Pioneer Grantham invests in the woods

NEW YORK -- Jeremy Grantham is famous both for pioneering index fund investing in the 1970s and his willingness to challenge conventional financial wisdom.

He's the chief investment strategist at GMO in Boston, which manages some $106 billion for institutional clients, including leading universities.

The man whom some have called a "perma-bear" recently shared his thoughts about where he sees both danger and opportunity ahead.

Q: You're known for spotting bubbles where too much money pours into one type of asset and prices rise unsustainably. How does a bubble form, and where do they get their momentum?

Answer: Why a bubble forms is an incredibly complicated topic. Fortunately, as investors, we don't have to know why they form. We only have to be able to measure where they are, how big they are, and that's relatively straightforward.

Q: Where are bubbles developing now?

A: I have made one prediction in my life really, and that is, emerging markets will very likely become some form of bubble. They will go to a premium over the developed world stock market -- they typically sell at a discount because they are riskier. I think they will go to a premium, and I have thought that for some time, because their growth rates have become so much bigger than ours and their financial condition actually is sounder. And, even as we speak, they are currently thriving while we still look fairly fair. So I think people will make the simple case that if emerging markets have the GDP growth and they seem to be doing so well, and recovering so quickly, why wouldn't they be worth the premium? Now, whether it gets big enough to be called a bubble by our technical definition is another matter.

Q: I understand you've been investing in timber by buying entire forests and selling when lumber prices rise. Why is timber attractive?

A: I've viewed timber as a mispriced and underappreciated asset going back to the mid-'90s. It was underappreciated then because, ironically, people have an exaggerated preference for liquidity. You have the paradox that a lot of institutional investors have a very long time horizon, so that they don't need much of their money to be liquidated next Wednesday or indeed in six months. And yet they used to make a fetish out of having everything liquid, and timber is clearly not.

You can sell a forest in six months, but you certainly can't do a decent job of selling it in six days. Investors insisted on having a very very handsome return. Another factor was that it wasn't readily acceptable. Not many institutions did it. And there was a premium for that, too, investors receive a premium for taking career risk and doing something that their peer group isn't doing.

When I first took an interest in it, timber was priced to yield something like 8 percent to 9 percent after inflation. And for a very safe asset class, that kind of return was ridiculous. In general, I consider it safer than everything except perhaps inflation-protected bonds and cash.

Q: Why do you like timber over gold?

A: Gold is largely used in jewelry and, therefore, derives its value from what people think it's worth. So there's no bedrock, you can't eat it, you can't make automobiles out of it -- so by its very essence, it is a very speculative investment. You are speculating that people will trust it despite its lack of clear usefulness. Timber, on the other hand, has myriad uses and has a very obvious yield. The yield on a timber portfolio has historically been around 4.5 percent, perhaps a little more. So there's no comparison. And timber, of course, is a very good inflation hedge, and gold may be, too, but you can't be certain.

One of timber's features that I like the best is that it's the only commodity with negative inventory cost. If you don't pump your natural gas, it doesn't increase, but if you don't cut your trees, they grow. If you just let your forest sit there, it becomes more valuable. This is a huge advantage. It allows people who have any flexibility to just sit back when the market is weak and not deliver timber to the market. When the market picks back up, they can deliver timber again.

Q: How does someone invest in timber?

A: That's the bad news for this article. We don't specialize in serving individual investors; we specialize in institutions. And how it works is we buy a pool of forests -- distinct forests we can go and visit for our institutional clients. We put them away in a pool, and then when the market is very favorable or when they've matured, we sell them.

There are some public companies and real estate investment trusts that own forests, but I haven't studied them enough, and don't want to comment on them.

Q: In the end, what should average investors be doing right now?

A: They should buy the great financially strong blue chips. What you might call the great companies, the franchise companies. There are no surprises about who they are. I'm not recommending these, but typically they would include the Johnson & Johnsons, the Coca-Colas, the Microsofts, and so on. They sell at a discount to junky companies, which is pretty strange at a time like this when most of those have more concerns than average.

Q: Should investors be doing anything else?

A: Yes, be cautious. Keep some money in cash. Because the one thing you won't forget about cash, is that it gives you the freedom to respond to anything that happens, whereas stocks do not. If the stock market collapses and you are invested in stocks, it doesn't do you a lot of good. But if you have some cash around, it gives you an option. And if you want to take any risks, I would definitely buy some emerging markets to spice up your portfolio. They blend very well with the high-quality blue chips.