By Christopher M. Wright

Name: Jeremy Grantham Title: Chairman, Grantham, Mayo, Van Otterloo & Co. LLC. (GMO) Age: 65 Experience: Jeremy Grantham helped found Boston-based GMO in 1977. GMO, a global boutique for sophisticated investors, now has more than $50 billion under management on behalf of more than 600 institutional and high net worth clients. Grantham specializes in quantitative products, asset allocation, and investment strategies. Prior to GMO, Grantham was co-founder of Batterymarch Financial Management, a portfolio manager at Keystone Custodian Funds, a management consultant with Cresap McCormick & Paget, and an economist with Royal Dutch Shell. He earned his undergraduate degree from the University of Sheffield (U.K.) and an M.B.A. from Harvard Business School.

Real Estate Portfolio recently asked celebrated investment manager and noted bear Jeremy Grantham, chairman of Grantham, Mayo, Van Otterloo & Co. LLC, to share his thoughts on the capital markets and REIT stocks.

Portfolio: There's a statue of Buddha in your office. Have you achieved "uncommon wisdom" together, like the tagline of the Wachovia commercials?
Grantham: Well, the statue does carry a subliminal message. I bought it during the last Asian crisis when you could buy used Mercedes-Benzs by the garage-full. Not surprisingly, it was very cheap and it is soothing for me to look at because it was such a bargain, which always gladdens the heart of a value investor.

Portfolio: Speaking of value, you are considered a champion of value investing. How do you define "value" and what is the evidence that it outperforms?
Grantham: We define value much more broadly than most. We pay up for "quality" stocks with high and stable profitability and low debt. Microsoft has been a value stock under our model 80 percent of the time, and Coca-Cola has too, sometimes, which is unusual for value models. The model has worked well for 25 years. Our model returns four points a year above the market before costs when we consider the most attractive 60 value stocks out of a 600 blue chip universe.

For the broad market, value bets have always won in the past—eventually—but the time horizon is uncertain. From year to year, there are plenty of other crosscurrents in the market, but value will usually win in a three to five-year timeframe.

There are other value models that use crude metrics like price-to-book ratios. They only return an extra one percent a year, which is not a great bargain because the stock selections tend to be very junky, low-quality companies. With our broader value, you get a free lunch because you get higher returns without higher risk, a point, I might add, that impresses professors of finance more than our clients.

Portfolio: You have said your thinking is influenced by the presidential election cycle. What is your outlook for 2004?
Grantham: We focus first on value. The presidential cycle is only the cherry on the cake for us. That being said, the fourth year of a presidential cycle is usually pretty calm. That means that the market will not want to go leaping around in 2004. The market is unlikely to collapse even though it is terrifically overpriced and getting more so by the day.

Portfolio: Sounds like you expect ordinary returns in 2004. People have come close to calling you an "eternal bear" and you have said elsewhere that you believe that the market is headed down in 2005 or 2006. You expect the S&P 500 to fall to 700. What will bring on a bear market and what should investors do?
Grantham: The market has gone down in fully half of all the first years of the presidential cycle since 1932. The precipitating factor is housecleaning by officials in Washington. We have very high levels of debt across the board—international debt to finance our deficit and dangerously high corporate and consumer debt. Debt takes away your flexibility.

Presidents want breathing room in year three of the cycle to stimulate the economy to set things up for reelection. There was a huge amount of economic stimulus thrown at the market in 2003—the tax cut, low interest rates, and a huge supply of low cost money to speculate with. Low rates, easy money and moral hazard. The market responded nicely and all speculative categories outperformed—growth, small cap and junk.

In effect, the president and the Fed said, "we will rush to help you, we'll give you a free roll of the dice, underwrite your risk, and make it safe for you to speculate."

Portfolio: The debt overhang was there in 2003 and earnings multiples still expanded. Are you saying that policymakers in Washington intentionally bring on a price-earnings contraction in the first two years?
Grantham: No. They intentionally move to houseclean the economy and an unintended consequence is that the market falls. They want to correct imbalances in the economy and smarten-up balance sheets for reelection. In 2005 and 2006, profit margins are likely to go down and interest rates to go up and, if that happens, the market will go down. It will be a good time to concentrate on value investing and that's what investors should do. The main point about the presidential cycle is that animal spirits rise in years three and four and fall in years one and two.

In the end, it's all about optimism. Average P/E's have been creeping up over time—from 8 to 14 to more than 23 now. People believed in the bear market rally in 2003 mistaking it for a real bull market, but you have to remember that in the long run you spend half the time below trend by definition, and trend is only 16 times.

REITs should play a substantially bigger role in the typical portfolio than is usually suggested. U.S. real estate is an important and different asset class and a very big one.

Portfolio: You have said that REITs have outperformed the market "brilliantly" this last year, but you don't know why. Do you think that high dividend yields on REITs have something to do with it?
Grantham: No, it's not simply the yield because high yield stocks, other than REITs, badly underperformed the market in 2003. And it's certainly not the fundamentals because rents and occupancy rates are weak. So it's a bit of a conundrum. The most likely candidate is that the low interest rates that Greenspan has engineered simply make buildings cheaper to buy with debt.

REITs outperformed from March 2000 to October 2003 through the worst part of the decline in the S&P. They were not in the same bubble as other stocks and it was a no-brainer to buy REITs and underweight the S&P. We placed a huge bet on REITs at the time, making them 9.5 percent of our portfolio, but REITs also outperformed in the rally that came after and that is exceptional. There are very few situations where a type of stock continues to outperform both when the market goes down 50 percent and also when it rallies 30 percent.

I believe the next important leg for the market is down, perhaps after a few more months of a rally, but I expect REITs to outperform once again in the next decline because they are still less expensive than the rest of the market.

Portfolio: So, you view REITs as a defensive play in the coming down market? Your firm's seven-year forecast calls for REIT stocks to return an average 3.8 percent a year while the market will drop one percent a year. The 3.8 percent is on a total return basis, implying that you expect REIT share prices to decline. Why would you hold any stock when you expect the price to go down?
Grantham: Nearly all money managers are held to benchmarks by their clients. They must report how well they are doing relative to the S&P or other benchmark. They often end up saying essentially, "look how well I have done being down only 27 percent when the S&P is down 30 percent."

At Grantham, Mayo, Van Otterloo & Co. LLC, we try to generate interest in absolute return portfolios, ones that actually make money for the client instead of meeting a benchmark. We did not own any regular S&P-type stocks in our absolute return portfolios during the decline, but we did own REITs and still do today.

Portfolio: However, you have said that better defensive plays than REITs are available. What are they and what makes them better?
Grantham: Emerging market equity and debt, international small cap value, TIPS (Treasury Inflation-Protected Security government bonds), and timber. I put them all ahead of REITs, but REITs are on a different cycle so I add them to the mix. It may sound strange to have emerging market equity and TIPS as backbones of a portfolio, but emerging markets will go up 30 percent if the U.S. market hangs in, and TIPS have no risk, which keeps total portfolio risk under control. That's how you build an efficient portfolio—with the highest return for the level of risk chosen.

Portfolio: You also view international stocks as a better defensive play than REITs. Why do you hold this view when international markets now move in tandem more so than before, while the correlations between REIT stocks and the U.S. market have been declining?
Grantham: International stocks are not a better defensive play in all cases. If the market goes up, hangs in, or goes down a little, international wins. If the market goes into a steep decline, REITs win.

Taking all the probabilities together, I'd take international over REITs, but it's better to have them both and that's what we do. We don't get carried away by monthly correlations. We look at multi-year periods. I believe we are at the end of a 10-year period where the S&P won. Before that, international outperformed for eight years. In the longer run, they still move in very different cycles.

Portfolio: Your firm runs hedge funds. Under what circumstances would you short REIT stocks?
Grantham: We're running over $2 billion in 10 hedge funds that follow a market-neutral long-short strategy [achieves constant returns by combining long and short positions to eliminate market risk]. We would short REITs if they doubled against the rest of the market and became splendiferously expensive. But we're nowhere near that now. We won't be shorting REIT stocks for the foreseeable future.

Portfolio: What place should REIT stocks have in the average investor's portfolio?
Grantham: REITs should play a substantially bigger role in the typical portfolio than is usually suggested. U.S. real estate is an important and different asset class and a very big one. REITs are a way to get in, and, at normal prices, investors should own several times the ratio of REIT capitalization to total market capitalization. This is despite the fact that REITs track U.S. small cap value when you look on a monthly basis.

On a longer-term basis, not surprisingly, they track the underlying real estate that is very different to regular equities. REITs are substantially different from regular stocks when you look at longer periods. In accounts where we have to own U.S. equities, REITs are 5 percent to 10 percent of our normal position—more when they are cheap relative to the rest of the U.S. market and less when they are more expensive.

Where we have a free hand, we own 10 percent to 15 percent U.S. REITs and no other U.S. stocks. In those accounts, our REIT position peaked at 23 percent of total portfolio and it's on the way down to 10 percent. Why? It's the fourth consecutive year that REIT stocks have been outperforming and, obviously, that can't continue indefinitely.

Editor's Note: GMO manages funds and separately managed accounts, several of which owned Coca-Cola and/or Microsoft at the time of this interview. References to individual stocks should not be considered a recommendation to buy or sell those stocks.