GMO asset class return forecasts.

In an earlier post, I had written about GMO’s 7 year asset class return predictions. Well, they have updated their charts, and here’s how the predictions look now:

The decline since March has made the long term returns look even more favorable. (There’s something to be said about not trying to time the exact market bottom and holding on for the long term! )

For those questioning the accuracy/relevance of their numbers, here’s how their 1998 forecasted numbers stacked up. While the absolute numbers might change, the rankings for the asset class returns were spot on.

Hmm..

• Seems like a good time to invest in international small cap, especially small cap value (DISVX?)


• Inflation-indexed bonds are expected to underperform US govt bond.


• US quality stocks and timber look attractive.


• The long range forecast on emerging markets and international equity has also gone up since March, partly due to the severe declines we’ve seen since then.

I was intrigued by the definition of “US Quality”. Here’s what the description reads: GMO U.S. Quality Strategy begins with a universe represented by large capitalization stocks in the U.S. market. Using proprietary quantitative models, the strategy screens an issuer's quality based on several factors, including, but not limited to, expected earnings volatility (as measured by the volatility of profitability), profits (return on equity), and operational and financial leverage (fixed operating costs and total outstanding debt, each in relation to equity). Further, the strategy seeks out stocks it believes are undervalued within this defined universe.

The top holdings in their "US Quality" asset class are:

Exxon Mobil Corp. 6.9%
Microsoft Corp. 6.8%
Wal-Mart Stores Inc. 6.8%
Johnson & Johnson 6.7%
Pfizer Inc. 6.3%
Coca-Cola Co. 6.3%
Chevron Corp. 6.2%
PepsiCo Inc. 5.0%
UnitedHealth Group Inc. 3.6%
Procter & Gamble Co. 3.4%
Merck & Co. Inc. 3.4%
QUALCOMM Inc. 2.7%
Oracle Corp. 2.3%
Cisco Systems Inc. 2.3%
Home Depot Inc. 1.9%

I would have guessed that the “predictability in earnings” would imply a heavier weight towards consumer staples, health care, pharma and other non-cyclical sectors. Turns out to be true, except I was a little surprised to see Oracle and Cisco.

Going forward, it’s going to become increasingly important to evaluate stocks from an inflation-pass through perspective. Any company which can pass on inflationary cost increases to its consumers is going to see a multiple expansion going forward (think Walmart, Proctor and Gamble). One name which has intrigued me thanks to Buffett is Kraft, but I need to do my homework on that one first.

In my next post, I’ll discuss Grantham’s quarterly missive.

Disclosure : Long Qualcomm, Microsoft, DISVX.