Tuesday, March 27, 2012

GMO: Two Questions We Can't Answer - By Robert Huebscher

The last part below is an important point when thinking about investing in mining companies. While eating lunch, I was watching Bloomberg and they showed a chart going back to 2006 showing Newmont Mining versus the price of gold, in which gold was up quite a bit and Newmont was almost flat. It could mean that Newmont is undervalued, or it could also be a result of what Inker describes below, where the cost of production and energy required to mine the commodity went up as much as the commodity itself.

Its reputation was built on stellar returns achieved with long-term bets on undervalued asset classes. Current market conditions, however, pose two unanswerable questions for Grantham, Mayo, van Otterloo (GMO) – leaving the firm with an uncertain strategy for its equities and fixed-income allocations.

Those questions have arisen because GMO foresees unattractive performance from both stocks and bonds in the next seven years, the time horizon over which the firm has traditionally forecast asset class performance. Ben Inker, the head of asset allocation at the Boston-based GMO, spoke at a Boston Security Analyst Society seminar on trends in asset allocation last Tuesday.

Given negative real interest rates, Inker said the first of those two questions is that it is not clear what role bonds should play in a portfolio. Second, is not clear that investors should overweight stocks, just because bonds are unattractive.

As a result, he said, GMO has upped its allocation to cash.

Let’s look at GMO’s outlook for bonds and stocks and at the reasons Inker cited for increasing its cash position. I’ll also review why there is only one commodity resource in which GMO is willing to invest.


Owning commodities, in other words, is possible if you own the asset directly, as GMO does with its timber assets. But if the asset is “in the ground,” then Inker said you want to own the companies that own those assets.

But GMO has found it exceedingly difficult to forecast returns for those companies. The problem is that one must forecast the price of the resource, and the cost of extracting it. Inker said that the reason gold mining companies have not appreciated in price during the recent bull market in gold is because the cost of the energy required to mine gold has also gone up.

“The cost of production rose apparently every bit as fast as the price of what they were getting paid for their production,” Inker said. “We haven't figured out exactly what to do about that.”

It’s even more complex today because China, he said, has an incredibly resource-intensive approach to growth. That will have to stop, he said, as the returns on Chinese investments diminish, and their economy will become less resource intensive.

Uncertainty about commodities mirrored Inker’s larger lack of confidence about the prospects for returns in virtually all asset classes. Value-oriented asset allocators, like GMO, will need to wait to find an opportunity that presents a sufficient margin of safety.