Jeremy Grantham on making long-term investments in a short-term market

Legendary investor Jeremy Grantham talks about global value, mean reversion, speculating, past and current stock market frenzies, and the potential of artificial intelligence

Disclaimer: This interview is a portion of Andrews' most recent recorded BFIA Talks podcast with Jeremy, which can be found on YouTube and all podcast platforms.

The co-founder and long-term investment strategist of Boston-based asset management firm GMO is Jeremy Grantham, a Yorkshire native. The foundation of Jeremy's reputation is his long history of identifying bubbles. In the late 1980s, he predicted the Japanese bubble, and in the late 1990s, he wisely refrained from jumping into the tech bubble, a move that made him a perennial. However, he also became optimistic in March 2009, when the market was at its lowest point following the crisis.

His memoir, The Making of a PermaBear: The Perils of Long-Term Investing in a Short-Term World, which was released earlier this year, details these incidents and a lot more.

Kaylie Pferten: You weren't always a patient value investor, as your book reveals. I liked the part about the late 1960s. You claim to have become a "gunslinging nitwit" in a pricey market, but you only had a few stocks. Could you briefly describe that episode and how it turned into a pivotal moment?

Jeremy Grantham: Fresh out of business school, I joined this lunch club of gunslinging kids in Boston shortly after I landed my first job in the investment industry. Every time we got together, someone would have a fascinating tale to share. Additionally, these stocks would usually rise and fall rapidly. Stirling Moss was a member of the motor-sports organization American Raceways. Formula One was to be introduced to the United States. I had faith that it would succeed. Power, noise, blood, and death all seemed incredibly American.

Everyone attended the one track that American Raceways purchased in the middle of the nation. I purchased 300 shares at £7 because I thought the races would become popular across the country. The stock was at £21 when we returned from our three-week trip to Germany and England for my wedding. I would therefore like to say that I did what any competent value manager would do. I tripled up after selling everything else I owned. I had 900 shares at £21, many of which were borrowed. The price was £100 by Christmas because fate always teases you and wants you to fully commit to a bull market. I just needed to sell and flee. The market began to collapse while my wife and I were debating whether to raise our bid on a house we were interested in, and American Raceways quickly began to decline. And I quickly left to join another company that was just as far ahead of its time (Formula One is currently doing well in the US).

Everybody would have a monitor on their desk thanks to this company, which at the time was extremely advanced. Additionally, each stock's option price would be displayed on this small screen. However, the conceptwhich was a precursor to the internet and Bloomberg terminalsdid not gain traction at that time, and the business never prospered. I was fortunate to escape with enough cash to reimburse the banks after it collapsed. I decided that I should go back to being a value manager and a cheapskate, following my Yorkshire instincts.

Kaylie Pferten: After suffering severe burns to your fingers, you made the decision to thoroughly examine the history of the stock market and how human nature consistently led to these circumstances. And you created the first small-cap stock index by hand as part of your research?

Jeremy Grantham: In agreement. We had to create an index dating back to 1925 by going back into the archives. We observed extended periods of both large-cap and small-cap dominance. In these multi-year cycles, they fluctuated. The intriguing aspect for me was that the valuations of small stocks had drastically decreased in comparison to the rest of the market, and we were in a major "nifty-fifty" blue-chip cycle. Therefore, we invested all of our money in small caps, which at the time was so novel that it was completely unique. Back then, institutions didn't experiment with small caps. They were unworthy of respect.

Consequently, we had an odd portfolio that was hard to sell. There were ninety-nine competitors selling Coca-Cola, and one of us was selling businesses that nobody had ever heard of. Therefore, it was at least amusing. The clients were more amused by it than anything else.

Kaylie Pferten: The goal was to find investments that others had missed, and you obviously liked doing the math. Later, your asset management team was among the first to use a computer to continue doing this, didn't you?

Jeremy Grantham: It filled the entire space, produced a great deal of heat, and was extremely costly. However, it did provide us with a small advantage for a year or two. By the way, we discovered that the figures we had manually calculated were fairly accurate. Hand-crunching numbers was also enjoyable because nobody else did it. On the other hand, everyone else got a computer after we did. Before long, a computer was merely an expense of conducting business.

And whether you liked it or not, you had to have it and pay for it; nobody made a fortune by owning one. To get ahead of myself, this is quite similar to AI. AI will become a business expense in five or ten years. But you won't be able to advance with it. If you don't use it, you will be irreversibly behind competitors. The early adopters of new technologies benefit from them. And when it becomes evident that they have an advantage, it disappears as everyone imitates them. AI will be discussed later, though.

Kaylie Pferten: One of the main themes to emerge from your research is mean reversion, which is brought up by the idea of an early lead being eroded. When something rises, it must fall. Corporate profits are subject to competition. In a similar vein, asset markets experience euphoria due to human nature, which causes us to overdo things both during highs and lows.

Bubbles rise and fall, but it's impossible to predict when things will return to normal. What was it like to stand essentially alone for years on end in late Japan and late 1990s America, knowing that you were correct to be pessimistic because mean reversion is an inevitable phenomenon?

Jeremy Grantham: You had plenty of time, especially in 1998 and 1999, to conduct additional research. It wasn't until the trailing price/earnings (p/e) ratio hit 21 at the end of 1997the same as the peak in 1929that we began to reduce our holdings of US stocks. Therefore, it was an emotional goal to achieve. We were as light as we could get by the end of 1998. Additionally, the p/e reached a peak of 35. Naturally, Japan was even worsethe birthplace of all bubbles. In 1989, the p/e shot up to 65, a level that had never been higher than 25.

Thankfully, 35 wasn't 65, or we would have undoubtedly gone out of business. Conveniently, though, the market made a spectacular retreat at 35, and we were ready for it. We had doubled and redoubled our stakes until there was nothing left to do, and we actually made good money.

Consider real estate investment trusts (REITs) to see how much of a bargain value stocks were during the peak of the market. Reits were yielding 9.1%, and properties were selling at a discount to replacement cost. The total yield of the SandP 500 was a record low of just 1.5 percent. Reits saw a 30% increase during a flight to safety and value when the market as a whole fell.

Kaylie Pferten: It sounds like a race against time for your company, and customers are probably getting more and more irritated that you missed out on the significant technological advancements of 1998 and 1999. They would have shared the viewpoint of Citigroup CEO Chuck Prince during the 2007 credit bubble: "You have to get up and dance as long as the music is playing." Do you believe you would have failed if the bubble had burst a year later?

Jeremy Grantham: In my opinion, yes. Returning to Mr. Prince, George Soros said, "Actually, the music had stopped, he just hadn't noticed," which was generally harsh.

Kaylie Pferten: Did many of the people you spoke with at the time agree that it was a bubble, but they were reluctant to express it in public?

Jeremy Grantham: Exactly. We were a strictly institutional company that handled numerous large pension funds. The pension funds' hired guns typically had a keen awareness of the market's volatility. However, their committees, which were composed of VC and private equity investors as well as a variety of wealthy and self-assured individuals, insisted on following the trend and said that anyone who didn't was in the past and ought to be fired.

In the end, there is more uncertainty about when bubbles will appear than the average client can tolerate. That's all there is to know about institutional investing. The bubble was visible to the majority of engine room players. Simply put, the bosses and marketing staff realized that scepticism was a bad business strategy.

You simply cannot wager on the burst of a bubble if you are a large company. You must accompany everyone else, be prepared to run off the cliff, and be quick, professional, and slick in order to save money and redeploy it on the way down. You will prosper if you do that. You might be fortunate enough to win one if you attempt to combat the bubble. In a way, the Great Financial Crisis was won by us. In quarterly letters, we provided an explanation. Everything went smoothly because we were ready for it and left on time. However, be careful if you get it wrong.

Keynes, who is essentially my only hero in the field of economics, stated that the secret to a successful investing life is to never make a mistake. Therefore, you can make mistakes in the workplace without losing your job. He claimed that even being correct on your own was risky because, if you prevailed, they would give you a pat on the head but, once you were out of the room, call you an eccentric. It's not a good reputation. Additionally, he stated that "you will not receive much mercy" if you were positioned for a bear market and the market failed to break.

Kaylie Pferten: Speaking of the current bubble, how do you feel about artificial intelligence and how the market perceives it?

Jeremy Grantham: Just like with the South Sea bubble, this moment in the history of the stock market will be discussed in a century. It is just incredible. The SpaceX prospectus was similar to the well-known South Sea bubble: "An undertaking of such profound importance but cannot at this time be revealed." "Just hand over your cash.

The SpaceX corporate logo is on display at the Nasdaq in New York.

Kaylie Pferten: When I learned that Isaac Newton pursued the South Sea bubble, I was appalled. He ought to have realized that everything that rises eventually comes down.

Jeremy Grantham: "I know a lot about the movements of heavenly bodies but nothing about human nature," he remarked. "Mining asteroids, establishing colonies on Mars, traveling through space, and projecting revenue streams90% of which appear to be related to artificial intelligenceare all unbelievable in SpaceX's prospectus. Naturally, it's unclear whether SpaceX's AI, which is currently being outclassed by Anthropic and the other guys, will survive in the long run. Discuss tulips.

Kaylie Pferten: You've stated that you believe the excitement surrounding the introduction of AI effectively prevented the late 2021 bubble from completely deflating.

Jeremy Grantham: We believed that December 2021 had all the makings of a bubble, and in 2022 there was a downturn. However, for the first time in history, midway through a bubble burst, you have an idea that is so massive and requires so much capital investment that you alter the course of events.

When ChatGPT first appeared on that infamous day in late 2022, someone rang the bell and declared, "All change." For ten months, the rest of the market didn't accept it and started to decline. However, by that time, the Magnificent Seven had doubled, which caused the market as a whole to rise.

I asked ChatGPT to summarize War and Peace in ten points, and it did so in German. And that was sufficient to convince me that this would be outstanding. Other than the railroads, it's obviously superior.

People are unaware that the likelihood of attracting excessive capital and experiencing both a capital bust and a market bust increases with the obviousness and importance of an idea. The railroads changed our lives and greatly increased productivity, but because it was so clear that they would do so, everyone built too many of them and lost money. And in AI, that will occur.

There are currently seven businesses and fifteen more that are vying for market share. AI is the market that all of them are targeting. They think that whoever arrives first has the right to earn more money than you can shake a stick at. More than anyone has ever earned on anything. They all agree that the primary risk is insufficient spending. They are saying, "We will spend our huge cash flows."

They won't stop fighting until one of them lives. Starting now, this might be the bloodiest battle to the death that we have ever witnessed. They don't make much money in that kind of battle, and the stocks are crushed. Then they come out of the debris. the internet, for example. During the tech slump, Amazon saw a 92% decline. However, it eventually rose to inherit the Earth. From the ashes, railroads emerged. It will emerge from the ashes.

Kaylie Pferten: Where are you finding value outside of the US, while investors wager on potential survivors?

Jeremy Grantham: At the start of last year, it was simpler to respond to that question. Valuations were priced to generate a respectable return at that point because they appeared unremarkable. Since then, the S&P has increased by an additional 23%, but this is in stark contrast to the rest of the world, which is dominated by emerging markets. The rise in emerging markets is sixty percent. Additionally, value has increased 45% in Europe. These gains over the S&P are also very significant. The US has entered "read all about it in 100 years" territory, while the rest of the world now appears slightly overpriced.

Kaylie Pferten: Although it's probably reasonable, it seems to us that Japan is no longer inexpensive.

Jeremy Grantham: It's done really well, and it makes sense. Once more, it has significantly outperformed the S&P since the beginning of the previous year. The S&P may have been at the bottom of the pack over the past 18 months, but it still rose sharply, giving the impression that it defies gravity. This is what most people find impressive.

Naturally, this sense that it will continue indefinitely is a classic. In 1929 and 2000, people wrote and thought exactly like that. It's the same this time.

If you say this, of course, people will hate you. They detest the idea that the entire thing is a mass delusion because they are so focused on making money. They may have despised me more in 2000, but it's getting close. Three individuals commented on a recent podcast that I had large ears. They are obviously large as well. Simply put, after the age of seven or eight, people tend not to say so.

Kaylie Pferten: I doubt that the boy who pointed out that the emperor was nude was also well-liked.

Jeremy Grantham: I have no idea. The episode was not captured on tape.