GMO's $8 Billion Fund Beats the S&P 500 Despite the Absence of NVIDIA and Tesla

In the realm of identifying speculative excess in financial markets, Jeremy Grantham has earned a reputation as a discerning bubble hunter, particularly attuned to highlighting exuberance on Wall Street and beyond. Therefore, it might raise eyebrows to discover that the largest mutual fund under his firm, GMO, is currently placing its bets on several of the renowned Magnificent Seven tech stocks. These tech giants have experienced substantial surges throughout the year, prompting concerns about potential bubbles.

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Yet, Tom Hancock, the manager overseeing the $8 billion GMO Quality Mutual Fund, sees no inherent contradiction in this strategy. From his perspective, he is simply adhering to the firm's established investment approach, centered on selecting companies with robust track records. This approach has propelled the fund to a remarkable gain of approximately 25% this year, surpassing the S&P 500's roughly 18% advance, even though the fund steered clear of two major gainers in the benchmark – Nvidia Corp. and Tesla Inc.

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This investment strategy is not confined to the mutual fund alone; it has been replicated in the firm's inaugural exchange-traded fund (ETF), the $17 million GMO US Quality ETF launched just last month.

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Hancock, who has been the lead portfolio manager of the mutual fund since 2015 and a part of GMO since 1995, finds it intriguing that companies like Microsoft and Apple, often perceived as widely held, may not be as crowded as one might think. Despite their popularity, these tech giants are retained in the portfolio based on the belief that their valuations remain reasonable.

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This perspective may assuage concerns that the significant rise in big tech stocks may have gone too far, fueled partly by speculation that the Federal Reserve will orchestrate a gentle economic landing and initiate interest rate cuts early next year. The Nasdaq 100 Index, a notable proxy, has surged by 44% this year, reminiscent of the gains observed in 2020 when the Fed's near-zero rates triggered a fervent surge in trading activity.

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The GMO fund has positioned the majority of its holdings, approximately 90%, in consumer staples, technology, and healthcare. It maintains an underweight position in industrial and financial stocks and, notably, has steered clear of telecom, utilities, and energy companies for the past four years. According to data compiled by Bloomberg, the fund has outperformed over 90% of its peers on a one-, three-, and five-year basis.

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Despite the remarkable rally this year, the managers of the GMO fund remain optimistic about the future prospects of Apple, Amazon.com Inc., Google-owner Alphabet Inc., Facebook-owner Meta Platforms Inc., and Microsoft Corp. – collectively known as the Magnificent Seven. The two exceptions are Nvidia, viewed as overly expensive, and Tesla, considered lacking a robust competitive edge.

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Hancock's strategic move to acquire Amazon in 2022, when its stock price was halved, reflects the fund's penchant for identifying established businesses whose shares have been battered during market sell-offs. The investment strategy involves accepting higher valuations if the projected profit trajectory justifies such premiums.

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In the preceding year, the fund was tilted towards seemingly undervalued quality stocks. However, as growth equities faced a sell-off, the investor increased exposure to some of the megacap names in the market.

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Hancock elucidated the GMO approach to value, emphasizing a comprehensive understanding of intrinsic value that acknowledges the premium deserving of quality characteristics. He stressed the belief that paying a higher multiple for companies capable of achieving high returns on capital represents good value.

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Throughout its history, the fund has consistently invested at least 75% of its assets in U.S. stocks, with the remaining holdings primarily in European multinationals. Some of the fund's top-performing investments include UnitedHealth Group Inc., Oracle Corp., and Eli Lilly & Co. Hancock concluded by emphasizing the fund's focus on both stock valuation and business quality, steering away from overly hyped investments in favor of sustained, prudent choices.