By Ian Salisbury
This hasn't been a great market for so-called quality stocks, typically defined as blue chips with steady profits and low debt. That makes it all the more impressive that funds run by GMO's Tom Hancock have consistently outperformed not just other "quality" portfolios but the broad market, too.
The $12 billion GMO Quality III mutual fund returned 15.6% annually over the past decade, compared with 14.4% for the S&P 500 index. The $3 billion GMO U.S. Quality exchange-traded fund doesn't have as long a record, as the ETF launched in November 2023. But it has outpaced the index so far in 2025. Hancock oversees both funds with co-managers Anthony Hene and Ty Cobb.
Hancock's team has succeeded, in part, by making bold calls. The team's mutual fund has about 41% of its assets invested in technology, compared with 33% for the S&P 500. But Hancock isn't just a trend follower. The fund has also made contrarian bets on out-of-fashion sectors such as healthcare and consumer staples.
Hancock recently talked with Barron's about where he sees the biggest opportunities in today's market. An edited version of the conversation follows.
Barron's : Quality is often in the eye of the beholder. How do you define it?
Tom Hancock: What we're trying to get at with quality is companies that can earn a high return on capital sustainably, and reinvest in the business. GMO in its early days was built around value managers. They were looking for low price-to-book-type stocks.
The idea of quality came from asking, what are the characteristics that make a stock trade at a premium multiple? We want to pay up for stocks that deserve it. That said, we still look for quality at a reasonable price. We are trying to avoid great companies that everyone knows are great and thus trade at superhigh multiples. Those don't give us high returns.
GMO has a reputation not just for value, but also for bearishness. Co-founder Jerermy Grantham, in particular, is known for saying for years that the stock market is overvalued. Do you feel the same way?
That is the GMO brand for people who know the firm casually. They think of us as bearish. They sometimes think of us as quantitative, and strongly value-oriented. None of those descriptions quite applies.
I am not as bearish on the U.S. market right now as Jeremy or his successors, such as Ben Inker [GMO's co-head of asset allocation and a portfolio manager]. We don't have a chief investment officer at GMO. We operate as a bunch of different boutiques that sometimes have views that are different from one another.
A lot of people talk about market multiples, or the market's price/earnings ratio, being nearly as high as it has ever been -- as high as the tech bubble, or variants of that. A lot of that talk ignores the changing composition of the U.S. stock market. Many stocks aren't trading at superhigh multiples. It's just that there are a lot more high-quality growth stocks in the market than there were 20 or 30 years ago, so the overall market should trade at a higher multiple than it once did. I don't think the valuation is insane.
You have a much higher weighting in tech stocks than the S&P 500, which has driven some of your recent strong returns. To put you on the spot, are we going to have an AI crash?
If you close your eyes and wake up in 10 years, AI will turn out to have been a good place to invest. At the same time, I'd be surprised if we don't get some kind of significant downturn in AI-related stocks. Crash is a strong word. But I don't have any great view about when that will be.
If you don't invest in AI just because there might be a crash in the next five years, you run the risk that stocks will double before they pull back, say, 30%, and you will have missed the doubling. So, I'd rather be involved, as long as we're buying stocks that can survive the pullback.
If you look at which AI stocks we own, they're the ones we believe are safer. They have more-diversified businesses. They don't have financial leverage. We sold our Oracle shares, which we had held for more than a decade, [due to] the kind of debt the company has taken on. [ Oracle recently borrowed $18 billion to expand its AI infrastructure after agreeing to provide computer power to OpenAI.]
Even if Oracle's revenue is guaranteed verbally by OpenAI, OpenAI is writing checks on which it doesn't have the money to pay right now. Even if OpenAI's technology is great, there is an existential risk to the company.
Your top holding now is Microsoft. Why do you favor the company?
Tech is part of the reason why we have outperformed our quality peers. At the same time, our tech holdings are less volatile than the tech you will find in an index. We own the tech stocks that are most defensive in terms of diversified revenue and customer lock-in -- like Microsoft.
Microsoft is an AI beneficiary but gets a lot of revenue from other things. It has been relatively conservative about its capital spending. If there is a pullback on AI, it isn't going to be great for Microsoft. The stock will go down, but it will go down less than some of its peers, and the company won't be impaired in any long-term way as a business.
Other tech stocks we own include Lam Research and Broadcom. These are more high beta. They tend to be our best or worst performers on any given day, but both companies have a lot of diversification beyond AI. We don't own Nvidia, in some ways a competitor to Broadcom.
Broadcom specializes in custom chips; it makes chips for a handful of the biggest companies, such as Google. Those big companies have already figured out a way to monetize AI. They use AI for search and to deliver content for YouTube. These are proven use cases.
I would contrast that with Nvidia, which will probably be great in the long run. But right now, everyone in the world is trying something with AI. They are just throwing stuff against the wall, and using generic chips from Nvidia. That's a lot more risky than having the hyperscalers as your customers, which Broadcom has.
Your other big bet is on healthcare, not a standout sector this year. What is the attraction?
We see healthcare spending growing faster than gross domestic product. Sometimes, people show us charts with healthcare spending rising as a percentage of GDP, and that looks unsustainable, but we think it is sustainable. We are a rich country, and it is a richer and richer world. We are getting older, and there is a lot of innovation in healthcare. And it isn't like we are paying more for the same things. We have cancer treatments and GLP-1s and Covid vaccines and all these things we didn't have 10 years ago.
At the same time, thanks in part to Covid, there has been a lot of short-term disruption, and this is still working itself out. The area where we are exposed -- the area with maybe the biggest profitability issues right now -- is health insurance. We own three of the stocks in that group: UnitedHealth Group, Elevance Health, and Cigna.
What has hurt profitability?
One example of what happened relates to Medicaid, the government program to cover lower-income people. During Covid, eligibility was expanded to meet the state of emergency. Usually, there is an income-verification process to make sure you're eligible. That was suspended, so the number of people on Medicaid expanded, which was good.
After Covid ended, the verification resumed. Most people who had jobs were no longer eligible, so membership went down. The people who were ineligible were healthier, and they hadn't been using the benefits as much, so they were cheaper for the system to cover. When those people left the system, the Medicaid population shrank and the cost of insuring the people who remained increased. This will correct itself. The states that administer Medicare reimburse the insurance companies, but there is a catch-up phase.
You also own drug companies such as Eli Lilly, Johnson & Johnson, and Merck. What is the outlook for pharma?
Large-cap pharma is an interesting area. Investors tend to be very negative about it because they always see patent cliffs. Any patented drug will go off patent at some point. That is true of almost any patented product in any industry -- patent protection doesn't last forever. But it is so much more explicit in pharma, so people focus on it.
At the same time, many pharma companies have been around a long time. They have a proven ability to reinvent themselves. They engage in research and development, and acquire it, too. In many cases, you need to be a big pharma company to get treatments through the regulatory approval process, which is complicated. A small biotech coming out of a university can invent a new drug, but often can't commercialize it. You need large-cap pharma.
Eli Lilly has created blockbuster GLP-1 drugs [diabetes and weight-loss treatments] and made a lot of money on them. Prices are coming down, and the traditional pharma investor will see that as a bad sign. But GLP-1s are also more of a consumer product, a traditional "revenue equals price times volume" product. If we lower the price, we can increase the volume. This is a rational economic tradeoff. People are reacting because they see that prices have started to come down, but they are underestimating just how big this market can be.
Johnson & Johnson and Merck don't have that kind of exciting growth engine right now. Some of their patents are slated to expire. There is a line of sight to the expiration of Merck's patent on Keytruda, its big cancer drug. Earnings will probably fall when that happens. But that is OK if the stock is cheap enough relative to expected earnings, and we think that is the case. [Merck is trading for 11 times next year's expected earnings of $8.82 share.]
J&J's immunology drug Stelara went off patent earlier this year, but the company is highly diversified. It's showing an ability to grow even through a meaningful patent cliff. The patent fear is overdone.
Consumer-goods companies have also struggled. Do you see bargains in the sector?
The U.S. consumer, a longtime source of strength for these companies, has had a tough time lately, particularly lower-income households. We are a little more picky in the category, because we want to find companies where there is still a certain amount of growth.
Going back to GLP-1s, they have curbed the public's appetite for some snack foods. We like Coca-Cola better than PepsiCo, which gets about half of its revenue from salty snacks. We expect the beverage category to be stronger than the food category, and think Coke can expect reasonably good growth.
One of our most contrarian positions is alcohol companies such as Constellation Brands, which makes Modelo and Corona beer. While alcohol hasn't been a great category, those brands were doing well until about a year ago, when sales declined due to the Trump administration's immigration crackdown. People are developing narratives around changing behaviors, saying, among other things, that young people don't drink anymore. In reality, these types of trends are much more tied to the economic cycle.
Your portfolio has no basic materials, real estate, energy, or utility stocks. Why are you skipping whole sectors of the stock market?
The way you beat a benchmark over time is to run a fund that doesn't try to look like the benchmark. You try to find areas of the market that you think will be winners, and invest there. You don't want to put all of your eggs in one basket, but as long as you have several baskets, you don't need to have every single basket.
We focus on having a portfolio that might lag in rising markets, but won't lose to the benchmark in down markets. We think that is what people who invest in a quality strategy are looking for.
Thanks, Tom.
Write to Ian Salisbury at ian.salisbury@barrons.com
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December 11, 2025 02:00 ET (07:00 GMT)
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