Will You Be Satisfied With 4% Returns?

4.4%.

That's what Jeremy Grantham believes large-cap stocks will return -- after inflation -- on an annualized basis over the next seven years.

Is that good enough for you?

Who on earth is Jeremy Grantham?
Jeremy Grantham is the co-founder of investment firm GMO, which has almost $80 billion in assets under management.

Grantham is often dismissed as a "perma-bear" when his views go against Wall Street's institutionalized optimism -- but the truth is, he's a rock-solid investment thinker, grounded in reality, who calls 'em like he sees 'em.

He believes that "mean reversion is the most powerful force in financial markets." In other words, periods of abnormally high returns must be balanced out by periods of abnormally low returns, and this holds true across the gamut of different assets, whether it be commodities, stocks, or bonds.

On that basis, at the end of 2001, Grantham predicted that the S&P 500 would suffer an annualized decline of 1.1% over the following seven years -- which was decidedly optimistic since the annualized real return turned out to be negative 3.9%.

In July 2007, as the credit crisis was in its infancy, Grantham wrote: "In five years, ... at least one major bank (broadly defined) will have failed." We've all witnessed the multiple failures, rushed takeovers, and government rescues in the financial sector since then.

So, it's worth taking his predictions seriously.

4.4%? Seriously?
While the S&P 500 is still down 37% from its all-time high in October 2007, it has gained 45% since its March 9 low, but it's still down over 40% from its all-time high in October 2007. That rally has set the stage for investors to earn 4.4% -- below the 6.5% average historical return on stocks -- going forward, which is nothing to sneeze at (remember that this is an after-inflation return). That might not sound like a big number, but it's nothing to sneeze at, either -- at 1.81%, inflation-indexed Treasury bonds are yielding less than half that amount.

The current bear market has been a source of enormous pain for investors -- but from the point of view of the prospective stock buyer, it's an opportunity, since stocks are at lower valuations than they have been in years.

In fact, at the end of January, Grantham called U.S. blue chips "manna from heaven"; indeed, when the credit crisis began to escalate, he said, "they were about as cheap, on a relative basis, as they ever get."

I wanted to verify that claim, and I was able to confirm that, even after the recent rally, over a third of the non-financial stocks in the S&P 500 currently sport price-to-book value multiples that are in the bottom decile of their range since the beginning of 1995. Even in the following sample of stocks that meet that criterion, you can't fail to notice some superb companies:

Source: Capital IQ, a division of Standard & Poor's.

But what if you aren't satisfied with 4% returns?

Getting to 4% plus
Grantham's prediction is based on the S&P 500, in aggregate, returning to fair value at the end of his seven-year timeframe (he pegs its current fair value at slightly below 880). If you pay more than fair value for the index, you can expect to earn less than the weighted average return that the underlying companies earn on their equity.

But within the S&P 500, some stocks will likely be overvalued, and some will likely be undervalued. If you're able to buy an individual stock for less than its fair value, that margin of safety will turbo-charge your expected return beyond the company's accounting return on shareholders' equity.

Grantham expects a subset of U.S. stocks -- those he labels "high quality" -- to produce after-inflation annualized returns of 10.5% over the next seven years. Nearly six percentage points on an annualized basis is an enormous difference -- and gives investors plenty of incentive to identify those "high quality" stocks.

Although Grantham doesn't directly define "high quality," he provides some clues in an interview with Forbes in which he said, "And the best bet, for my money, then and now, a year later, was to buy the great franchise companies, the great quality companies." This suggests that he favors companies that possess a moat -- a sustainable competitive advantage -- that enables them to earn excess returns over their cost of capital.

Helping you earn better returns
No investor is "condemned" to 4% returns going forward -- and neither are we promised them. Investing -- at reasonable prices -- in excellent businesses that are likely to grow is the best strategy for securing your long-term returns.

Of course, even among stocks that are perceived as "high quality," you can expect a range of different returns. The trick is identifying which stocks are genuinely undervalued.

That's what we do at Motley Fool Inside Value. If you'd like to find out which stocks will afford investors the best odds of earning premium returns to beat Grantham's 4.5% hurdle rate, just click here to sign up for a 30-day free trial today. You'll be able to see all stock recommendations, including Inside Value's five best ideas for new money now.

This article was first published March 18, 2009 under the headline "Will You Be Satisfied With 7% Returns?" It has been updated.

Alex Dumortier, CFA , has no beneficial interest in any of the companies mentioned in this article. Walt Disney and National Oilwell Varco are Motley Fool Stock Advisor selections. Chesapeake Energy, Walt Disney, and Home Depot are Motley Fool Inside Value picks. Automatic Data Processing is a Motley Fool Income Investor recommendation. The Fool owns shares of Chesapeake Energy and XTO Energy. The Motley Fool has a disclosure policy.