Jeremy Grantham Hates Yield Curves & Wants You To Buy Deep Value

This guest post covering Jeremy Grantham's thoughts on the yield curve and how net nets can help investors weather difficult markets was written by guest contributor Xavier Hill and may or may not reflect the views of anybody else at Broken Leg Investing. Article image: Balint Földesi

While Jeremy Grantham would disagree, arguably the single best predictor of an impending recession is when the yield curve inverts. It is close to inverting right now. Yet Jeremy Grantham, a value investing legend, disagrees. Who is right and should deep value investors be worried?

Jeremy Grantham, What's A Yield Curve?

The size of the world’s stock markets is a mere pimple compared to the size of the world’s bond markets. This means that changes in the bond market have even greater consequences to the world economy than changes to the stock market. The largest bell weather of the world’s bond market is the US government bond market.

You can buy $US debt on all manner of terms but, as a rule, the longer the maturity date of the debt instrument the higher the interest payment (coupon) the market will require because nobody knows the future. Say you buy a US 30 year treasury at 5.00% coupon and in 10 years time interest rates rise to 10% you will be losing 5% of your money in real terms every year from year 10 onwards. Ouch. However, if you buy a 2 year treasury at, say, a 4.00% coupon rate and interest rates spike to 10% in the second year of the bond, you lose 6% in real terms but only for one year.

This relationship between the coupon rate and bond maturity is known as the yield curve. Here’s what a typical yield curve for US bonds looked like in February 2006:

US Yield Curve, 2006 (Source: Wikipedia)

You can buy 1 month all the way to 30 year US bonds but the relationship remains the same. The shorter term of the debt, the lower the risk and therefore the lower the yield.

Why Everybody But Jeremy Grantham Is Worried About The Yield Curve

As I write this, the yield curve is nearly flat and people are becoming worried. For example since January 2017 the difference between 2 year and 10 year Treasury yields has collapsed from 128 basis points to 57 basis points and is now the lowest it has been since the ‘08 recession.

You can see the changes in the yield curve over the past year below.

2017 US Yield Curve (Source: Bondsupermarket)

There are now economists everywhere predicting that yields will invert sometime next year. An inverted yield curve means investors are prepared to receive a lower yield on longer maturing debt than shorter maturing debt. This means investors believe interest rates and inflation are going to remain low or fall well into the future.

In a seminal 2004 paper on the subject, Professor Leland B. Yeager et al at Auburn University, in simple terms, found that Inverted yield curves only occur in an environment of cheap money where debt is easily accessible. These borrowed funds are often poorly invested and this inevitably leads to a crash. During periods of an inverted yield curve, the forces of inflation (due to the cheap money) and deflation (due to a poor economy) are fighting against each other, though deflation inevitably wins in the form of a recession.

In fact, inverted yield curves have occurred on only eight occasions since 1958 but, on 7 of these 8 occasions, a recession has occurred within 2 years.

You can see the phenomenon in the figure below:

Historic Inverted Yield Curves and Recessions (Source:

The correlation between inverted yield curves, recessions and therefore stock prices is clear and the causation (too much debt available that is poorly invested) is equally clear. It is a metric the market keeps a close eye on, yet I am not worried.

Jeremy Grantham Thinks You Should Ignore This Mega Trend

In his latest quarterly newsletter value investing legend Jeremy Grantham provides a compelling argument that the stock market is not headed for a crash and that bond yields can still decline further. Jeremy Granthams’ model considers US stock data back to 1925 the p/e (price to earning) ratios, inflation, profit margins of US stocks since 1925, and, to a lesser extent, stability of GDP growth (note not actual GDP growth). The analysis has been a big contributor to Grantham’s current thoughts on the market. Whereas in 2015 Jeremy Grantham was publicly stating that stocks were overpriced, his analysis justifies why stocks are at their current heights and more importantly why they are unlikely to fall.

As Jeremy Gratham states...

“Whether sensibly or not, investors love high margins and like stable growth even if it’s modest, and hate inflation. They felt this way from 1925 to 1997 and they felt exactly the same way in our new era of 1997 to 2017. So, behaviorally it is absolutely not a new era.”

This has large implications for investors as investors require higher earnings (and therefore lower p/e) in higher inflation environments. You can see the model’s correlation below. Note its predictive powers with the exception of the internet bubble of the late 1990’s.

GMO's Revamped Behavioural Model (Source: GMO)

Stocks have always been viewed as being an inflation hedge and, in many ways, they are unlike a bond. A company can pass additional costs onto consumers, yet as Jeremy Grantham and Nobel prize winning economist Franco Modigliani have discovered “ real life, when inflation first appears or accelerates, there is an immediate, coincident negative effect on P/E multiples.”

Jeremy Grantham’s refining of the model has seen him overturn his bearish calls from last year and is now firmly a bull.

So we have effectively two major forces at work right now. One is that cheap money will cause a whole lot of mal investment which will see stocks crash when the debt cannot be repaid. This is what history has nearly always shown since 1958 when the yield curve inverts. The other force is that interest rates are low, inflation is low and therefore the market will go higher as stocks are still attractive relative to bonds.

Weathering Jeremy Grantham's Perfect Storm With Net Nets

It is in these competing forces that net net stocks stand out on their own. Net net stocks often do not enjoy strong profit margins (in fact the best are often losing money) and can rarely claim having experienced stable growth in the recent past.

On the surface net nets look horrible but they straddle these competing forces nicely. Net net stocks come with large inflation protections built in. Through buying a stock below NCAV you own inventories which are typically good hedges in an inflationary environment, you own cash which can be put to use by management within the business, and you own receivables, all bought below fair value if you were to liquidate the business. On top of these, you are getting non current assets such as property plant and equipment for free. While these assets do not always perform great in an inflationary environment, they do provide further protection.

Further to this, in an inflationary environment, net net companies can look to lift their profit margins -- a major positive factor. Since net nets typically have small profit margins, a small increase in profitability leads to a disproportionately large percentage increase in earnings growth, pushing the stock higher. It often has a dramatic effect on the value of the business in the market. While a growth stock may enjoy a 70% margin, a small increase in profitability also means a small percentage growth in profit. An increase to a 75% margin produces a relatively tiny increase in profit of just 7%, for example. Compare this with a net net with a margin of 1% that suddenly rises to 2% -- a 100% increase in profit and possible doubling for the stock! Luckily, drops in profitability from 1% to 0% rarely have the same effect on the downside since terrible performance is already priced in.

“Rule one never lose money. Rule two, don’t forget rule one.”

- Warren Buffett

This ability to outperform in inflationary environments which are followed by a recession is a major reason why net net strategies are so effective.

If the yield curve thesis, which is being hotly talked about by all manner of pundits right now, is correct, we are headed for recession and a stock market correction. Net net stocks have some of their best periods of outperformance in down markets relative the index, so net net stock holders are likely well protected in this event.

If Jeremy Grantham’s model continues to hold, with inflation remaining low and p/e ratios continue to increase, then net net stocks are again in a good position to profit. If your net net stocks are well selected according to Core7 principles, they are likely to turn around for a host of reasons, including mean reversion. As net nets typically have low margins and high p/es, as growth stocks become more expensive, net net stocks appear more attractive.

What I like most about net net stocks, or Ultra and Negative Enterprise Value stocks for that matter, is that they are off the radar of nearly all stock market analysts. Grantham’s fund is too big to consider net nets and other tiny deep value companies. Actually, most professional fund managers are excluded from the deep value mico & nano cap gold-rush due to the amount of money they have to put to work.

This is probably very frustrating since recessions always mean falling stock prices. Yet deep value strategies outperform strongly during an average down period, on top of offering strong protection from inflation and great performance in a strong economy.

Well selected deep value stocks follow Buffett’s most golden of rules -- not losing money -- which is why I will continue to buy net nets despite what economists say.

If you lack the time or the skill needed to invest well, take a look at The Broken Leg Investment Letter. If you're intent on doing all of your own investment research, then it's probably not for you; but, if you want a strong team of analysts to dig up great deep value opportunities for you or to do ALL of your investing for you, then you really should join now.

10 thoughts on “Jeremy Grantham Hates Yield Curves & Wants You To Buy Deep Value

  • Hey Xavier,

    Thanks for the interesting post! You mention that "[n]et
    net stocks have some of their best periods of outperformance in down
    markets relative the index." Do you have any specific data or studies you can share that have led you to this conclusion? I haven't seen much data on this point (most studies don't break down performance annually), but what I have seen is mixed and suggests that net nets can get really crushed in a sharp downturn. For example, Table IV of Oppenheimer's study shows net-nets as being down 43% in 1970 while the small firm index was down only 31%. Similarly, the next year, net-nets were down about the same as the general market (19% vs 20%).

    • Oens,

      Oppenheimer study was for between 1970-1982 - The whole period was largely a downturn! Yet still net/nets outperformed dramatically! The S &P 500 only went from 95 to 120 in those 12 years.
      What you say is correct. Check out page 15 of the following paper by Tobias Carlisle
      Cherry Picking timeframes can paint an array of pictures. As net net stocks are often in distress or the market at least perceives them to be in distress for periods within a downturn they will likely under perform, what is important is their net performance within the downturn. Net nets typically net outperform because as the downturn receeds they dramatically outperform. To be clear the market as a whole is still in a downturn, though in hindsight we realise that it was coming out of the downturn or that the market stagnated and at least did not fall further. The phenomena was seen not just in 1970 but in '01-02 and '07-'08.

      For net net portfolios using the core 7 principles I am confident the downturn will be less severe as the companies have a stronger overall business relative to all net nets. In a severe downturn credit dries up and current assets like receivables and inventories can suffer large write downs, this brings the company's viability into question and therefore its stockprice falls. By carefully selecting companies without these sorts of exposure downside risk can be reduced.

      Timing where a downturn is within its cycle is a fools errand in my view, what counts is how a portfolio performs during the entire downturn.

      • Hi Xavier,

        "For net net portfolios using the core 7 principles I am confident the downturn will be less severe as the companies have a stronger overall business relative to all net nets."

        I doubt this for the simple reason that the market price is made between just two participants; the most optimistic buyer (bid) and the most pessimistic seller (ask) - that need not reflect fundamentals.

        Furthermore, isn't that an entirely hypothetical point since there aren't enough Core7 net nets currently available to construct a portfolio?

        While valuations need not be high to precipitate a crash, in the case where a crash has come after a sustained bull market and valuations (chose your value metric) are "high" it is probable that the number of net nets available diminish in the lead up to that crash (this is empirically proven) and it would be reasonable to conclude, in my opinion, that the net nets that remain are even less likely to possess "Core7" attributes.

        Out of interest I took 8 stocks (7 Japanese, 1 Singaporean) from the NNH shortlist that were perennial net nets but met the other 6 criteria on the "Core7" scorecard. Making the big (read: wild) assumption that they were still net nets during the Oct-2007 to Mar-2009 crash based on their price (as data wasn't available for the last 10 years, only the last 5) I found that collectively they returned -49% i.e. right in line with the general market. (for reference the max, min and median was -22%, -76% and -48% respectively i.e. not driven an outlier).

        I have seen nothing to suggest any long only strategy survives a major crash, however, net nets generally appear to recover faster and outperform when market returns are positive.

        "what counts is how a portfolio performs during the entire downturn."

        I agree with this, but again, if net nets get destroyed during a crash the emotional turmoil that causes irrational decision making doesn't bypass the net net investor, and that, in my opinion is the crux of the matter.

        Kind regards,

        • G man

          Thanks for your comment. I agree there is no long only strategy I know of that survives a market crash.

          I have posted many times about the importance of temperament, Buffett continually talks about this “Temperament is more important than IQ” is one of his many quotes on this. Temperament is one of the most important parts to stock investing according to Buffett.

          “...if net nets get destroyed during a crash the emotional turmoil that causes irrational decision making doesn't bypass the net net investor, and that, in my opinion is the crux of the matter.”

          To be a net net investor you need to have the right temperament. If you do not have the right temperament and you are prone to get caught up in the swings of the market you should not buy stocks. You should instead buy short term bonds.

          As Carlisle’s paper shows, beta for net nets goes above 1 during a big downturn but remember this is a measure of volatility, not risk and beta conflates the two.

          Ultimately I accept my limitations as an investor and that I am unable to time the market. In order to still participate in it, I need to accept the volatility as hard as that will be at certain periods.

          Always appreciate your contributions G-man



      • Hi Xavier,

        Thanks so much for the thoughtful response! I think we're in agreement. From what I've seen, it appears that net-nets have a tendency to seriously outperform during the recovery period, so if you consider the downturn and recovery as a whole, net-nets do indeed outperform. Consistent with this, it's very hard to find a three-year period where net-nets did not have a significantly better return than the general market. But if you consider the downturn period alone--which, to be fair, is the most psychologically straining--it seems that net-nets are liable to at least suffer as bad (or worse) than the general market. As G-man pointed out and explained, I don't think any long-only strategy should expect to be spared during a downturn, even one that focuses on the highest of quality. I think net-net investors, like all investors, should prepare themselves psychologically for the very real possibility that (at some point) they will see their accounts halve in value. Though, in line with your points, I think they should be able to take solace in the belief that they should outperform in the long term.

        On a not-entirely-on-point but related note, I'll point out that studies appear mixed on the number of down periods for net-nets relative to the general market. Goebel's study suggested that from 1971-2007, net-nets had only 25 years of positive returns, whereas non-ncav firms had 31 years of positive returns. On the other hand, Montier's "study" (if it can be called that, given its total lack of transparency) found that net-nets had fewer down periods than non-net-net stocks.

        Thanks again, Xavier. I appreciate your insights and your willingness to take the time to respond to my comment!

      • Thanks for mentioning this, Evan. Any idea where you saw this? I'm not doubting it; I just don't think I've seen data for that period and am wondering whether I overlooked it or if it comes from your own back tests.

        • You're very welcome. All of my own backtests that I've conducted show this trend for the early 2000s dip. Performance for net nets (and deep value generally, I hear) was quite good.

          I think that a lot of the time we fail to take notice of market characteristics before a crash and crash characteristics. In 08/09 liquidity almost completely dried up but, to my knowledge, there was no stock bubble preceeding it. I'm sure a few housing stocks were over valued, and the market wasn't cheap, but this is different from a bubble. I could be wrong but expensive housing stocks did not result in extreme overvaluation of the markets generally. In the late 90s, dotcom pulled up the indices to a huge degree and the crash in the 00s was largely a revaluation of securities (along with a recession). Today the market is definitely overvalued but this could be a lot due to FANG stocks, etc. We may see an event more akin to the 00s crash... though a lot deeper research would be needed before drawing a proper prediction.


  • Hi, in relation to this:
    "Say you buy a US 30 year treasury at 5.00% coupon and in 10 years time interest rates rise to 10% you will be losing 5% of your money in real terms every year from year 10 onwards. Ouch. However, if you buy a 2 year treasury at, say, a 4.00% coupon rate and interest rates spike to 10% in the second year of the bond, you lose 6% in real terms but only for one year."
    Would you please explain how an investor loses in "real" terms because as I understand it the difference between "real" and "nominal" returns is the rate of inflation, not a change in coupon rate on a bond.

    • G-Man,

      Thanks for commenting. The term "Real" accounts for the discounted value of an asset. If you can invest your money risk free at the bank at 10% yet you are locked in to receiving 5% on the bond coupon, then you are losing 5% a year in real terms. I agree I am conflating "inflation" with "interest rates" but for the sake of explanation and to keep the post short I have used them interchangeably. Maybe going forward with inflation now getting close to 3% in the UK whilst interest rates are at record lows this will change into the future.

      Obviously the price of the bond drops in value to account for this according to the Bond pricing formula. You can see how this works or if you want I can PM you some spreadsheets I have for bond pricing.

Leave a Reply

Your email address will not be published. Required fields are marked *

comments powered by Disqus