Bargain, Value Trap or Something in Between? (Ben Inker and Anna Chetoukhina)

GMO's asset allocation team contends that U.S. large value equities have reached historically extreme cheapness—trading at the 7th percentile versus their own history—and are positioned to outperform after a decade of underperformance driven by falling valuations rather than deteriorating fundamentals. The firm argues that value stocks' underlying businesses remain sound, with positive fundamental returns persisting across historical periods, making them attractive especially in long/short portfolios where stock-specific risk can be controlled. U.S. small caps present a more complicated picture. While also trading at unusually low valuations relative to history, the team finds that falling relative valuation is partly justified by deteriorating profitability, increasing leverage, and slowing growth stemming from fewer IPOs and an aging cohort of public firms. The average age of small cap firms has risen roughly 15 years since the early 2000s as venture capital pools have delayed company maturity at IPO, reducing the dynamism of the small cap universe. Where GMO owns small caps, the firm emphasizes higher-quality businesses to mitigate these headwinds. China presents the most cautious case. Though valuations appear mildly attractive and China is the cheapest major market globally, the team identifies a troubling shift in fundamentals: after delivering world-leading returns from 2005–2014 driven by 17.5% real growth, China's fundamental returns have collapsed to -4.5% over the past decade. The deterioration stems from slowing growth (now 4.6% real), persistent shareholder dilution at -2.6% annually, and a -6.3% annual drag from index rebalancing as higher-valuation companies enter indices and free-float changes favor expensive sectors. Structurally, China's investment rate remains near 40%—far above peers—despite slowing GDP growth to 5%, a recipe for continued return-on-capital erosion. Geopolitical risks around Taiwan and regulatory uncertainty add further caution.