Equity Dislocation is designed to profit from the ongoing extraordinary dislocation between value and growth stocks. Launched in October 2020, the strategy consists of 100% long positions in cheap value stocks and 100% short positions in expensive growth stocks. Although the portfolio’s long and short positions differ significantly from market indices, the baseline expectation is that equity dislocation will deliver positive absolute returns when value outperforms growth stocks. When value underperforms growth stocks, it is reasonable to expect negative returns. The strategy’s realized performance has far exceeded this naive baseline.
Since its launch, Equity Dislocation has delivered an impressive return of 55.3% before fees (42.6% after fees), while MSCI ACWI Value has lagged MSCI ACWI Growth by 1.2%. The two series showed similarly positive results through the end of 2022. However, since 12/31/2022, MSCI ACWI Value has underperformed MSCI ACWI Growth by an incredible 36.2%, while Equity Dislocation has delivered a positive 10.7% before fees (7.3% after fees) over the same period. 1
How has Equity Dislocation been able to deliver such differentiated performance since the end of 2022? Our approach has not changed significantly since its inception. The difference in realized returns compared to passive value performance can be attributed to three main sources, as shown in Figure 2: 2
- GMO’s proprietary price-to-fair-value model for valuation assessment (+13.1% return)
Equity dislocation is not simply about buying stocks with the lowest multiples and selling stocks with the highest multiples. We perform a sober assessment of each company’s fundamentals, including quality and growth potential, to select stocks that are truly mispriced relative to their fair value. Two design elements distinguish our model:
- A better starting point: We recalculated the accounting data for each company to determine GMO’s proprietary economic book value and economic return, which are more aligned with true fundamentals. For example, we capitalize costs associated with intangible assets and then amortize those costs at a rate linked to the asset’s economic life.
- Better forecasts: We use a multi-factor approach to forecast each company’s profitability over the next 20 years, including an estimate of ultimate profitability. Forecasts are customized for each individual company and incorporate information on quality and growth characteristics from a range of sources.
GMO’s price to fair value metric estimates current fundamental value and future growth potential much better than traditional indexes, which has been particularly impactful in the strategy’s short book. Equity Dislocation’s short positions have seen a 12% cumulative decline in their expected book value since the end of 2021, compared to a 22% cumulative gain for MSCI ACWI Growth. In addition, the growth in future book value of Equity Dislocation’s long positions has outpaced the growth in book value for MSCI ACWI Value (+27% vs. +19%); most of this lead has occurred since the beginning of 2024. When we compare price to our fair value estimate, we sort stocks into cheap and expensive, which is very different from MSCI’s view of “value” and “growth” stocks.
- Low value and extreme growth instead of broad value and broad growth (+24.2% return)
Once we have our own categorization of stocks, we don’t just buy all value stocks and short all growth stocks. Today’s value opportunities are best captured at the extremes, so we also use our price-to-fair-value model to identify the most serious mispricings: the very cheapest value stocks (say the cheapest 20% or “deep value” opportunities) and the most expensive growth stocks (say the most expensive 20%). These segments are particularly mispriced historically and are best positioned to deliver excess returns in a reversal scenario. Consequently, equity dislocation focuses capital on the best opportunities identified by the price-to-fair-value model and allocates little capital to companies that we believe are only slightly mispriced or trading close to fair value.
- Strategy design & risk control (+15.7% return)
When developing the strategy, we made a specific decision to limit active bets other than value vs. growth. We implement limits on the size of individual positions, as well as on net sectors, industries, countries and currencies, and balance market capitalization risk across long and short positions. While these limits primarily serve as a risk control measure and a way to align the portfolio with our top-down insights, they have proven useful during a period when certain industries (e.g., technology) and securities (e.g., the Magnificent Seven) have been unusually dominant.
Despite the strategy’s excellent performance to date, value remains wonderfully cheap (top decile historically). We expect value needs to outperform growth by 60-70% globally for relative valuations to return to long-term average levels. We expect decisions like those above to continue to benefit our portfolio beyond this beta opportunity. As a result, equity dislocation remains the largest single exposure in our benchmark-free allocation strategy at nearly 20%.
