Cautious Grantham hopes timing is better

Jeremy Grantham staked out familiar ground this month, scaling back risk in a market that his firm, Grantham Mayo Van Otterloo & Co. LLC, argues is once again on the cusp of bubble territory.

This time, however, the veteran of bubbles past expects his firm to suffer relatively modest fallout from being cautious too early.

In a May letter to clients, Mr. Grantham conceded there've been times over the past four decades when his propensity for getting out of overpriced markets too soon has “damaged the financial well-being” of money management firms he has served at — most recently when he bet against the tech bubble 2½ years before it burst in March 2000.

Over three torrid years through Dec. 31, 1999, during which the S&P 500 benchmark roughly doubled, client defections left GMO's assets under management mostly treading water at between $25 billion and $27 billion.

“We often arrive at the winning post with good long-term results ... but not necessarily with the same clients that we started out with,” the client letter noted.

In a recent interview about the firm's prospects in the current buoyant market, Mr. Grantham said, “I'm hoping I'm a little more accurate this time in the timing.”

For the past nine months, Mr. Grantham admitted to uncharacteristically, if incrementally, “going with the flow” — leaving two percentage points more in equities in GMO's asset allocation strategies than pure value considerations would have called for, in homage to the U.S. Federal Reserve's powers to puff up the market.

But a recent string of negative developments — including Japan's devastating earthquake and tsunami, and surging oil prices — on top of the looming end to the Fed's quantitative easing program, convinced GMO to “take that back off the table” in May, and be “strictly conservative,” said Mr. Grantham.

While admitting GMO's minor deviation from strict value rectitude left him feeling “slightly wicked,” Mr. Grantham concluded, “It was nice. It made us a bit of money, which we're happy to bank.”

Even with those experiments in timing, however, Mr. Grantham said — in light of the ability of markets to levitate above fair value for three years or so in great bull markets, like the current one — GMO could once again prove to be a year or two early.

The S&P 500, at its May 27 close of 1,331.10, remains dangerously overpriced, compared to GMO's fair value estimate of 925, but if history is any guide, it's “perfectly capable of rallying quite a bit more for another year,” said Mr. Grantham. Despite recent negative developments, he said he still sees a better than 50% chance the market will barrel ahead another 20%, “deep into bubble territory.”

Since the market's meteoric rebound started March 9, 2009, a few of GMO's biggest strategies have been giving back some of the strong outperformance they racked up when markets imploded in 2008.

The $16.8 billion GMO Quality Strategy, which focuses on the blue-chip U.S. companies Mr. Grantham and his colleagues have cited as defensive plays, trailed its S&P 500 benchmark by nine percentage points in 2010 and six points in 2009, after besting it by 13 points in 2008, according to Marietta, Ga.-based data tracker eVestmentAlliance. For the first quarter of 2011, the strategy continued to lag 2.3 points behind the benchmark.

GMO's $3.8 billion Global Allocation Absolute Return strategy, meanwhile, trailed its S&P Global Broad Market index benchmark by 3 points in the first quarter of 2011, 11 points in 2010 and 23 points in 2009, after besting it by 37 points in 2008.

Even so, there are signs that clients are responding to that recent underperformance in a more nuanced way, compared with GMO's experience during the tech bubble.

The company is clearly experiencing net outflows, with its year-end AUM of $106.8 billion unchanged from the year before, despite a more than 16% gain for broad U.S. equity benchmarks and just less than a 10% rise for non-U.S. equity benchmarks.

The strategies the firm lists on eVestmentAlliance's database listed combined gross outflows of $10.2 billion for 2010, but also inflows of $6.9 billion.

Despite its recent underperformance, the GMO Quality Strategy, for example, pulled in more than $800 million in 2010 and roughly $1.4 billion the year before. For the quarter ended March 31, another $65 million came in.

The Global Allocation Absolute Return strategy, meanwhile, saw outflows of $289 million in 2009, but net inflows of $900 million in 2010 and $750 million in the first quarter of 2011, according to eVestmentAlliance.

Asked about the ability of the GMO Quality Strategy to garner inflows in the face of lagging performance, Mr. Grantham noted that, from the S&P 500's peak in October 2007 through its trough on March 9, 2009, the strategy dropped 38%, 16 points less than the broader index. Even with the past two years' underperformance, investors in the strategy remain ahead of the index, he noted.

The inflows for GMO Quality — from sophisticated investors “who know exactly what they're trying to do” — probably are more a reflection of the scarcity of “risk-off bets,” a defensive investment that allows investors to lower their risk profile, in anticipation of market declines, than evidence of some broad difference in the environments facing GMO in the late 1990s and today, said Mr. Grantham.

Still, he conceded that clients — cognizant of GMO's calls on past bubbles — probably are being a little more patient with the firm in the face of its current underperformance. In the late 1990s, clients had “no evidence that we would get it right,” but in light of GMO's performance after the tech bubble and during the market debacle of 2008, there are some “splendid examples” to weigh against doubts about the firm, Mr. Grantham said.

Noting that the quality stocks he favors — both in the U.S. and abroad — tend to begin outperforming in the final stages of an extended market rally, Mr. Grantham said he's comfortable with how GMO is positioned for what he expects will be a final push by the market into bubble territory over the coming year.

Since April 1, those stocks “have come to life finally,” outperforming the S&P index by half a percentage point per week, on average, he said.

With that in mind, the GMO Quality Strategy remains an offering that investors who agree that the market is overextended can consider, Mr. Grantham said. If the market runs another 20%, then quality stocks should rise 25%, and in the likely post-bubble event of a 40% or more plunge back to fair value, the strategy would probably lose only 28% or 29%, he said.

GMO's latest forecasts for major markets call for the S&P 500 to suffer an annualized decline of half a percent a year over the next seven years. However, quality stocks — which account for roughly a quarter of that index's market cap — should buck that trend, with an annualized gain of more than 4%, said Mr. Grantham.