A look at how one of the savviest money managers of our time plans to produce high returns -- with low risk. By Steven Goldberg, Contributing Columnist May 17, 2010 Jeremy Grantham is one of the very few market seers who accurately predicted both the 2007-09 market collapse and -- almost to the day -- the market’s bottom on March 9, 2009.The bad news is that Grantham has again turned bearish. In his latest market letter, the chief investment strategist at GMO, a Boston-based money-management firm, predicts that stocks will suffer “a second consecutive very poor decade.” Over the next seven years, as far out as the firm’s specific forecasts go, GMO anticipates dismal returns for virtually all kinds of stocks -- and bonds, too. But GMO says one class of stocks will come closest to matching the market’s long-term return, before inflation, of 6.5% annualized. What’s more, these won’t be the high-risk stocks of small companies or troubled financial firms that have paced the bull market so far. No, they’re high-quality, mega-cap stocks -- stocks of huge, growing companies with low debt, most of them household names. “This is a rarity in history, that the biggest of the big and the safest of the safe actually turn out to be the lowest-priced,” says Chuck Joyce, GMO’s lead manager for quality stocks. His team is currently focusing on stocks in the consumer-staples, health-care and technology sectors. GMO estimates that high-quality, large-capitalization stocks will return an annualized 5.8%, excluding inflation, over the next seven years. Throw in expected inflation of 2.5% and you get 8.3%. That compares with the U.S. stock market’s long-term return of just a bit less than 10% annualized. Advertisement Joyce’s top holdings in the four GMO Quality funds are a who’s who of American corporate royalty: Microsoft (symbol MSFT), Wal-Mart Stores (WMT), Johnson & Johnson (JNJ), Oracle (ORCL), Procter & Gamble (PG), Pfizer (PFE), Coca-Cola (KO), ExxonMobil (XOM), Chevron (CVX), PepsiCo (PEP) and Google (GOOG). What determines a high-quality mega cap? The most important measure of quality, Joyce says, is a company’s ability to produce a high and sustainable return on equity (ROE), a measure of profitability. To determine return on equity, you divide a company’s net income by its book value (assets minus liabilities). Most stock databases figure ROE for you. Joyce prefers companies with low debt and stocks selling at cheap prices. The shocker is that high-ROE mega caps are dirt-cheap compared with other stocks today. “The fund is purposely mega-cap because we believe that, generally, the biggest companies are the most attractive on value right now worldwide,” says Joyce. By what measure? “You pick the metric,” he replies. “You don’t need your abacus for these. It’s commonsense judgment. Just look at the business model. If you’re selling fizzy water for a lot of money, it’s probably a pretty good company.” Dividends aren’t the determining factor. “Dividends are wonderful and delightful things,” Joyce says. “But the problem we saw in 2008 is that dividends can disappear.” Advertisement What you won’t find in the GMO Quality funds are any financial companies, utilities or media stocks. Nor will you find many economically sensitive companies. Almost none of the companies in these industries boast high returns on equity, and those few that do tend to command high valuations. Unless you have at least $10 million to spare, you can’t invest in any of the four GMO Quality funds, which are designated by Roman numerals from III to VI. But that’s hardly a drawback. It’s easy enough to buy some of the individual stocks listed. Or, invest in a solid fund with a lower minimum that fishes in the same waters. My favorites are PrimeCap Odyssey Growth (POGRX) and Fidelity Contrafund (FCNTX), both members of the Kiplinger 25. A more defensive fund that matches up nicely with GMO Quality is Jensen (JENSX). Grantham has a long record of being right most of the time. He’s often stated that the biggest factor in his forecasts for the market and for types of stocks is the concept of “reversion to the mean.” That is, stock-market returns may wander much higher or lower than their long-term trend line for many years, but eventually they end up back at their average. Grantham thinks (and I agree) that stocks of many small companies and other lower-quality stocks are dancing on a high wire in today’s market. Mega caps (the 50 largest public companies, by one common definition) currently trade at an average of 15.6 times estimated 2010 earnings, while small caps trade for 18.8 earnings, according to the Leuthold Group. That’s the most that small-cap price-earnings ratios have exceeded mega-cap P/Es since Leuthold began tracking P/Es in 1983. And it defies common sense for small caps, which are inherently riskier than mega caps, to command much higher P/Es. Advertisement GMO currently estimates that small-company U.S. stocks will lose 1.9% annualized after inflation over the next seven years. Large U.S. companies (essentially, Standard & Poor’s 500-stock index) should return a meager 0.3%; large foreign companies, 3.2%; and small foreign companies, 0.8%. The only other bright spot: emerging-markets stocks, which GMO believes will return 4.7% annualized after inflation. As Joyce sees it, the numbers speak for themselves -- as does history: “I’ve been amazed that there’s such an appetite for high-risk stocks. After 2008, you’d think people would be saying, ‘Maybe there are some risks out there.’ ” The trick is patience. Money managers can lose their jobs for lagging their benchmarks. You don’t face that danger. My advice? Buy mega-cap growth stocks and hang on to them. Steven T. Goldberg (bio) is an investment adviser.