Morningstar Advisor - October/November 2010 - 42

Morningstar Conversation

FPA Crescent FPACX
$14K

that. But we can think of other companies where it’s not going to be as easy as that.
Leggio: Ben, I assume you think that margin levels are sustainable for high-quality firms.
Morningstar Moderate Target Risk

a sign that people are a bit less worried about deflation than they are now. But certainly, if we’re going to wind up with bond yields of 8% or 9%, associated with a real inflation scare, we would have to think stocks may well trade cheaply under those circumstances. Now, because we think that most stocks are real assets, that would provide a nice buying opportunity, and it looks like investors tend to demand a higher rate of return when there’s inflation, or don’t quite understand the positive impact that inflation will have on corporate cash flow. So, if we’re buying assets at fair value or better and we’re worried a little bit about inflation, it’s not that big a deal. The more confident we are that inflation is going to get out of hand, the more we would want to wait for a really good buying opportunity— not something trading at fair value, but something trading at a 25% or 35% discount to fair value. Today, we don’t see anything that is trading at a 25% to 35% discount to fair value, with the possible exception of dividend swaps in Europe, which is a pretty esoteric asset class.
Leggio: GMO’s long-term inflation assumption is still 2.5%, which is where it’s been for a number of years now. Inker: Yes. Honestly, we don’t think we’re good

Category Moderate Allocation Morningstar Rating

Expense Ratio (%) 1.17 5-Yr Anl Total Rtn (%) 4.40 10

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Inker: Yes. One of the things that scares us a little bit is that the past 12 to 15 years have been a pretty good time to be a company from a margin perspective, whether you’re looking at return on sales or ROE, or what have you. We have been in a pretty good place. But it has affected the high-quality guys less than the rest of the market. So today, we think that their margins are probably just about normal.

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GMO Global Balanced Asset Allocation GMWAX
$14K Morningstar Moderate Target Risk 12

Category World Allocation Morningstar Rating

Expense Ratio (%) 0.50 5-Yr Anl Total Rtn (%) 4.01 10

I do want to say one thing with regard to stocks versus bonds. The thing about bonds is that they’re nominal instruments. So they hate inflation and they love deflation. The way we think about it is that stocks are real instruments, but there’s a strong behavioral aspect to valuations. Investors in stocks do not like “flation”—they don’t like inflation, they don’t like deflation. So right now, we have bond yields that look to us as being consistent with mild deflation. As near as we can tell, stock-market investors are happy with nice, stable inflation of around 2%, or maybe 2.5%. As you get further away from that, either up or down, they get increasingly less happy. If we got rising interest rates because people stopped being quite so scared about a double dip and thought that deflation was off the table, and we got bond yields going back up into the fours and maybe as high as five, it’s not clear to us that stocks would care that much. Now, if we get deflation on its way to inflation, that would probably be a bad thing for stock valuations, because stocks around the world generally tend to trade at lower P/Es when we’ve got high inflation, just as they tend to trade at lower P/Es when we’ve got deflation. So we’re not worried that if the 10-year goes from 2.5% to 3.5% stocks would fall. We think it’s as likely under those circumstances that stocks might rise, because it might be

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5-Yr Anl TR % Rank Cat 37

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at predicting inflation, which is probably why our inflation forecast has stuck around 2.5% for a long time. We don’t think the market is particularly good at predicting inflation either. So we’re not too impressed by how low bond yields are. We don’t think that means that the bond market knows that we are headed for a Japan-style event.

from rising inflation. Aon is in the insurance business but without the underwriting risk. They are just brokers. So if a building costs more to replace in 10 years, they benefit—annually. They’ve basically got a tithing. It’s a tax on economic activity. They also have a couple billion dollars sitting around on the balance sheet. If interest rates go up, then they’re going to get a higher return on

Thriving or Just Surviving?
Leggio: You have a few stocks in common. Steve, you mentioned Johnson & Johnson, but there’s also Kraft KFT, Wal-Mart WMT, and Anheuser-Busch InBev BUD. To your concern about rising rates, and maybe even the worst

42 Morningstar Advisor October/November 2010

Morningstar Advisor - October/November 2010

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