The Value Perspective Podcast episode – with James Montier
Hi everyone and welcome to The Value Perspective Podcast. If you caught our episode with Ranmore Fund Management founder Sean Peche earlier this year, you may recall him mentioning his hopes of one day meeting James Montier, the author of one of his favourite books. Well, today that dream comes true as Sean and our own Andy Evans welcome James to the pod. In addition to being an author, James is a member of GMO’s asset allocation team and a partner at the firm. Previous to his tenure at GMO, he was co-head of global strategy at Société Générale. He is also a visiting fellow at Durham University and a Fellow of the Royal Society of Arts. In this episode, Andy, Sean and James discuss the ‘Seven Sins’ of fund management’; James’s explanation of why he was wrong to predict corporate margins would come down and why they stayed above their median for so long; and Andy’s favourite-ever investment piece, If it makes you happy – again authored by James many years ago when he worked for Dresdner Kleinwort. We trust you take as much fun from this episode as we had making it. Enjoy!
AE: James Montier, it is a pleasure to have you on The Value Perspective Podcast. Welcome.
JM: Thank you very much. Thanks for having me.
AE: We are also very pleased to have a guest interviewer with us today – Sean Peche, welcome. You were a guest on the show back in May – how does it feel to be to the other side of the microphone?
SP: Andy, I am a little nervous – but thank you so much to The Value Perspective for the invitation. At the end of my last podcast, I recommended James’s The Little Book of Behavioural Investing and I now feel like I am on the fund manager equivalent of ‘Make a Wish’! So this is a rare treat – thank you for the opportunity.
AE: Very good. James, maybe we could start at the very top. Many of our listeners, I imagine, will know you and some of your work. But how about giving us a bit of personal and career background?
JM: Sure. It is a scary thought but I started nearly 30 years ago in this industry – and the sad point is, I still think of myself as that 20-year-old in the office yet I look around and I am suddenly the old one! And I’m like, How did that happen? How did I go from being this young, thrusting, massively confident 20-year-old to where I am now in my mid-50s thinking, goddamn these whippersnappers!
So I started all the way back in 1992 at what was then Kleinwort Benson. I joined as an economist, having trained in economics, and I was incredibly fortunate. I worked alongside Albert Edwards, who is a great friend of mine, and an amazing team of people over the years at what became Dresdner. I left to do a short stint at Old Mutual and then Albert and I reunited at Dresner for a second time – and from there we went to SocGen and from there GMO headhunted me. I got a call from Ben Inker one day – which was now 14 years ago – and he said, Would you like to come and work at GMO?
Of all the firms I had come across, there were only a handful I thought I could ever work with because – as I think Ben said on your podcast with him – I can be very frustrating! I know not a huge number of places would tolerate my attitudes and habits but GMO does. Somebody asked me what it was like working at GMO and I described it as ‘flypaper for freaks’! If you’re essentially unemployable anywhere else, you are at home a GMO! So that is where I ended up and, 14 years later, I am still there having a whale of a time.
AE: Fantastic. I am glad you mentioned Ben Inker as we will come back to him a little later on. I am going to talk a bit about how I got into your stuff because I was actually at Dresdner all those years ago and I used to read your work – and I was absolutely fascinated there was someone sat there writing about how useless everyone else was in the department! So I was instantly drawn to that and I always enjoyed your work. In fact, you bear partial responsibility for me being a value investor, for which I don’t know whether to hug you or hit you! Still, that is where we have ended up – and, Sean, I think you have a similar sort of experience of enjoying James’s work over time?
The biggest ‘sin’ in fund management
SP: I do indeed. The first time I came upon your work, James, was at Orbis in 2005, when you wrote your Dresdner note, Seven Sins of Fund Management – A Behavioural Critique – and I have to say it is the piece of broker research I have kept for the longest time. It really hit home to me and many of its principles we actually embody in managing the global equity fund at Ranmore Fund Management. So, first of all, thank you for that – but, for the benefit of those people who have not read the piece, could you maybe summarise it? And then, given almost 20 years has passed, have any ‘sins’ changed at all?
JM: Good question. ‘Seven Sins’ was a collection I put out in 2005 and it was an attempt to try and analyse the average investment process and where I thought people were making mistakes – and probably the biggest single mistake was the massive overreliance on forecasting. One of my favourite quotes comes from Lao Tzu, the 6th Century BC Chinese poet, who said: “Those who have knowledge don’t predict. Those who predict don’t have knowledge.” It always struck me as weird that our industry seemed obsessed with trying to know the future – and yet the future was inherently unknowable.
Years after I wrote it, I came across a great quote from Elroy Dimson of the London Business School, who said: “Risk is more things can happen than will happen.” I really liked that because it framed some of what I was trying to get across on the folly of forecasting, which is – history always looks beautiful and linear, right? It is, Oh, this is the sequence of events – yet, at any point in time, we could have branched out in a myriad different ways. And trying to choose which of those paths we ought to be going down is nigh-on impossible.
It doesn’t matter whether you’re looking at economists and their inability to forecast growth and inflation, or analysts and their inability to forecast earnings – there is just no evidence that people can forecast well. And so putting that at the heart of an investment approach, I thought, was kind of nuts. Yet that was the typical investment process – it was, Hey, we start by forecasting GDP or inflation but then we take that down into stocks and sectors and we forecast earnings. And I was like, Why? Why would you put something that is so deeply flawed at the heart of your approach?
So that was probably the first and most obvious of the seven sins – that overconfidence and overoptimism that really drive our behaviour. It made me wonder why people do that. And then I came across the Dunning-Kruger effect, which is a neat little psychological set of results, which shows that the people who are the worst at forecasting also lack the skills to know they are the worst at it! So they are both unaware and appalling – and maybe that is a blissful combination, I don’t know! – but that kind of thing is just mad to me.
So that was the first ‘sin’ I really wanted to take on. I looked at the overoptimism and overconfidence people had and I came across this beautiful study on two different groups of people – weathermen and doctors. Weathermen, it turns out, are really good at knowing they are bad, right? Particularly here in the UK, where we live on this tiny island, we get blown around all over the place and who the hell knows what the weather is going to be like tomorrow? Weathermen are therefore pretty well-calibrated – they know they are pretty bad.
Doctors, on the other hand, are a terrifying bunch of people – these guys are so sure about everything. And the reason for this is they don’t get feedback, right? If you go to the doctor and he gives you a diagnosis and then you die two weeks later, he may never even know about it. So that lack of feedback is very clear. Meanwhile, weathermen just go, Oh, yeah, we were wrong again but it’s fine. I got drenched, I should have taken the brollie but I didn’t. So the feedback is really immediate. For doctors, that is not the case.
But then another study revealed the one group of people who make doctors look unsure – investors. Investors are even more confident than doctors about everything – and that was just staggering because, you know, there are days when I get up and I’m not sure I even exist, let alone anything else! I could be a brain in a jar for all I know – spend time watching The Matrix, right? It is a terrifying prospect that people are so sure about stuff. So it struck me as a very odd thing to base your investment approach on – I know the future. Really? Great – but I sure as hell don’t. And if I don’t, how do I build an investment process that doesn’t rely on that?
The illusion of knowledge and five more ‘sins’
JM: So that was sin number one. I’ll try and be briefer on the others otherwise we will take up all the time we have! I moved on from the folly of forecasting into other areas. In particular, I started looking at the idea that, effectively, people thought ‘more knowledge’ was ‘better knowledge’ and this obsession with ‘knowing more’ – and, again, that struck me as weird. I was like, Well, why would I care about everything? But our industry is great at that – you know, I used to work with a tech analyst who was brilliant on technical detail. He used to take a PC around with him and take it apart in front of fund managers to explain every little detail and, Wow, I never knew that was how a PC worked.
Could he forecast for toffee? No! Could he convince these guys they should be investing in this PC maker? Absolutely. But I was like, Why? Why do I care about how this thing works? All I need to know is, How much is the company actually worth and how much am I paying for it? Not, Hey, look – this little chip does this. It was just staggering. And there was this wonderful study by psychologist Paul Slovic where he told bookmakers, Look, I am going to give you various amounts of information and I want you to handicap this horse race. And what he found was the degree of accuracy of their views remained constant – regardless of the amount of information he gave them.
What did happen was, as he gave them more and more information, their confidence soared. So all this extra information wasn’t improving their performance in the slightest – it was just making them more and more confident. And I think the same thing happens in our industry. My dad, bless him, used to say that specialists were people who learn more and more about less and less until they know absolutely everything about nothing. And yet, unless you’re a specialist, you’re in great danger of learning less and less about more and more until you know absolutely nothing about everything! I love that quote and it has always stuck with me. My dad was a tremendous plagiarist and I have no idea where he stole it from, but it was a great little framing.
So I have always thought of myself as ‘not a specialist’, right? I know less and less about more and more – but I do just try and think about what matters. You know, instead of trying to know everything about everything, let’s just focus on the few things that really, really matter. Yet that is anathema to analysts, right? They want to know everything about everything. And, of course, we like people who sound confident – the more confident somebody sounds, the more we are comfortable with them. Just go back to those doctors, bless them! If you say, Doctor, I’ve got this strange rash, and he goes, Ah, I don’t know what that is. Take these and see if you’re alive in a week – you are not going to feel so great about life. But, if he goes, Don’t worry, I know exactly what that is. Take this, you’ll be fine – you will feel much better about life.
So that habit of being confident, I think, is increased by the amount of information we have, which drives this obsession with collecting information. I am a compulsive collector – you can see my office behind me and I have a tremendous amount of toys and Lego. So I know I am prone to wanting to collect stuff and I have had to train myself to make sure collecting information isn’t part of that obsession as it is too easy to fall into. And that takes us to sin number three, actually – one of the ways people collect information is meeting companies, right? I will probably get into trouble for saying this but what the hell – it is kind of like intellectual masturbation, right? It is tremendous fun – it is great to meet companies – but is there really any benefit to it?
It is far from obvious to me that most investors get any benefit from it. Why? Well, first of all, it is just an exercise in collecting information – we are back to increasing confidence, not accuracy. Secondly, corporate managers are just as likely as the rest of us to suffer cognitive illusions – and guess what? They are going to be overconfident too. Every manager you ever meet is going to be more optimistic about their firm than they are about everybody else’s firm. When was the last time a company manager told you, You know what? We are a really terrible company. We have appalling management. I wouldn’t touch us with a bargepole
If they did, I would almost certainly invest in them! But they don’t. They all turn up and say either, We’re brilliant or We’re on the brink of a turnaround. It is going to be great in the future. They never turn up and say, We haven’t got a clue. Frankly, I’d fire us. It just doesn’t happen. So you get this hugely biased source of information. On top of that, we have a really bad habit of looking for the information that agrees with us – confirmatory bias. When you do meet company managements, you want to hear all the things you want to hear – and that is a major problem. You are not collecting information in an unbiased fashion.
Also, as human beings, we have this terrible tendency to obey figures of authority. Let’s be honest, if you see the CEO and the CFO of a company, they are at the top of their tree – they are figures of authority so we feel we must doff our caps and do what they say. And we know humans will do all sorts of weird things when people appear to be in a position of authority. Psychologist Stan Milgram proved that with his experiments where he got people to shock other people with electricity on the say-so of someone wearing a lab coat – and simply the fact they were wearing a lab coat made them a figure of authority. It is just staggering that one human being would be willing to give another an electric shock on the orders of somebody wearing a white coat. It is staggering that people don’t stop and think, Am I being nice here? Should I be shocking this person? No – I was told to do it. Bang! Let’s crank it up! Where’s people’s thought control here?
Also there is the problem that we are actually terrible at spotting liars, right? Just think about Enron; think about Madoff – those may be really extreme cases, but all the evidence says we can’t tell whether somebody’s lying to us or not. There’s this tremendous industry about micro expressions of spotting lies – most of it is complete bullshit. Nobody’s trained to do it anyway – and it doesn’t work. So company management, saying, Oh, yeah, we’re going to turn it round. Oh, great, great – but we’re not really very good at spotting when people are lying to us. So the third of the sins was this obsession with meeting company managements and wasting hours and hours of time listening, effectively, to a kind of echo chamber of agreement, which to me was just a nonsense. Why would you choose to spend your time doing that?
Sin number four was just thinking you could outsmart everybody else – thinking you are always one step ahead. Take market timing – the idea people can find the bottom and call the top – there’s just no evidence we can do that. Ben Graham used to talk about ‘the way of timing’ and ‘the way of pricing. The way of timing is trying to be one step ahead of everybody else – and, as Keynes pointed out, it is incredibly hard to do this. He talked about the beauty contest, right? There was a set of photos and you had to pick the prettiest person – but the objective was not actually to pick the prettiest person, but to pick the person the average person would find prettiest. And when you play those kinds of games – you can do it mathematically – you find that people are really bad at being just one step ahead of everybody else.
And it is the same idea when you’re trying to call the top or find the bottom. It’s just really hard. Why would you do it? And we’ve all seen those studies where you see, if you missed the best five days or you missed the worst five days, the impact that can have on your investment performance is enormous. And that’s all about ‘the way of timing’, which is next to impossible. Instead, I have long argued we should follow ‘the way of pricing’ – that, Hey, if something’s cheap, I will buy it. Yes, it could get cheaper but I already have a margin of safety in there. So I always thought a much better framing of an investment philosophy was to say, OK, I know I can’t time stuff, and therefore I won’t. I’m going to buy what’s cheap – knowing it could get cheaper. And I’m not going to own what’s expensive, knowing it could get more expensive.
That leads onto the fifth sin – short time horizons. Everybody, of course, wants short-term results – and that overfocus on short-termism can lead to overtrading. The average holding period for a stock is – what? – 10 months today in the US, which is insane. If we go back to the 1950s and 1960s, it was 10 to 12 years; now, it is less than one year. I think at one point, somewhere around 2008, it got down to something like five or six months. That’s not investment, that’s just speculation – that’s just absolutely insane. I don’t know anybody who can say anything about the next year – it’s next to impossible. The next 12 years – OK, we can begin to think about valuation mattering. But on a one-year view, who the hell knows? So that absolute obsession with the short term and trying to be one step ahead of everybody else just made no sense to me. And trying to think about ways of structuring an investment process that didn’t fall into that trap was really important.
The next sin was believing everything you read, right? We have a really, really bad habit of what Nassim Taleb calls the ‘narrative fallacy’ – that is, believing what we read. This goes back to a very old debate in philosophy between Descartes and Spinoza. Descartes argued we could hold an idea in limbo and then evaluate it but Spinoza said, No, no, no – that’s wrong. The way we hold ideas is we tend to believe them to be true – and then sometimes we go and check whether they actually are or not.
It turns out you can test this – and psychologist Dan Gilbert did a huge amount of work in this field. He showed humans are essentially Spinozian – that we really do believe what we read and therefore stories matter. There were some great experiments done on legal trials. In one, they allowed the information to pop up randomly through the course of the trial as it actually would; in another, they plotted out a story and had the prosecution lay out the story of the events. In both cases, the same information and evidence was revealed – just in different formats – but the conviction rate was massively higher when the story format was used.
So we are suckers for a story – and that’s what our industry largely is, right? We are dream sellers. It may be a terrible reflection on us that we wander around selling stories to people – but it’s because they work, right? They are emotional and make it easy to process information. So people cling on to stories, which is a dreadful way of thinking. It’s one of the reasons I like the quants teams I work with – they lack any imagination! They don’t have stories, they have numbers. I’m going to get fired after this – or at least run out of friends – but I’m used to that! It’s why I work from home – it’s safer for me! But they are like, Here are the numbers, this is what matters – balls to the story, nobody cares.
But the average investment philosophy is all about the story – selling the story or buying the story – and it is a really bad way of handling information. So that was another sin I wanted to make sure people were aware of and tried as hard as they could to steer clear of. And that, I’m pretty sure, takes me to the final of the ‘Seven Sins’ – the fallacy of group decisions. There is a belief groups make better decisions than individuals. Writ large, that is ‘wisdom of crowds’ kind of stuff but, in micro, it can be, Well, two heads are better than one. But it turns out groups aren’t actually very good at making decisions.
A really small size, like three people, just about works – but get much beyond three and what tends to happen is people stifle their own opinions. Instead, they begin to share common information – because of conformity. I have made a career out of disagreeing with almost everybody – so perhaps I’m just a weirdo! – but most people like to agree with other people. What you would hope a group would do is bring these divergent opinions together and discuss them and evaluate them – no. Instead groups come together and they talk about what they agree on, which is a really bad way of uncovering information.
And the wisdom of crowds really only holds with some very strict provisos. Only when people have some idea about the correct answer; only when their views are entirely independent – those are sorts of things that make the wisdom of crowds work but they’re not a good description of financial markets. So we shouldn’t think of financial markets as anything like the wisdom of crowds – they are more like the madness of crowds, where we see people charging off doing strange things. For me, any belief that groups and investment committees were effective decision-making bodies was just flying in the face of all the evidence we had. And, collectively, I thought those seven ideas doomed the average investment process to be a pretty ropey one.
SP: Thanks, James. So, almost 20 years on, are there any new sins you would add?
JM: No. One of the nice things about sins like these, I think, is they tend not to change that much. If anything, they can get worse over time. There is a belief that behavioural biases should be, I guess, ameliorated or removed – either by us learning, which is fairly laughable, or by the efficiency of markets. Well, I don’t believe in either of those two things, right? We have a subgroup of GMO – called ‘Nebo’ for ‘needs-based optimisation – which is aimed at retirement planning and I wrote a paper for them earlier this year on the origins of behavioural biases, which I should probably publish for GMO more widely.
I called it ‘Darwin’s Mind’ and it basically argued that the brain is the outcome of a process of evolution – and evolution is incredibly glacial in the way it moves – and so we shouldn’t expect behavioural biases to change. When I look at the average investment process, I still think those ‘Seven sins’ are relevant, right? People are still forecasting; the holding periods are still short; most people spend their time meeting company managements; there are still committees going on – you know, it’s not like anything has altered as far as I can see. That is depressing when you have written an entire book on why people shouldn’t do these things – but good from the point of view of, Hey, look, these things are still absolutely valid!
SP: And I guess we’re finding new liars – Sam Bankman-Fried being a case in point.
JM: Exactly. Who was it said, ‘History doesn’t repeat itself, but it does rhyme’? These are the things we keep coming up against time and again and you’re right – there is another generation of liars and frauds. It is the nature of the world.
AE: Given you were writing about this 20 years ago and a lot of books have been published since on the behavioural side of things, do you think anything has changed for the better or are we just the same people we were before, humans like to do the things they like to do, and therefore changing our behaviour is incredibly difficult unless you are very, very focused on it?
JM: I think that is exactly right – it is really hard to change. The late, great Amos Tversky, who with Danny Kahneman really created this field, said he never discovered anything second-hand car salesmen hadn’t known for generations! And he’s right – it is just testament to human nature. Unless you are really focused on changing and figuring out ways of debiasing – and, probably more importantly, re-biasing – because there is this belief that we can debias, that we can wave a magic wand and these things won’t effect us anymore.
That is completely wrong. I think, because they are the product of the brain structure, we are effectively ‘cognitive misers’ – we are aiming to get away with being as stupid as we could possibly be. The brain is an enormously expensive organ to run – it takes far and away the most energy in your body to actually run your brain – so people don’t want to run it. That is just evolution’s good sense – and so it is incredibly hard to change. So, rather than asking yourself, How do I remove these biases? I think a better question – or an easier question – is, How do I turn these biases to my advantage?
I don’t mean that in a cynical, second-hand car salesman kind of way but rather, Hey, look, if I know I’m going to hang on to irrelevant information – to ‘anchor’ – how do I change that so it becomes something relevant? How can I build an investment process that is centred on the sorts of things that should matter for long-term returns? How do I build a business that is able to exploit long-term horizons when everybody is looking at the short term? Those are much more sensible framings of the questions we need to address.
Value investing as ‘behavioural self-defence’
SP: James, a newcomer listening to you saying it is a waste of time speaking to management and forecasting and so on may read Nassim Taleb’s Fooled By Randomness straight afterwards and think, Oh my goodness, how on earth can I make it work? And I guess that brings us to your excellent book, Value investing, which I have had many copies of in my office – I have handed them out to interns and staff members along the way and they’ve never returned them to me. I guess they just enjoyed the book so much or were too worried about what I might ask them about it! Obviously we are both value managers here – but how you think the discipline overcomes some of those problems you mention?
JM: The way I would frame that is by using Howard Marks, right? Howard is a brilliant writer, heads up Oaktree Capital Management and has this dichotomy I love: there are two types of investors – the ‘I know’ investors and the ‘I don’t know’ investors. That is such a powerful framing – and it links so nicely with Ben Graham’s ‘the way of timing’ and ‘the way of pricing’. I am an ‘I don’t know’ investor – I don’t know the future and I’m fine with saying, I don’t know the future. It makes me very dull company at dinner parties! You know, when people say, I don’t know – whereas what could be more interesting than sitting around with someone who has an opinion on everything and knows what’s going to happen? That’s fascinating, right?
Still, the ‘I don’t know’ investors – and Howard is exceptionally good at articulating this – are really the value guys, right? We don’t know the future. That’s why we invest with a margin of safety – we know we’re going to be wrong about stuff. That’s why we insist on buying cheap – because at least some of the bad news is in the price already. If I buy a stock on a ludicrous multiple, all the good news is already in that price. So everything has to turn out perfectly for that company to be worth what the market has priced in. And maybe it will – it’s possible. I’ve been hideously wrong on companies before where, yes, they have been the winner. The trouble is, there were also the losers, who were up there and just never, ever delivered on expectations.
So, for me, value investing is kind of like behavioural self-defence. It is saying, Hey, I don’t know the future – I can’t know the future – so I need to work out how to build a portfolio that will be robust to lots of different outcomes. That comes back to the Dimson view of risk – that more things can happen than will happen. So I need to build a portfolio that isn’t optimal – it doesn’t depend on one state of the world occurring but, rather, has the ability to survive lots of different states of the world. And so I want to a robust portfolio and it must be value-oriented because then I have wiggle room for being wrong – because I will be wrong about stuff.
Also, for me, growth investing – trying to pick the winners – is incredibly hard. Whereas value investing is more about avoiding the value traps. That is still hard enough – but at least I have a framework where I have this margin of safety. So value investing is behavioural self-defence – and it is also long-term. You can’t buy a stock thinking, Oh, it is going to turn around tomorrow – because it won’t, right? We’re all value guys – we’ve all bought stocks where the ‘short-term buy’ became a ‘very long term hold’! It is a ‘core holding’ now and you’re thinking, Gosh, has it really been that bad! We’ve all been there so that is protecting ourselves – it is saying, Look, we have to be long-term because, as a value guy, I don’t know when this thing turns around.
Seth Klarman talks about it. Whenever there is a big crash, Seth always talks about not trying to call the bottom – you invest on the way down because you don’t know where that bottom is. You can’t know – and so you’re like, OK, I’m going to have a battle plan. GMO’s own Jeremy Grantham talks about battle plans and he’s like, This is the way we’re going to invest. Literally, we have battle plans so that, Hey, when the market hits this level, we’re going to buy and when the market hits this level, we’re going to buy – and we buy on the way down. We probably won’t get the bottom any more than anybody else will and so we have these plans – we slice in. And that’s just our way of saying, Look, we don’t know the future.
That value approach is inherently long-term and it gives you a margin of safety – and then whether you meet company managements or not is up to you. But we don’t very much – some of my colleagues do. I’m not sure why – probably they have too much time on their hands and it’s good fun – but I don’t bother. For me, it’s a waste of time – unless you’re an activist investor, in which case maybe it’s a bit different. But if you’re not an activist, I don’t see the point.
Value investing is so naturally aligned with trying to protect yourself – you don’t try and know everything as a value guy, right? You focus on valuation – that’s the thing that matters most. If you only know one thing about a company – for me, it’s its valuation. That is just the most important criteria I can think of – everything else is secondary. So I also don’t get massively confident about stuff – I don’t run a hugely concentrated portfolios because, hell, I could be wrong about an awful lot of stuff.
So there’s a lot in investing that naturally aligns with behavioural mistakes people make and value investing is just a natural response to the problems. It’s not flawless – we’re still going to get stuff wrong – but it’s at least a lot of baby steps in the right direction. And that’s one of the most important things, right? If you’re trying to build a behaviourally robust investment process, you can’t just solve everything in one go. It’s baby steps, right? It’s like, if you are dieting, it’s best if you don’t keep a jar of sweets on your desk. Why? Because if you do, your hands are going to be in the bloody jar, right? I’m a sucker for liquorice – I’ll eat liquorice all day long – so guess what? I don’t have liquorice around. That way, I can’t eat it. It is those kinds of ‘easy wins’ that I think value investing helps bring to the table to combat some of these behavioural biases.
My mistake! Growth v fixed mindsets
AE: That’s brilliant. I love that answer. Let’s change tack and talk about something you’ve written about more recently. The Curious Incident of the Elevated Profit Margins is a follow-up note to a note you wrote about 10 years ago, which argued margins in the US were extremely elevated and so very likely to prove unsustainable. Yet they have stayed at those levels so this note is you publicly stating, Actually, I was wrong – which is really interesting but comes back to what you were saying a moment ago. I want to touch on that aspect too but maybe you could start by talking about the piece a little?
JM: Sure. It was an interesting piece because – you’re right – people tend to be very bad at admitting their mistakes. And it comes back to that idea that, in general, it is better sound confident. Putting your hand up and saying, Yeah, I messed up, is not very common. I’ve done it plenty of times, though – I’ve got stuff wrong and I’ve admitted it publicly. I think my worst mistake actually wasn’t even on profit margins – it was back in the mid-1990s, when Japanese government bond yields were at 3% and I wrote they could not possibly go any lower. Then I watched them halve, halve and halve again, which was a fairly humiliating experience.
As I’ve got older, though, the ego I had when I was in my 20s has just taken such an almighty bashing over the years that I no longer feel any shame. I’m just like, Yeah, I screw up! And there was a great piece by political science writer Phil Tetlock, who has studied forecasting and forecasting errors, where he pointed out how people tend to use one of five defences for why their forecast was wrong. The first is the ‘if only’ defence – you know, ‘If only the Fed hadn’t raised rates, my market forecast would have been right’.
The second he called the ‘ceteris paribus’ [‘all else being equal’] defence – so, ‘I would have been right, if nothing else had changed’. Yeah, right! The third is ‘I was almost right’ – the thing nearly happened. Well, how do you judge if something nearly happened or not? I don’t know – but I kind of like that one! There is also the ‘single prediction’ defence – ‘I was wrong but you can’t judge me on just one wrong prediction’ – but the one I have constantly used over the years is Tetlock’s fourth: ‘It just hasn’t happened yet’.
And that was really the genesis of my follow-up note on corporate profits because I spent 10 years saying, They’re going to mean-revert, it just hasn’t happened yet – and 10 years later, it still hadn’t happened and I was like, Yeah, I was utterly wrong. But I wanted to know why I was wrong – because there are two ways you can deal with mistakes. Psychologist Carol Dweck talks about the ‘fixed mindset’ and the ‘growth mindset’. With the former, errors are held as mistakes, while the latter goes, Hey, errors are a way of learning and improving – and, to me, that’s very true. I do martial arts in my spare time – I do a lot of Taekwondo – and there’s an expression when we spar or fight: ‘You never lose – you either win or you learn.’
I really like that – and it’s true. I mean, yeah, of course you’ve lost – but you want to learn something from that experience. If I’ve just had my ass handed to me by an 18-year-old, I’m like, OK, how? Why? Yes, he was younger and faster but what can I do about that? How do I adapt my fighting style to try and deal with that? And, to me, that is the essence of it. I take no shame in being wrong. I was wrong? Fine – what do I learn from it?
And in the case of the elevated profit margins, I was looking at it going, Geez, I thought that fiscal deficits would come down. They had been a major driver up to about 2012, when I wrote the first note, What Goes Up, Must Come Down – but I was clearly wrong. Still, fiscal deficits had been elevated and I was like, OK, they are likely to come down, therefore, margins are likely to come down. Well, guess what happened? Fiscal deficits didn’t come down – and it wasn’t just Covid-19. If I strip out the Covid years, it isn’t just about the pandemic. It turns out that, over the last 10 years, we have had fiscal deficits that have been surprisingly high – by my standards – and that was the source of my forecast error.
And, knowing that, I was fascinated. I had another try – I was like, Oh, it’s because everybody has reduced their taxes. I was wrong again! It turns out it had nothing to do with revenues being lower – it was just that expenditures were much higher. I was like, Wow, that’s shocking! That led to a really interesting opportunity to learn. I was like, OK, so why did I think that? Well, I fell into my own pitfall! I was like, I am going to forecast – wrong! So I’m no better than anybody else. I was overconfident, overoptimistic and I screwed up – and, for me, that was a great experience to learn from and remind myself, Yeah, you got this wrong.
The one thing I did take some comfort in – and this may be me looking for the silver lining, having really messed up – was to say, Hey, even if these margins are incredibly high, the US market is actually very expensive. Even if I say these margins are now on – to borrow Irving Fisher’s terrible phrase – ‘a permanently high plateau’, even if I build that in, the US market is still outrageously expensive. So I take some comfort in the fact our portfolio positioning hasn’t been driven by my error – I’m sure it was informed by my error but it doesn’t matter as such because there were other reasons for not owning the US in general. But, to me, it was really a learning exercise. And errors are just that – they are a way of learning how I can look to get better. I’ve been doing this 30 years, I hope to be doing it a few more and I still want to get better.
SP: Just on the US being expensive, James, it is expensive on a price basis – but, as soon as you start adding in the debt from companies thinking interest rates are going to be low forever on an enterprise-value (EV) basis and compare that to the EV multiples elsewhere in the world, how do you feel about that? And where else do you see opportunities these days?
JM: Absolutely. So you look at that and it is insane, right? I looked at EV/EBITDA [earnings before interest, tax, debt and amortisation] ratios for the US – it is at 13x while Japan is at 5x! So as soon as you bring any of the debt side into the balance sheet equations, this is nuts. So what looked bad on a guide of Shiller price/earnings metrics looks so much worse when you start building in the debt equations. I am just in the process of having a note published called ‘Slow-burn Minsky Moments’ – and the idea here is there are systemic vulnerabilities that build up over time and the US’s private sector debt is one of those.
It is one of those things that doesn’t matter right up until it does. So you can carry on building up debt and the world looks hunky-dory but economist Hyman Minsky used to talk a lot about how stability begets instability. It’s like Taleb talking about ‘black swans’ only these aren’t black swans – these are these are grey swans or even white ones that people just don’t look for. They are predictable surprises. So when it all goes wrong, everyone will go, Oh, yeah ... look at that – that’s why! The problem is the timing uncertainty – you never know when – and that takes me back to the value approach that, Hey, we don’t know anything about timing. So we are used to dealing with timing uncertainty – and we are back to, How do I build a robust portfolio?
But for me, the emerging markets, Japan – basically anything but the US – looks OK. The US sucks! There are pockets of interesting stuff in the US – deep-value looks kind of interesting because it has been shunned. Nobody wants to own the cheap and cheerful stuff. No, people want to own the great stuff – the companies they’re not embarrassed to talk about! So deep-value, actually, in the US looks interesting but, in general, anything but the US looks much more interesting.
Japan is fascinating because, like the US, it has had high profit margins – not as high as the US but still high – but I think there it is much more sustainable or, at least, I understand it much better because they have been paying down debt. Japanese corporates have spent so long deleveraging that what’s happening now is their operating profits are actually flowing through to the bottom line and hitting net income, which has to be good news for equity investors. So I think their profits uptick is much more clear and probably sustainable from my point of view. So, when I’m looking at them on 5x EV/EBITDA, I’m like, Yes, please!
SP: And I believe the EV number doesn’t include the investment securities on the balance sheet at all – just cash – and, of course, that will have gone up with the rise in the market and makes things cheaper.
If it makes you happy (it can’t be that bad)
AE: James, let’s return to our time machine and head back to Dresdner and another piece of research you wrote there. It is actually my favourite-ever piece of sell-side research – although it had nothing to do with markets whatsoever! Called If it Makes You Happy – The Psychology of Happiness, it was 10 things that can make people happy, based on data you collected from a whole bunch of scientific studies. I won’t ask you to go through all of it as I suggest everyone looks it up online for their own wellbeing – but is there anything you would now add to your original list?
JM: I think there is a note I wrote subsequent to that on the same topic [It Doesn’t Pay: Materialism and the Pursuit of Happiness], which was really about trying to defend yourself against what is called ‘hedonic adaptation’ – the simple fact that we get used to stuff. So you buy a new car and, at first, it’s really awesome – I’ve got a new car! Six months later, the kids have been in the back, the dogs have been in the boot and your wife’s been driving it and, if it’s anywhere like where I live, it’s been through massive potholes – it’s like off roading, just driving down my road! – and the new car is not new anymore. You’ve adapted to it.
Now, physical possessions are very subject to hedonic adaptation – experiences, on the other hand, are not. So what I argued in the note I wrote subsequent to those 10 rules was that a nice addition would be an 11th rule that says if you’re going to spend money, spend it on experiences and not on physical goods – at least, beyond a certain level because everybody needs a certain amount of income and a certain amount of goods to be alive. But, beyond those kinds of metrics, you can make yourself much happier by going to concerts, going diving, training taekwondo – whatever it may be – something that gives you an experience because the treadmill of hedonic adaptation just doesn’t kick in with experiences in the way it does with physical possessions.
So that is something I would really want to add to the list. Incidentally, that list has got me into so much hot water over the years – particularly number three: ‘Have sex’! GMO won’t thank me for telling this story but somebody asked me to revisit the list at one of our bashes. So I put the presentation together, sent it to compliance and so on – and they came back and went, Yeah, we can’t have you talk about number three. And I went, Why not? I’m pretty sure – pretty sure – everybody here has done number three – even if it’s only with themselves! But they were like, No, you cannot talk about number three. So I didn’t do it – I was like, We talk about number three or I won’t do it! So yeah, number three has got me into a lot of hot water over the years. Just go do something you enjoy – have sex – but what the hell? What would I know!
AE: Number three aside, the key point to take away is to spend time with your family – go on holiday with them and so on – rather than buy a Ferrari or a big house as you just won’t enjoy those so much?
JM: Exactly – but those material things are so tempting because everybody thinks they are what matters. In the rat race, it’s a measure of your success – but, actually, it’s not. The other one I love – which will also probably get me into trouble – is ‘Nobody on their deathbed has ever said, I wish I had spent more time at the office’. It is, I think, one of the good things that came out of the pandemic – that people re-evaluated their work-life balance. I love my work – it’s a passion – but that doesn’t mean it is all I have in my life. I have my family. We all train taekwondo together, which is great – we have a passion as a family together. We have dogs, we go for walks – those kinds of things are so much more important than the big house and the fast car.
SP: James, that reminds me of a quote, Even if you win the rat race, you’re still a rat! Just on the experiences point, I recall reading somewhere that your experiences improve with age. So you recall your holiday 20 years ago and you go, How magnificent the weather was and the beach – but you forget about the fact you queued for three hours at passport control.
JM: Absolutely – and you forget the food-poisoning as well! But that is the point of hedonic adaptation – you simply don’t adapt to experiences so much and so the memory stays crisp. I love rock concerts – which may account for why I am deaf in one ear! – but there is nothing better than going and seeing AC/DC live. I can’t hear for a week afterwards but, damn, the experience is awesome. And I want my kids to have that experience – I would probably protect their hearing a bit better than I did mine but I want them to have that sense of joy and that experience. And going diving – my kids just last year qualified as open-water divers – and what better experience is there than strapping on an aqualung, dropping into the waves and playing with sharks? It’s a wonderful experience and, wow, you want to accumulate as many of those as you can – because that is what you will look back on in later life and go, Yeah, I did that – and it was damned awesome.
Winnie the Pooh – and two book recommendations
AE: That’s brilliant. Thank you. We are coming towards the end but there are two things I wanted to touch on. First, I did say we would come back to your colleague Ben Inker and that is because, when he was on the podcast, I primed Juan to ask, What is it like to work with James Montier? And he gave his answer so it’s only fair you get the same chance – what it is like working with Ben Inker?
JM: Oh, superb! I’ll tell you a story. Many years ago now, I wrote a parody of GMO based on the characters of Winnie the Pooh. So Jeremy was clearly Christopher Robin – he could take us out, play with us and then put us back in the box whenever he wanted! And Ben was Owl, the wisest creature in the forest, because he is! He sits in charge of asset allocation and he thrives on asking really, really difficult questions. Sadly, my job is to try and answer them.
It drives me nuts because he comes up with these really, really tricky questions and I’m like, How am I going to answer that? There was one that has taken me almost 10 years to kind of reach an answer on. I finally did so about six months ago – light bulb! Ben was like, Nice! So everybody in asset allocation was a character from Winnie the Pooh and I was Pooh Bear, by the way – I am the ‘Bear of Very Little Brain’ and long words bother me!
But working with Ben is brilliant – honestly. If Ben does have a flaw, it is that he can be a little detail-obsessed. So Ben thinks, you know, 5.7 is different from 6.0 – I don’t. I’m like, First order, they are the same. One of the nice things – and Ben and I have talked about this a lot – is that, both being value guys, three out of four times we come to the same conclusion. But it’s that fourth time when we differ – that is what’s really interesting, because then it’s like, OK, let’s understand why. What is it that we are seeing differently?
And I have read Ben’s response to what it is like working with me – and I had to smile because he said it was good and frustrating, simultaneously. And I was like, Yeah, that’s fair! I am sure I am deeply frustrating to an awful lot of people. But, at GMO, there are two jobs you want – one is Jeremy’s and the other is probably mine. The one job you don’t want is Ben’s – because Ben has to sit in the middle of the two of us and kind of think, Jesus, who put these two mad Englishmen on either side of me?
He has all the downside because he – together with John Thorndike these days – runs all the portfolios. Meanwhile, I am like a ‘minister without portfolio’ – I have lots of freedom to go out and talk and form views and try and influence things and none of the responsibility of, Hey, you own this stuff. That’s all on poor Ben, who wears the world on his shoulders. Jeremy and I have the best jobs in the world because we don’t – we just get to pontificate about whatever we choose. And Ben’s left there kind of going, Gee, thanks! How do I put that into a portfolio?
Ben and Jeremy with the reason I joined GMO, right? Ben called me up and said, Look, I’ve known you for 15 years, come and work with us. And I’m like, Awesome! So I flew out to Boston and had an interview with various people at GMO. I was actually really depressed after that – I sat on the harbourside, where our office used to be, and I called my wife and said, OK, I’m dead here! I have met 15 people – or whatever it was – and every one of them wants me to do something different at GMO. Now, I am a pessimist and I look at the glass as always half-empty, but my wife is an eternal optimist – she obviously had to be as she married me! And she turned around and said, Yes, but look on the bright side – you can do whatever you want!
It was a good point and so, 15 years later, here I am, still at GMO – and it’s a spiritual home, right? It may be ‘flypaper for freaks’ but I’m as freakish as the next guy. So, for me, it’s home and working with Ben is nothing but pleasurable. Yes, he drives me nuts – and I know I do the same to him – but it’s a productive kind of nuts that I think is also founded on a really quite deep respect.
We were talking earlier about how groups make decisions but we don’t do group decisions – Ben and John have the final say in the portfolios. But we have a group, called the Investment Review Group, whose job it is to challenge that. So we sit there and we talk backwards and forwards – and I think one of the features that makes groups work is where group members have mutual respect. And it’s hard not to have respect for people when you’re sitting around the table with Jeremy Grantham and Ben Inker. These are guys I’ve grown up with – Jeremy was a huge inspiration on the way I write and the way I think while Ben really is the wisest creature in the forest. So, to work with those guys, it is an absolute pleasure.
AE: Brilliant. There is just one last question – something we ask every guest on the show – and that is what book would you recommend for listeners to read?
JM: Ah, that’s a tough one – so I’m going to give you two. One is Howard Marks’s The Most Important Thing because, to me, there is so much wisdom packed in there – just in terms of how the markets move from optimism to pessimism and the ‘I don’t know’ versus the ‘I know’ and so on, I think Howard’s framing of the investment problem is really top-notch. I have tremendous respect for him. The other one is a classic that I don’t think more than one in 10 people in this industry have ever picked up – and that is Security Analysis by Ben Graham. It is not a riveting read – you know, if you’re having trouble sleeping grab it! And don’t pay attention to the chapter on balance sheets and railroad companies – it is irrelevant – but there is so much wisdom in there when he’s talking about markets and how they behave.
We talked earlier about how little things change over time and, when you read Security Analysis – a bit like Chapter 12 of Keynes’s General Theory – these things may have been written in the 1930s yet, somehow, they resonate so much with everything we do today. Graham talks about the problems of short-term thinking and how people don’t focus on valuation and you’re like, Jesus, here we are, nearly a century later, and yet still people are falling into the same damn mistakes. So, to me, it’s an incredibly powerful work because it’s still so relevant – and yet, you know, CFAs won’t even pick the book up. That, to me, is just a crying shame.
AE: There is timeless advice in there, definitely. So we have come to the end and all that is left is for me to do, James, is thank you very, very much for coming onto The Value Perspective Podcast. I have really enjoyed this. I loved hearing about those ‘Seven Sins’ of fund management again – it has been fantastic. And thank you very much as well, Sean, for joining me as co-host.
JM: Thank you, guys. It has been an absolute blast. I’m sorry I’ve prattled on for so long!
SP: And thanks from me, James – even though I didn’t make a forecast, you beat expectations! That was fabulous.
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