Waiting for the fat pitch, or, The Joy of Cash

GMO North America | Europe | Asia-Pacific

Proprietary information – not for distribution beyond intended recipient.

February 2011

James Montier

GMO

Ted Williams: Last player to hit .400 (in 1941) Career Average of .344

Science of Hitting (1970)

GMO 2

The 7 Immutable Laws Of Investing

1.  Always insist on a margin of safety

2.  This time is never different

3.  Be patient and wait for the fat pitch

4.  Be contrarian

5.  Risk is the permanent loss of capital, never a number

6.  Be leery of leverage

7.  Never invest in something you don’t understand

GMO 3

Fortune’s 10 To Last The Decade – 2000 - 2010

0

10

20

30

40

50

60

70

80

90

100 Nokia, Nortel, Enron, Oracle, Broadcom Viacom, Univision, Schwab, Morgan Stanley, Genentech

Average PE @ purchase = 347x

The securities identified above represent a selection of securities identified by GMO and are for informational purposes only. These specific securities are selected for presentation by GMO based on their underlying characteristics and are not selected solely on the basis of their investment performance. These securities are not necessarily representative of the securities purchased, sold or recommended for advisory clients, and it should not be assumed that the investment in the securities identified will be profitable.

Source: Bloomberg, Datastream, GMO As of 30/6/10

GMO 4

GMO 7-Year Asset Class Return Forecasts*

6.5% Long-term Historical U.S. Equity Return

Estimated Range of 7-Year Annualized Returns

*The chart represents real return forecasts1 for several asset classes. These forecasts are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above.

Stocks Bonds Other

1 Long-term inflation assumption: 2.5% per year.

±6.5 ±7.0 ±6.0 ±7.0 ±10.5 ±4.0 ±4.0 ±8.5 ±1.5 ±1.5 ±5.5 ±6.5

Source: GMO

0.4%

-1.9%

4.9%

2.1%

-1.4%

4.1%

0.5%

-0.9%

1.4%

0.2%

-0.2%

6.0%

-4%

-2%

0%

2%

4%

6%

8%

U.S.equities

(large cap)

U.S.equities

(small cap)

U.S. HighQuality

Int'l.equities

(large cap)

Int'l.equities

(small cap)

Equities(emerging)

U.S. Bonds(gov't.)

Int'l. Bonds(gov't.)

Bonds(emerging)

Bonds(inflationindexed)

U.S.treasury

(30 days to2 yrs.)

ManagedTimber

Annu

al R

eal R

etur

n O

ver 7

Yea

rs

As of December 31, 2010

GMO 5

0

2

4

6

8

10

12

14

16

1798

1806

1814

1822

1830

1838

1846

1854

1862

1870

1878

1886

1894

1902

1910

1918

1926

1934

1942

1950

1958

1966

1974

1982

1990

1998

2006

%

U.S. 10-Year Bond Yields – A Return-Free Risk?

Source: GMO As of 10/5/10

GMO 6

What Happened To Bonds 60 Years Ago?

Source: Global Financial Data, Federal Reserve, BLS, GMO As of 31/12/09

Cumulative Real Returns on T-Bills and T-Notes

1

10

20 24 28 32 36 40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08

1920-1940T-Notes +6.4%T-Bills +3.7%

1941-1981T-Notes -1.9%T-Bills -1.0%

1982-2009T-Notes +6.6%T-Bills +2.0%

Dec-

GMO 7 Source: GMO

Bonds – A Simple Valuation Approach

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Fair Value Current Yield

Perc

enta

ge

Real Yield

Expected Inflation

Inflation Risk Premium

GMO 8

Bond Risk Premium

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

Source: GMO, Federal Reserve

GMO 9

Is The U.S. Turning Japanese?

Bond Yield Agnostic

Probabilities Market Implied

Normal 5.0 0.5 0.25

Japan 1.0 0.25 0.5

Inflation 7.5 0.25 0.25

Expected Yield 4.6 3.5

Source: GMO

GMO 10

Valuation Matters

Source: GMO

U.S. Govt. Bonds (1926-2010)

0

1

2

3

4

5

6

7

8

9

2.8 4.0 5.2 7.6Starting Yield

Retu

rns

(% p

er Y

ear)

Nominal ReturnsReal Returns

GMO 11

The Fed Model: The two ugly step-sister problem

0

5

10

15

20

25

1925

1928

1932

1935

1939

1942

1946

1949

1953

1956

1960

1963

1967

1970

1974

1977

1981

1984

1988

1991

1995

1998

2002

2005

2009

Warning: A statistical anomaly

Source: GMO As of 12/1/11

S&P500 Earnings Yield

10Y bond yield

GMO 12

Everyone loves equities…

Source: BoAML FMS, Feb 2011

GMO 13

And hates cash!!

Source: BoAML FMS, Feb 2011

GMO 14

GMO Fear and Greed Index

Source: GMO

-4

-3

-2

-1

0

1

2

3

Jan-

86

Jan-

87

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Irrational exuberance

The depths of despair

GMO 15

Paltry payment for risk

Slope of the risk return line

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Jun-

05

Sep-

05

Dec

-05

Mar

-06

Jun-

06

Sep-

06

Dec

-06

Mar

-07

Jun-

07

Sep-

07

Dec

-07

Mar

-08

Jun-

08

Sep-

08

Dec

-08

Mar

-09

Jun-

09

Sep-

09

Dec

-09

Mar

-10

Jun-

10

Sep-

10

Dec

-10

Equilibrium Slope

Take More Risk Than Normal

Take Less Risk Than Normal

Short Risk

Source: GMO As of Feb 11

GMO 16

S&P 500: Building A 7-Year Estimate

The chart includes forecasts that are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above.

+ + + =

Source: GMO As of 31/12/10

Components of annual return of S&P 500, with regression over 7 years

-2.6%

3.6%

0.4%

2.3%

-2.7%

-4%

-2%

0%

2%

4%

Loss from P/EContraction

Loss from MarginDecrease

Gain from SalesGrowth

Dividend Yield

Total Return

P/EProfit

MarginDividend

Yield1926-1999 14.0 4.9% 1.8% 4.3%Averages

Starting 18.1 7.3% 1.9% 1.8%Levels

Assumption for 15.0 6.0% 3.6% 2.3%Next 7 Years

Real Sales per Share Growth

(Terminal Value)

(Terminal Value)

GMO 17

S&P500 Graham and Dodd PE

In the top decile of expense

0

10

20

30

40

50

60

1881

1885

1890

1895

1899

1904

1909

1913

1918

1923

1927

1932

1937

1941

1946

1951

1955

1960

1965

1969

1974

1979

1983

1988

1993

1997

2002

2007

GMO 18

Where would Ben Graham be shopping today?

% of stocks passing Graham’s deep value screen (Large Cap)

0

5

10

15

20

25

UK Europe US Japan Asia

Current Jan-10

Mar-09 Nov-08

Source: GMO

GMO 19

High Quality: Building A 7-Year Estimate Components of annual return of high quality stocks, with regression over 7 years

0.5%

2.5%

4.9%

2.1%

-0.2%

-2%

0%

2%

4%

6%

Gain from P/EExpansion

Loss from MarginDecrease

Gain from SalesGrowth

Dividend Yield

Total Return+ + + =

The chart includes forecasts that are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above.

*Return on equity as calculated by GMO. High Quality: Top 250 stocks ranked by quality in the largest 1000. Source: GMO As of 31/12/10

P/EProfit

Margin*

Real Net Worth per Share

GrowthDividend

Yield

Starting 16.6 13.2% 1.9% 1.7%Levels

Assumption for 17.3 13.0% 2.5% 2.1%Next 7 Years (Terminal

Value)(Terminal

Value)

GMO 20

US Mega Caps Are Cheap(ish), Small Caps Aren’t!

Source: Thomson Reuters Datastream

Mega Caps

Small Caps

0

5

10

15

20

25

30

35

40

45

50

Feb-

78

Feb-

79

Feb-

80

Feb-

81

Feb-

82

Feb-

83

Feb-

84

Feb-

85

Feb-

86

Feb-

87

Feb-

88

Feb-

89

Feb-

90

Feb-

91

Feb-

92

Feb-

93

Feb-

94

Feb-

95

Feb-

96

Feb-

97

Feb-

98

Feb-

99

Feb-

00

Feb-

01

Feb-

02

Feb-

03

Feb-

04

Feb-

05

Feb-

06

Feb-

07

Feb-

08

Feb-

09

Feb-

10

GMO 21

Emerging Equities: Building A 7-Year Estimate Components of annual return of emerging equities, with regression over 7 years

2.5%

4.1%

-1.3%

-0.4%

3.4%

-2%

0%

2%

4%

6%

Loss from P/EContraction

Loss from MarginDecrease

Gain from SalesGrowth

Dividend Yield

Total Return

P/EProfit

Margin

Real Sales per Share

GrowthDividend

YieldStarting 14.6 5.6% 2.1%

Levels Assumption for 13.3 5.4% 3.4% 2.5%

Next 7 Years (Terminal Value)

(Terminal Value)

+ + + =

The chart includes forecasts that are forward-looking statements based upon the reasonable beliefs of GMO and are not a guarantee of future performance. Actual results may differ materially from the forecasts above. Source: GMO As of 31/12/10

GMO 22

Emerging Markets – oh what a fickle world! Talk about the momo tribe

Source: BoAML FMS, Feb 2011

GMO 23

Emerging Valuations (PE, x) Take your pick

0

10

20

30

40

50

60

5y G&D

10y G&D

Source: GMO As of 12/1/11

GMO 24

A Conservative Estimate Of Fair Value

Source: GMO

80

100

120

140

160

180

200

2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Implied dividends Historical dividends

Implied dividends

Intrinsic value

GMO 25

Implied Dividends Are A Useless Forecaster Of Actual

GMO 26

Conclusions

Those with the enterprise lack the money and those with the money lack the enterprise to buy stocks when they are cheap – Ben Graham

•  You need both cash and courage •  ‘Investors’ today are acting with a surfeit of the latter, and a

dearth of the former •  Remember the sage words of Winnie the Pooh – Never

underestimate the value of doing nothing!

GMO 27

Final thought

GMO 28

Performance data quoted represents past performance and is not predictive of future performance. The foregoing does not constitute an offer of any securities for sale. Returns are presented gross of management fees, net of transaction costs and include the reinvestment of dividends and other income. If these expenses were deducted performance would be lower. For example, if the strategy were to achieve a 10% annual rate of return each year for ten years and an annual advisory fee of 0.75% were charged during that period, the resulting average annual net return (after the deduction of advisory fees) would be 9.25%. A GIPS compliant presentation of composite performance has preceded this report in the past 12 months or accompanies this presentation, or is also available at www.gmo.com. Actual fees are disclosed in the Prospectus for each fund and are also available in each strategies compliant presentation. Performance is shown compared to broad-based securities market indices. Broad-based indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly into an index.

Disclaimer

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