Friday, February 24, 2012

Jeremy Grantham's Quarterly Newsletter February 2012 Summary

Jeremy Grantham, GMO, has just released its Quarterly Newsletter entitled "The Longest Quarterly Letter Ever" a 15 pages report divided into 3 parts in contrast to his previous Letter "The Shortest Quarterly Letter Ever" with 4 pages only.

Part I: Investment Advice from Your Uncle Polonius
In the first part, which he could also have called "the 10 commandments of the individual investor", he gave 10 recommendations:
  1. Believe in history - Be patient and fair for assets to be at or below fair value
  2. Neither a lender nor a borrower be - Avoid leverage because it impacts an investor greatest asset: Patience
  3. Don't put all your treasure in one boat - If you diversify, your portfolio will be much more resilient
  4. Be patient and focus on the long term - Wait until markets are very cheap before making your move. Individual stocks usually recover, and markets always do.
  5. Recognize your advantages over the professional - Again, patience is your asset. Professional cannot wait to career and/or business risk (losing one's job or clients due to short term underperformance). You can afford to wait several years, professionals can't.
  6. Try to contain natural optimism - This is especially true for Australian and US investors that do not like to hear bad news
  7. But on rare occasions, try hard to be brave - You can't take bigger risks than professionals when markets are extremely mispriced even though it may come with pain in the short term.
  8. Resist the crowd: cherish numbers only - If you see your neighbors get rich during a bubble, do not jump on the wagon, follow some simple ratios that can help you estimate the markets over/udner valuation.
  9. In the end, it's quite simple.  Really - Workout simple ratios and follow them. For example, the meaning reversion of profit margins and price earnings ratios. GMO does that for the 7-year market forecast.
  10. This above all: To thine own self be true - Know yourself.  If you are easily influenced by others and cannot resist temptation during a bubble, you should NOT manage your own money.
Part II: Your Grandchildren Have No Value (And Other Deficiencies of Capitalism)

In the second section of the newsletter, Jeremy Grantham talks about the shortcomings of capitalism and how it focuses on short term gains and ignore long term pain. Examples are the current debt and resources depletion. The other problem is that capitalism buys (political) influence as was the case with tobacco companies that also insisted smoking tobacco was harmless, and now with energy companies that try to misinform the public and influence regulations.

The main problem, however, is capitalism inability to process finite resources and maintain rapid economic growth as it is mathematically impossible. Many people would cry foul if you say that a decline in population is necessary so that we can live peacefully. Some scientists also estimated that if Indian and Chinese were to catch the average American lifestyle, we would need 3 planets to live sustainably.

To conclude, he says that capital does thousands things better than other systems, but the 2 or 3 where it fails, could bring it down.

Part III: Investment Observations for the New Year

In the last part of the newsletter, he reflects on the year 2011 where most markets ended basically flat. Most equity markets are currently close to fair value, except the S&P 500 with expected returns of only 1% per year.

Overpricing exists in debt markets however. He sees great opportunities in avoiding duration in fixed income and recommend to underweight the most of the US market as a whole.
  • Inflation Hedges
 Although inflation is not an issue right now, it will certainly rear its ugly head soon enough.He recommends stocks, and especially things in the ground such as oild and copper as well as forestry and farmland. He also thins Gold may be a good hedge
  • Resources
Farmland has gone up a lot recently, especially in the US, and GMO is looking for opportunities in foreign markets.

On the other end, natural gas is dirt cheap and the natural gas to crude oil ratio (BTU equivalent) is now 14% which is the lowest in 15 year. Anybody with a brain should look into investing in natural gas. Unfortunately,  he did not give any specifics.

He also said that Gold producers look cheaper than Gold itself.
  • European Complexity
GMO could not comment on the European issue specifically because they do not consider themselves experts in "sovereign debt-regulation-political-monetary mess". However, one or two other companies  - which have a good track record on those issues - seem to be more worried than the rest of the market.

Finally, he gave GMO recommendations for the year ahead:
  • Heavily underweight U.S equities, but not the high quality quartile, which is almost fair price. Non-quality equities, in contrast, have a negative imputed 7-year return after their handsome rally in the last 3 months through to mid-February.
  • Slightly overweight other global equities, which are almost fair price, down from a little cheap at year end.
  • In total, be about neutral in global equities. Yes, there is more than our normal fair share of potential negatives lurking around, but on our data: a) most of the negatives are reflected in stock prices; and b) all fixed income duration is dangerously overpriced. This last situation is, of course, engineered by the Fed, which hopes to drive us all into taking more risk, notably by buying more equities. I hate to oblige, but at current equity prices it just makes sense to do what they want. As mentioned earlier, equities are also good long-term hedges against inflation.
  • Underweight as much as you dare long-term bonds, especially higher-grade sovereign bonds.
  • In the long term, resources in the ground, forestry, and agricultural land are attractive, but come with the usual caveats of the risk of short-term over pricing, so average in.
You can read the complete newsletter for free on GMO website.

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