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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.
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800-988-0886 for additional copies.
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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.”
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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 emergence of companies that sold chemicals on-line.
Individual stocks that justified more-detailed fundamental analysis were monitored and
evaluated by focusing on characteristics such as price to book, price to cash flow, price to
earnings, price to sales, and GMO’s proprietary dividend discount model. Discussions with
management teams and industry analysts augmented the group’s combination of fundamental
and quantitative research efforts. Importantly, Mayo and his colleagues in U.S. Active tried to
never lose sight of the fundamental economic value of a company discernible in its earnings,
cash flow, and return on equity. GMO believed that, historically, investors overpaid for comfort
and excitement, under the guise of non-economic criteria such as size, image, favorable
publicity, and familiarity of a company. Recent investor enthusiasm over companies associated
with the nascent Linux operating system as a potential competitor to Microsoft was an example
of investor sentiment swayed by favorable publicity. Despite Linux’s premise of free opensource coding, prepackaged software provider Red Hat Software exceeded $20 billion in equity
value in early 2000, surpassing that of Apple Computer, an established company in the midst of a
renaissance of its own. “It is GMO’s conviction that a portfolio of securities that sells below its
inherent worth or that may be worth more after fundamental changes can consistently provide
above average returns relative to the total market.”6
Performance
Mayo’s strategy of identifying and investing in undervalued companies had paid off
throughout the 1980s and early 1990s. From the firm’s inception through 1993, U.S. Active had
returned an average of 19.1% per year, 4.3% above the S&P 500 Index of large capitalization
stocks, net of management fees.7 The firm’s only retail mutual fund, the Pelican Fund (managed
by Mayo), had achieved similar success since its introduction in 1989. In March 1998, Mayo and
the Pelican Fund were hailed by an influential financial publication as potential successors for
Fidelity’s superstar fund-manager Peter Lynch. The Pelican Fund’s 19.7% five-year return
placed it within the top 5% of all funds.8 Even through 1998, at which time value investing had
5
An example of an out-of-favor industry in March 2000 was real estate investment trusts (REIT).
GMO’s “Firm Overview” (1999): 4.
7
HBS case N9-295-023, 7.
8
Christopher Oster, “In Search of the Next Peter Lynch,” Smart Money (March 1998).
6
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already suffered from the stampede toward growth stocks, GMO’s U.S. Active strategy
outperformed the S&P 500 Index on an annualized basis by almost 2%.
Investment Style
In the asset-management business, an investment manager employed an investment style
that characterized the firm and which, incidentally, provided a degree of transparency to
potential investors and clients. In distinguishing itself by a particular style, a firm generally
framed the scope of its competition by limiting the firms against which it should be judged to
those with similar investment styles. Representative styles included investments based on market
capitalization (large, mid cap, small) or more company-specific measures such as growth or
value orientations. While the stock market had reflected divergent performance between largecap stocks and small-cap stocks during the latter half of the 1990s, perhaps even greater disparity
occurred between growth and value stocks.
The apparent dichotomy between growth and value investment styles could be illustrated
by using a common valuation metric, the price-to-earnings ratio (P/E).9 P/E ratios could prove
useful when comparing companies within an industry that had different operating results, or
against a benchmark representative of a basket of companies with similar characteristics (size
and industry, in particular). However, P/E ratios could not tell the whole story, or else investors
would conceivably only buy companies with low P/Es. To generalize, value investors paid more
attention to absolute measures, such as P/Es, while growth investors tended to accept the
perceived tradeoff of paying “more” to own a stock with a high P/E. Indeed, some might say that
growth investors were more concerned with the prospects for growing a company’s earnings (the
“E” in the P/E equation) than they were about the price, or cost to acquire such a stock (the “P”
in the P/E equation). Conversely, others would argue that value investors focused on the “P” at
the expense of the “E.” Both styles merit further investigation.
9
Other valuation metrics included (but were not limited to) share price to the book value of equity (price to
book), P/E to earnings growth (PEG ratio), equity value to revenue (market capitalization divided by a firm’s
estimated revenue), equity value to EBITDA, and equity value to free cash flow. A stock’s P/E, which represented
the share price divided by the company’s net earnings per share, was a proxy for its relative expensiveness. Thus, a
company trading at a large multiple of earnings (reflected in a higher P/E ratio of the stock) could be seen as more
expensive than alternatives trading at smaller multiples.
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Growth investing
Growth investors were typified by
Business Lifecycle
Growth
their pursuit of companies with aboveaverage growth characteristics. They were
willing to pay a premium for companies
whose future prospects were perceived to be
“Value” Company
extraordinary, or at least above average.
Hence, most growth stocks garnered P/E
“Growth”
Company
multiples or other valuation measures that
exceeded that of the overall market. The
inherent rationale was that it was close to
Time
impossible to affix a traditional “value” (in
terms of multiples of book value, earnings,
etc.) to a company that was
experiencing exceptional growth because of the early stage of the company’s business cycle or
because the company’s market opportunity was only beginning to emerge (see the Business
Lifecycle chart above).
Such an investment style placed greater emphasis on identifying less-tangible
characteristics, which might help predict future success. Identifying sustainable competitive
advantages such as superior technology in an emerging market was an important criterion, as in
the case of Intel Corporation, which currently enjoyed a dominant position in the microprocessor
market that appeared unlikely to be challenged in the near future. Another benchmark might be
capital investment earmarked toward growing the business, represented by next-generation
telecommunication infrastructure companies rapidly trying to enlarge their “footprint” of
services at the expense of near-term profits. Moreover, there were growth investors that focused
on the size and scope of the potential market opportunity itself, which made a strong argument
for investing in even the most nascent of Internet companies. Generally, technology companies
were the standard bearers of growth investing.
For example, Millennium Pharmaceuticals, a biotechnology company that expected to
use the information that it had gathered about the human genome to develop novel drugs,
eclipsed $14 billion in market capitalization in early March 2000 despite earning no tangible
revenues from products. To its credit, the company had partnered with many of the
pharmaceutical industry’s biggest players and had amassed over $1 billion in funded research
and development. As it delivered on promised research milestones to existing corporate partners,
the company recognized “revenue” in the form of R&D funding associated with the particular
partner or project. Millennium also happened to be one of the pioneers in the genomics
movement, which many industry analysts hailed as the road map to future drug discovery.
Growth investing required a degree of faith that a company would eventually deliver on
the implicit promise of additional economic value through above-average growth, but this was
not to imply that growth investors were necessarily overoptimistic. Consider the example of
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Qualcomm, a leader in wireless-communication technology, whose stock appreciated an
astounding 2,600% in 1999 alone! While Qualcomm had come to symbolize the euphoric
conditions of the new economy stocks, looking back at the beginning of 1999 would prove
instructive. A January 1999 research report from the Wall Street firm CIBC Oppenheimer rated
Qualcomm’s shares a buy at a price (adjusted for stock splits) of $8.25. Indeed, the shares were
only trading at 24 times their expected earnings for 1999, a low multiple for a stock with
expected earnings growth (forecast by CIBC Oppenheimer) of greater than 60% in 1999 and
almost 30% for 2000. As it turned out, Qualcomm exceeded even the most optimistic estimates
by recording earnings growth of over 150% in 1999, and currently projected 75% earnings
growth for 2000. With such impressive operating results, it was perhaps less difficult to
understand why the company’s shares were trading at 120 times its expected 2000 earnings in
March 2000.
Value investing
Most people associated value investing with one word: cheap. However, this did not
accurately reflect the mindset of the value manager. For instance, just because a stock had an
attractive valuation in terms of absolute measures such as P/E or price to book did not
automatically make it a value investment. Rather, a value investment was one where the intrinsic
value of the stock was not accurately reflected in the current market valuation. Value investors
seized on the opportunity to purchase shares of “undervalued” companies with the understanding
that, at some point in the future, there would be cause for the market to correct the perceived
inefficiency. The following quote from perhaps the most famous value investor, Warren Buffett,
sheds some light on the value mindset: “If the choice is between a questionable business at a
comfortable price or a comfortable business at a questionable price, we much prefer the latter.
What really gets our attention, however, is a comfortable business at a comfortable price.”10
Typical characteristics of value stocks included mature companies (see the Business Lifecycle
chart) or companies in slow-growth industries, and companies that paid dividends to
shareholders (rather than reinvest in the business). An important determinant in finding an
attractive value company was a management team committed to taking steps to boost the
company’s shareholder value when the market finally recognized the hidden potential. Although
sector swings or corrections often happened independently of management decisions, competent
executives certainly enhanced a company’s chances for success. Unlike growth investing, where
sudden momentum changes drove huge price swings,11 value investing necessitated patience.
Value investors might buy “stocks in unfashionable industries or troubled companies that have
been beaten down … and wait for the forces that are depressing the stock to recede and then reap
the profits.”12
10
Berkshire Hathaway’s Annual Report (1999): 16.
Momentum largely related to investor psychology. In momentum i …
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