Friday, August 12, 2011

Grantham: What to Buy?

An excerpt from Part II of Jeremy Grantham's latest quarterly letter with some commentary to follow:

-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.

Grantham's Quarterly Letter - Danger: Children At Play

Grantham and his team think that the S&P 500 is worth no more than 950.

Whether the S&P 500 is worth 950 or not there seem to be plenty of shares in individual businesses selling at a discount to value.

Most of them are, in fact, large and of the high quality variety.

Things like Berkshire Hathaway (BRKa), Pepsi (PEP), Johnson & Johnson (JNJ) along with large cap tech stocks like Microsoft (MSFT), among many others, are not at all expensive.

It almost seems routine now to see quality businesses selling at low teens or even single digit multiples of earnings. Yet, you only have to look back ten years or so to know the situation is far from routine.

A decade ago many of these businesses were selling anywhere from somewhat to massively overvalued.

The fact is most of these have been cheap for quite a while and most continue to get cheaper. That may seem like a bad thing (dead money or worse) but as a long-term holder of shares it's usually beneficial if the shares remain low or better yet, get cheaper, in the short-to-intermediate run:

1) It allows more shares of a good business to be accumulated by an investor over time at a fair or better price via dividend reinvestment or as new sources of cash become available.

2) Management can use the company's own free cash flow generation to buy more of the shares over time, whenever they are selling below intrinsic value, to the benefit of long-term holders of the stock.

The market weighing machine will in the long run reflect the cumulative effects of the buybacks and each businesses core economics on a per share basis.

So, as long as the favorable economics of these businesses remain in tact, hopefully prices remain low or even decline from here. With long-term returns as the focus that's precisely what investors should want.

Whether those favorable economics remains in tact is something far from certain that must be evaluated on a regular basis (especially for any technology business).

Now, I realize this approach flies in the face of the hyperactive trading ethos that is so popular these days. I'm sure there is one heck of an adrenaline rush for those involved in the trading game.

Those in the business of attempting to make a quick buck on a well timed trade will likely find the above somewhere between useless and uninteresting.

Yet, even if admittedly less exciting, it works when applied with discipline and sound judgment. I'll take the highest possible risk-adjusted forward rate of return in lieu of the adrenaline rush.


Related posts:
Defensive Stocks Revisited - March 2011
KO and JNJ: Defensive Stocks? - January 2011
Altria Outperforms...Again - October 2010
Grantham on Quality Stocks Revisited - July 2010
Friends & Romans - May 2010
Grantham on Quality Stocks - November 2009
Best Performing Mutual Funds - 20 Years - May 2009
Staples vs Cyclicals - April 2009
Best and Worst Performing DJIA Stock - April 2009
Defensive Stocks? - April 2009

Long BRKb, PEP, JNJ, and MSFT

* From the Grantham letter: The forecast provided above is based on the reasonable beliefs of GMO and is not a guarantee of future performance. Actual results may differ materially.
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