GMO's Cautious Founder Finds Some Stocks to buy

NEW YORK (TheStreet) -- Jeremy Grantham, founder of money manager GMO, gained a wide following after he made a series of on-target market calls.

In the late 1990s, he protected clients by urging them to stay away from high-priced stocks. Then, in 2007, he again warned about stocks being overpriced. The cautious stance enabled GMO's mutual funds to outperform peers during the financial crisis.

These days Grantham is still pessimistic about the outlook for most U.S. stocks, but he has a positive view on some sectors. Speaking at the recent Morningstar Investment Conference in Chicago, he said European stocks look cheap. Investors should also get decent returns from the emerging markets and high-quality stocks in the U.S.

Most of Grantham's mutual funds are aimed at institutions. But retail investors who want to follow his advice can try Wells Fargo Advantage Asset Allocation ( EAAFX), which is managed by GMO. The Wells Fargo fund invests in GMO's institutional funds. The portfolio manager varies the mix as GMO's outlook changes. During the past five years, the Wells Fargo fund has returned 1.6% annually, compared to a loss of 0.4% for the Standard & Poor's 500.

The Wells Fargo fund's biggest holding is GMO Quality VI ( GQLOX), which focuses on undervalued stocks with high returns on equity. Companies in the portfolio include such reliable performers as Microsoft ( MSFT), Johnson & Johnson ( JNJ) and Chevron ( CVX). The Wells Fargo fund also has a sizable stake in GMO International Core Equity VI ( GCEFX), which has 40% of its assets in European stocks such as French oil producer Total ( TOT) and British drug giant GlaxoSmithKline ( GSK).

To arrive at his market calls, Grantham looks at valuations and earnings prospects. He assumes that sectors with below-average prices will revert back to their normal ranges.

In the latest forecast, GMO projects that emerging markets stocks will return 6.7% annually above inflation during the next seven years. International large caps will return 6.1%. Grantham is wary of small-cap U.S. stocks and government bonds, which should not keep pace with inflation.

If you are inclined to dismiss the forecasts, consider GMO's predictions that appeared at the end of 2001. At the time, emerging market stocks had suffered through years of disastrous returns, and few investors were clamoring to try funds specializing in Asia and Latin America.

But GMO saw bargains and predicted that emerging-market stocks would return 9.4% annually above inflation in the next 10 years. The stocks did even better, returning 11.4%.

In 2001, the S&P 500 was sinking, but many investors still expected the benchmark to deliver the historical annual average of around 10%. GMO took an extremely bearish view, arguing that the S&P was wildly overpriced and would lose 1.0% annually after inflation. For the decade, the index returned 0.4%.

In his Chicago speech, Grantham told the audience to invest in resources such as oil and potash. He said the world is facing a huge shortage of land and commodities. "We are losing the ability to feed poor countries as we sit," he said.

Grantham said that prices of commodities had trended down for 100 years as mining and production facilities became more efficient. The decline stopped 10 years ago, and prices began skyrocketing. "The price of grain, fertilizers, metals, energy, oil, coal -- they all tripled," he said.

While some analysts have argued that the rise in commodities represents a temporary bubble, Grantham said prices would continue climbing because of rapidly growing demand from China and India. Last year China alone consumed 53% of all the cement used in the world and 47% of the coal.

"China has been growing at 10%," Grantham said. "That doubles demand in seven years, and quadruples it in 14 years."

Grantham cautioned that a bet on resources would not necessarily produce big gains in the next year. But by waiting patiently for years, investors should be rewarded.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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