Jeremy Grantham's Q2 Letter: Outlining What Investors Should Buy

by: Devon Shire
Like many investors, I follow the investment actions of a short list of well respected professional value investors. Near the top of that list is Jeremy Grantham.
Grantham’s letters to investors are usually pretty depressing. He has a knack for spotting bumps in the road and rarely thinks stocks are cheap. So when he provides some advice on what to buy rather than what to avoid I sit up and pay attention.
In his most recent quarterly discussion he did exactly that (link).
Grantham Suggestion #1 – Farmland/Forestry
Grantham comes as close to pounding the table on an investment idea with farmland and forestry. His exact words are “ for those with a long horizon, I am sure well-managed forestry and farmland will outperform the average of all global assets."
I’m not sure I’ve ever seen him use the word “sure” before.
I only really follow closely one company that fits the bill as a farmland investment and that is Canadian company Sprott Resource Corp (OTCPK:SCPZF). Sprott owns 2.1 million acres of cropland stretching across Alberta, Saskatchewan and Manitoba. Sprott has exposure to gold, silver, oil and fertilizer, but its One Earth Farms has big plans:

“The goal of One Earth Farms Corp. (“One Earth Farms”) is to become Canada’s largest fully integrated corporate farm. A true partnership between the private sector and First Nations, One Earth Farms represents a new model for North American farms. One Earth Farms is committed to becoming an industry leader by delivering superior results and a reduced risk profile through economies of scale, professional management and progressive farming practices.”

At the current stock price of $4.79 I think Sprott Resource is a good long-term bet given the value of its net assets comfortably exceeds that and because management will undoubtedly grow those net assets at a healthy clip.
Grantham isn’t the only smart guy who thinks farmland is a sure bet. Investment biker Jim Rogers and housing meltdown star Michael Burry have both indicated a focus on the sector.
Grantham Suggestion #2 – Resources in the Ground
Grantham hedges a little on suggestion number two simply because so many of them have increased so much over the past five years. Grantham’s words on resources in the ground were:

I think it is likely that resources in the ground, hydrocarbons, metals and fertilizer, will also win on a 10-year horizon. I am not certain, though, because of the remarkable gains in so many of these in the last five years. I would put the odds at 2 to 1. As mentioned last quarter, many commodities have the potential for very sharp declines in the short term. If that occurs, then the odds would, of course, rise.”

Strangely there is one company that offers exposure to hydrocarbons, metals and fertilizer. It is again Sprott Resource Corp which I mentioned earlier. But as an investor you could also consider a company affiliated to Sprott Resource Corp and that is Sprott Inc. (OTCPK:SPOXF). I recently provided some detail on Sprott Inc.
The idea is pretty simple. Sprott Inc. is an investment manager focused on all of those resources in the ground that Grantham mentions. If these commodities do well then Sprott’s funds will do well which will in turn attract more investor dollars. I consider it a leveraged play on commodities.
If you are interested in exposure to oil and like to sleep at night I would strongly encourage you to check out Penn West Energy (NYSE:PWE) which has massive amounts of land in Western Canada that is going to have a lot of oil unlocked by horizontal drilling techniques. Penn West currently yields over 5.5% on existing production and that production is going to ramp up for years as Penn West takes new technology to its land base.
Grantham Suggestion #3 – Quality Stocks
Grantham has been suggesting a focus on blue chip quality for a while. Here is his most recent advice:

“On a regular time horizon, I would continue to overweight quality stocks, which may well be on a roll. They are not priced to make a fortune, but they are priced to give approximately 4.5% to 5% real return, which I think is acceptable for low-risk assets. They have also delivered dependable downside – risk off – relative performance for several years, which is a characteristic generally in short supply.”

Here are the top holdings from the GMO U.S. Core Fund at the end of June 2011, loaded with blue chip quality ideas:
Microsoft (NASDAQ:MSFT) 4.8%
Pfizer (NYSE:PFE) 4.6%
Wal-Mart (NYSE:WMT) 4.1%
Oracle (NASDAQ:ORCL) 3.8%
Google (NASDAQ:GOOG) 3.2%
Johnson and Johnson (NYSE:JNJ) 2.8%
Merck (NYSE:MRK) 2.7%
Procter and Gamble (NYSE:PG) 2.7%
Coca-Cola (NYSE:KO) 2.5%
Exxon Mobil (NYSE:XOM) 2.4%
Qualcomm (NASDAQ:QCOM) 2.3%
Philip Morris (NYSE:PM) 2.1%
Verizon 1.8% (NYSE:VZ)
Pepsico 1.8%
Total of top holdings: 44.8%
Grantham Suggestion #4 – Emerging Markets
Grantham said emerging markets will outperform other non-high quality equities for the next seven years. Grantham points out that in a global financial crisis the foreign reserves held by these emerging economies are twice what is held by developed countries and can help the rebound more quickly or help investors weather through.
Grantham carefully suggests that these developing countries are moving toward the profitability of the developed world:

Emerging markets are hard to evaluate because they are clearly going through many phases of development in a real hurry. So what is normal profitability? Probably not the old levels. They are moving toward developed status and probably toward our developed world’s level of profitability. (Yes, James Montier, that would be a change and, therefore, I admit, far from certain.)”

Grantham Suggestion #5 – Japan
At the bottom of his recommendation list but still a recommendation nonetheless is Japan, of all places. Grantham’s thesis here is interesting as he thinks Japanese companies may be able to finally move profitability levels toward those of other developed countries.
Here is what Grantham had to say:

“We at GMO also believe that Japan is likely to “regress,” in the mathematical sense, toward levels of profitability that would be considered normal in other developed countries. We expect the progress to be very slow and uneven.

If it does not happen at all, then Japanese stocks are priced like the average of all other developed equities, or a bit cheaper. If, however, by some chance margins improve quite fast, then Japanese stocks will likely be the best performing stocks around and could hit double-digit real returns for seven years. Japan’s remarkable resilience in the face of electricity shortages gives some inkling of what they are capable of. How quickly we have forgotten the nation's obvious talents of 20 years ago. Can all of those talents really be lost forever?”

Avoid Everything Else
The rest of the letter is classic Grantham, a grumpy old bear. He views global equities not covered above as ranging from unattractive (as of August 2) to very unattractive. He thinks that 950 is fair value on the S&P.
Generally Grantham thinks rise avoidance is a good idea. He suggests cash is a good idea not just because it is a safe haven, but also for its optionality as dry powder to take advantage of opportunities.

Disclosure: I am long PWE.