabilize with the stock gaining the normal stock
value. In case this happens, there is a high chance that the investor will incur huge losses.
4
Also, the two styles exhibit differences in their trading features. In case of value
investment, a low price to earnings ratio is used. This is primarily due to the operation below the
standard value of the stock. For that reason, the out of favor industry groups remain the major
focus of this strategy. The growth strategy stocks on the other hand have hand have a high price
to earnings ratio as well as a high price to book ratio. This is due to the operation of the stock
value above the market value.
2. What are GMO’s main arguments in favor of value investing?
The main argument by GMO that favors value investing as opposed to growth investment
is that value investment consistently shows better performance that growth investment in the
long run. Finding companies with undervalued stocks and investing in them is likelier to bring
huge returns compared to the operation based on market averages. The companies featured in
value stocks are those that are stable, and with the highest possibility of remaining in the market
for a long period of time. The stocks in these company portray a lower volatility degree and
outperform market averages in the long term. Therefore, compared to growth investment style,
value investment seems a better way of ensuring investment success.
3. Estimate the Real risk-adjusted long-term expected return for CVS, RR Donnelley, and
Manor Care. (Show the step-by-step calculations for each of them.) And Compare with
that of Cisco.
CVS:
Step 1:
Year 10 earnings = current earnings x (1 + growth rate) ^10
5
Year 10 earnings = 1414 x (1 + 0.17) ^10 = $6,796.85
Step 2:
Year 10 market value equity = (P/E) x year 10 earnings
Year 10 market value equity = 14 x 6796.85 = $95,155.97
Step 3:
10-year holding Annualized CGY = (Year 10 market value equity /current market value equity) ^
(1/10) – 1
10-year holding Annualized CGY = (95155.97/10893) ^ (1/10) -1= 0.2420 = 24.20%
Step 4:
Long-term expected return = 10-year holding Annualized CGY + dividend yield
Long-term expected return = 24.20 + 0.8 = 25%
Step 5:
Real risk-adjusted long term expected return = 25 – 6.1 – 2 = 16.9%
The Real risk-adjusted long term expected return of 16.9% is greater compared to that of Cisco
System which is at 1.1%. This implies that CVS’s profitability potential is higher.
RR Donnelley:
Step 1:
Year 10 earnings = Earning now x (1+growth rate) ^10
Year 10 earnings = 905 x (1+0.12) ^10 = $2810.80
6
Step 2:
Year 10 market value equity = (P/E) x earning in year 10
Year 10 market value equity = 14 x 2810.80 = $39351.10
Step 3:
10-year holding Annualized CGY = (year 10 market value equity/current market value equity)
^1/10 – 1
10-year holding Annualized CGY = (39351.10/2370)^1/10 – 1 = 0.3244 = 32.44%
Step 4:
Long-term expected return = 10-year holding Annualized CGY + dividend yield
Long-term expected return = 32.44 + 4.5 = 36.94%
Step 5: Real risk-adjusted long term expected return = 36.94 – 6.1 – 2 = 28.84%
The Real risk-adjusted long term expected return of 28.84% is greater compared to that of Cisco
System which is at 1.1%. This implies that R.R. Donnelley’s profitability potential is higher.
Manor Care:
Step 1:
Year 10 earnings = Current earnings (1 + growth rate) ^10
Year 10 earnings = 346 x (1+ 0.15) ^10 = $1399.76
Step 2:
Year 10 market value equity = (P/E) x earning in year 10
7
Year 10 market value equity = 14 x 1399.76 = $19596.64
Step 3:
10-year holding Annualized CGY = (year 10 market value equity/current market value equity)
^1/10 – 1
10-year holding Annualized CGY = (19596.64/1285)^1/10 – 1 = .3132 = 31.32%
Step 4:
Long-term expected return = 10-year holding Annualized CGY + dividend yield
Long-term expected return = 31.32 + 0 (no dividends)
Step 5: Real risk-adjusted long term expected return = 31.32 – 6.1 – 2 = 23.22%
The Real risk-adjusted long term expected return of 23.22% is greater compared to that of Cisco
System which is at 1.1%. This implies that Manor Care’s profitability potential is higher.
4. Why wouldn’t GMO include Cisco Systems, an otherwise excellent company, in its
portfolio at this time? Answer this question based on your answer for question (3).
The reason as to why GMO will fail to include Cisco Systems in its portfolio currently is that,
Cisco Systems’ long term expected return is very low at 1.1%. Compared to other companies as
determined in question 3 above, Cisco has the lowest long term return on investment as that of
other companies start at 16.9%. The reason for the low long term return on investment can be
found through conducting an examination of the book value of equity as well as the market
value. The price of book value ratio shows a comparison between the market share value and the
balance sheet share value. In the case in question, Cisco’s price of book value ratio is greater
than that of the other companies. This implies that what the investors were paying was more than
8
the actual value of the company in the market. Thus, in the given market scenario, Cisco is
overvalued, with CVS and RR Donnelley being undervalued. The expectations of the investors is
that in future, the market price will be higher.
Using the P/E ratios to compare the companies, it is evident that Cisco has a greater P/E ratio
compared to the others. Value investors consider the companies with low P/E ratio undervalued,
thus attracting them to invest in the company’s stocks in expectation of a future price increment.
This makes Cisco investment less attractive to the investor as compared to both CVS and RR
Donnelley.
5. In 1999, the P/E ratio of Cisco was 171.47 since the market value equity was $435,542
and the earnings was $2,540. Now assume that the P/E ratio was 50 instead of 171.47. Then,
the market value equity was supposed to be 50*$2,540=$127,000 instead of $435,542. Reestimate the Real risk-adjusted long-term expected return for Cisco with the newly
assumed P/E ratio. (Show the step-by-step calculations for each of them.) Was the GMO
supposed to include Cisco Systems if the P/E had been 50 instead of 171.47? Assume that
the GMO makes decision based on the expected return
Step 1:
Year 10 earnings = Current earnings (1 + growth rate) ^10
Year 10 earnings = 2540 x (1+ 0.3) ^10 = $35016.06
Step 2:
Year 10 market value equity = (P/E) x earning in year 10
Year 10 market value equity = 50 x 35016.06 = $1750803
9
Step 3:
10 year holding annualized CGY= (year 10 market value equity/current market value
equity)^1/10 – 1
10 year holding annualized CGY= (1750803 /127000) ^ (1/10) – 1 = 0.3000000114 = 30.00%
Step 4:
Long-term expected return = 10 year holding annualized CGY+ dividend yield
Long-term expected return = 30.00 + 0 (no dividends)
Step 5: Real risk-adjusted long term expected return = 30.00 – 6.1 – 2 = 21.09%
The P/E ratio of 50 yields a real risk adjusted long term expected return of 21.09% which is
almost a 20% increase from the current 1.1%. Therefore, with this P/E ratio the growth potential
of cisco is higher, and therefore an attractive investment. In this case, GMO is supposed to
include Cisco systems in its portfolio.
6. Now assume that the P/E ratio of Cisco Systems was expected to be 100 instead of 30 for
year 2009. (For this question, the market value equity of Cisco in 1999 remains unchanged
at $435,542.) Re-estimate the Real risk-adjusted long-term expected return for Cisco with
the newly assumed year 2009 P/E ratio of 100. (Show the step-by-step calculations for each
of them.) Was the GMO supposed to include Cisco Systems in this case? The GMO will
have only 10-year holding period. That is, it will sell the Cisco Systems in year 10. Assume
that the GMO makes decision based on the expected returns.
Step 1:
Earning in year 10 = Current earnings (1 + growth rate) ^10
10
Earning in year 10 = 2540 x (1+ 0.3) ^10 = $35016.06
Step 2:
Year 10 market value equity = (P/E) x earning in year 10
Year 10 market value equity = 100 x 35016.06 = $3501606
Step 3:
10 year holding annualized CGY= (year 10 market value equity/current market value equity)
^1/10 – 1
10 year holding annualized CGY= (3501606 /435542) ^ (1/10) – 1 = 0.2318 = 23.18%
Step 4:
Long-term expected return = 10 year holding annualized CGY+ dividend yield
Long-term expected return = 23.18 + 0 (no dividends)
Step 5: Real risk-adjusted long term expected return = 23.18 – 6.1 – 2 = 15.08%
The P/E ratio of 100 results in a real risk adjusted long term expected return of 15.08% which is
almost a 14% increase from the current 1.1%. Therefore, with this P/E ratio the growth potential
of cisco is higher, and therefore an attractive investment. In this case, GMO is supposed to
include Cisco systems in its portfolio.
UV0090
GMO: THE VALUE VERSUS GROWTH DILEMMA
As his computer screen displayed the reflection of nearby yachts moored in scenic
Boston Harbor, Dick Mayo could not help but recall the image of ships passing in the night. It
was March 2000, and Mayo had recently witnessed the NASDAQ Composite Index, which had
come to represent the new economy of technology and Internet stocks, shoot past the 5,000 mark
for the first time ever. As one of Grantham, Mayo, Van Otterloo, & Co. LLC’s (GMO) founding
partners, and the portfolio manager of GMO’s U.S. Active institutional equity accounts,
however, Mayo had also watched his investment philosophy (identifying fundamentally sound,
and sometimes unexciting, companies trading below intrinsic value) rejected in favor of the
market’s insatiable appetite for hypergrowth technology stocks. Investment cycles within the
capital markets were common, yet the NASDAQ’s dramatic ascent embodied an unprecedented
divergence between the performance of value and growth investment styles. In the 30 years that
he had been in the investment business, the past two years had been the most frustrating for
Mayo. Although his long-term performance still outpaced the returns of the benchmark S&P 500
Index of large capitalization stocks, the past two years had brought down an otherwise lofty
performance record.1 Exhibits 1 and 2 show graphs of index capital appreciation and relative
total return data.
Turning back to his computer screen cluttered with security quotes, Mayo reflected upon
the current state of the capital markets. The U.S. economy remained strong, undaunted by five
Federal Reserve interest rate hikes in the past year and Chairman Alan Greenspan’s consistent
warnings of potential inflationary impacts of the economy’s 7.3% GDP growth in the fourth
quarter of 1999 (or 4.5% on an annualized basis). Inflation had remained dormant in the past two
years amid historically low unemployment and surging industrial productivity, however, while
the consumer confidence index recently rose to a level not seen since the go-go years of the late
1960s (Exhibit 3 presents relevant economic indicators). While Mayo had a hard time
swallowing the argument of a new investment paradigm heralded by bullish stock market
pundits, he had to concede that emerging technologies were changing the ways companies
conducted business. Was value investing (whereby investors identified misunderstood companies
1
In 1998 and 1999, the total return (net of fees) on the U.S. Active was 11.1% and 3.3% versus 28.8% and
20.9% for the S&P 500, respectively.
This case was prepared by William Barton (Darden ’00) under the supervision of Professor George Allayannis. It
was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an
administrative situation. Copyright © 2001 by the University of Virginia Darden School Foundation, Charlottesville,
VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication
may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any
means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden
School Foundation.
This document is authorized for use only by Hien Dang (hiensidang@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or
800-988-0886 for additional copies.
-2-
UV0090
trading at less than fair market value and waited for the market to acknowledge the inefficiency)
no longer valid in this brave new world of Internet companies with multibillion dollar valuations
and multimillion dollar losses?2 And, on the contrary, if this all turned out to be another instance
in a long history of periodic stock market excesses, how long could Mayo wait for the return to
normalcy before GMO clients lost their patience with subpar returns relative to the market
indices? What were his options as a value investor in this market environment?
The Company
Mayo had founded GMO in 1977 with partners Jeremy Grantham and Kingsley Durant,
with whom Mayo had worked previously at the Boston-based money-management firm
Batterymarch Financial Management, and Eyke Van Otterloo, an equally seasoned investment
professional with international experience. The firm applied a fundamental bottoms-up approach
to institutional investing, focusing on out-of-favor domestic companies or sectors trading at a
perceived discount to intrinsic value, in what became known as U.S. Active. In 1981, GMO
broadened its scope to include international investing (International Active) headed by Van
Otterloo, and shortly thereafter, developed quantitative investment strategies headed by
Grantham. Grantham oversaw the growth of the quantitatively managed division into 20 equity
funds driven by proprietary computer models and algorithmic selection methods. Quantitative
fixed income funds followed in 1993. As of December 31, 1999, the firm managed in excess of
$20 billion for almost 500 institutional clients, including educational endowments, corporate
pension funds, and private foundations, placing it among the top 100 money-management firms
in the United States. Although the firm’s relatively small size (approximately 200 employees)
created a close-knit culture, the inherent differences across GMO’s product families engendered
separate, distinct identities.3
U.S. Active
Since the firm had developed additional products to complement the original domestic
equity product, Mayo had spearheaded the U.S. Active division. From day one, GMO sought to
limit the growth of assets under management to a level “consistent with [its] ability to perform in
a superior way as an investment and professional organization.”4 Thus, the U.S. Active division
controlled its asset growth as early as 1980, when assets reached $250 million. As of the end of
1999, Mayo oversaw approximately $2 billion for representative institutional clients such as
Stanford University, Campbell Soup Company, New York’s Metropolitan Museum of Art, and
2
For example, on March 7, 2000, Amazon.com, a pioneer in the Internet retailing space, enjoyed a market
capitalization (share price × shares outstanding) of greater than $22 billion despite absorbing over $350 million in
operating losses in 1999 and close to $900 million in losses in its five years of existence. Further, Amazon.com
acknowledged in its 1999 Annual Report that it anticipated incurring additional losses “for the foreseeable future” as
it invested heavily in the growth of its business.
3
See HBS case N9-295-023 for more information about GMO’s organizational structure and non-U.S. Active
divisions.
4
GMO’s “Firm Mission Statement.”
This document is authorized for use only by Hien Dang (hiensidang@gmail.com). Copying or posting is an infringement of copyright. Please contact customerservice@harvardbusiness.org or
800-988-0886 for additional copies.
-3-
UV0090
the University of Virginia. A team of in-house analysts assisted Mayo in identifying sectors and
companies whose market values did not reflect intrinsic value. Sector identification might
include looking at sectors or industries that had fallen out of favor,5 examining differences in
liquidity/risks between large and small capitalization stocks, or assessing the current stage of the
economic business cycle and how that related to particular industries. For example, in an
investment world enamored with new economy stocks defined by their affinity to the Internet
and emerging technology, U.S. Active was taking a hard look at the so-called old economy
represented by industries such as chemicals or consumer products that were largely being
ignored by investors in spite of compelling franchises and underlying value. Indeed, it was U.S.
Active’s belief that large, powerful companies such as DuPont or Dow Chemical were not going
to disappear simply because of the emerg …
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