NEW YORK ( TheStreet ) -- GMO's famously contrarian portfolio managers have been sticking to their guns.
At a time when markets have been soaring, the GMO funds have turned cautious. Instead of owning red-hot small stocks, the managers favor stodgy giants. As a result, most of the GMO funds trail their categories.
During the past five years, GMO US Core Equity III (GMUEX - Get Report) returned 15% annually, lagging 74% of peers in Morningstar's large blend category. Other funds that trailed more than 70% of peers include GMO Quality VI (GQLOX - Get Report) andGMO Benchmark-Free Allocation (GBMFX - Get Report).
Should shareholders jump ship? Not necessarily. In the past, the GMO managers have often proved prescient. During the roaring bull market of the late 1990s, GMO founder Jeremy Grantham told anyone who would listen that stocks were too expensive.
Avoiding highflying technology shares, he trailed until the market sank in 2000. Then the GMO funds surged to the front of the pack, and Grantham was hailed as a hero. He again protected shareholders during the financial crisis.
Even if GMO is wrong about its latest forecast, the funds could still be worth considering because they provide diversification. Ranking among the least volatile choices in their categories, the funds have excelled in downturns. By avoiding big losses, the GMO funds delivered competitive long-term returns. During the past 10 years, GMO Benchmark-Free Allocation returned 9.3% annually, outperforming 85% of peers.
Most of the GMO funds are designed for institutions. Retail investors who want to follow the approach can buy Wells Fargo Advantage Asset Allocation (EAAFX - Get Report), which is managed by GMO. During the past 15 years, the Wells Fargo fund returned 7.2% annually and outperformend 76% of peers in the world allocation category.
The GMO strategy is based on the idea that stock valuations always revert to their long-term averages. When prices are high, they must sink eventually. GMO bases allocations on forecasts for the performance of assets over the next seven years.
In December 2010, the managers were convinced that prices of small-cap stocks were excessive and predicted that the asset class would lose 1.9% annually during the next seven years. Since then, small blend funds have returned 14.7% annually.
But that strong showing has made the GMO analysts only more pessimistic. Now they predict that small stocks will lose 4.5% annually for the next seven years. U.S. large caps will lose 1.3% annually. The forecasters have a brighter outlook for the biggest high-quality stocks, which should return 2.3% annually.
In speeches and letters to shareholders, Grantham has long admitted that his approach can test the patience of shareholders. Because it is difficult to call market bottoms, GMO often moves well before stocks shift. Shareholders have been forced to wait patiently for several years while competing funds raced ahead.
Grantham has said that most investors lack the discipline to sit out bull markets. In the late 1990s, GMO lost most of its assets as shareholders tired of stubborn managers who refused to buy hot technology stocks.
In the current market, Grantham argues that the price-to-earnings ratio of stocks is above the long-term average. That has occurred partly because profit margins are at record highs and the Federal Reserve is providing stimulus.
Bulls say that margins can remain at historic highs because of lower tax rates and advances in productivity. That is hogwash, Grantham says. Soon enough the Fed will withdraw stimulus and profit margins will revert to historical trends.
Grantham concedes that stocks can continue rising for another year or two. But eventually margins will sink, and there will be another major stock crash.
To prepare for harder times, the GMO funds are emphasizing giant blue-chip stocks. GMO US Core Equity owns such high-quality stocks as Microsoft (MSFT - Get Report), Johnson & Johnson (JNJ - Get Report) and Procter & Gamble (PG - Get Report). Such behemoths sell at modest valuations, and they can withstand a downturn.
While the holdings of large blend funds have an average market capitalization of $45 billion, the figure for the GMO fund is $79 billion. GMOs holdings have above-average returns on equity and below-average debt levels. That should enable the fund to excel the next time stocks drop.
At the time of publication, the author had no position in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.