The World’s Best Investors: What to Buy (and Avoid) Now

The sober mood of the conference was reflected in the choice of keynote speakers, including Bill Gross, co-chief investment officer of PIMCO, and FPA’s Rodriguez, both of whom predict slow economic growth and a shrinking of America’s global stature. Despite their generally grim outlook, though, they still see pockets of opportunity. Gross recommended that investors look to the “BICs” — that’s Brazil, India, and China — for opportunities. The group usually includes Russia and is referred to as the “BRICs,” but Gross has dropped Russia, which has suffered from lower oil prices and whose government hasn’t always seemed friendly to capitalists.

With respect to China, Gross said consumers only account for 35 percent of that country’s economy, a share that he expects will increase and fuel growth. Contrast that with the U.S., where tapped-out consumers drive 70 percent of economic activity — a share that may very well shrink.

Jeremy Grantham, chairman of Boston-based GMO, is another investor whose doom-and-gloom predictions proved eerily accurate. Now he sees big returns from emerging markets, even beyond their surge in recent weeks. “We’re growing in the developed world, if we are lucky, at 2.25 percent,” he said, while emerging economies are expanding by 4 to 4.5 percent a year. “Twice the top-line GDP is going to look awfully appealing” to investors, Grantham said, and will command a growing price-earnings ratio. “It doesn’t take a genius to see that that’s the next great bubble,” he added. But he thinks investors can make lots of money before emerging markets become overpriced.

Glenn Fogle, a portfolio manager at American Century Investments, summed it up this way: “The next Google, more than likely, is not going to be an American company.”

In a stem-winder of a speech that he acknowledged was a “tirade,” Rodriguez criticized the financial industry and decades of mismanagement by our “fiscally inept government,” and he predicted more tough times ahead. But he thinks investors in the energy sector will do well as the price of oil climbs past $100 per barrel in the coming years. Expanding on the point in a recent letter to shareholders, FPA managers note that oil production has exceeded oil discovery for nearly 30 years, and that energy investments offer a hedge against inflation.

Rodriguez and his fellow managers have put their shareholders’ money where their mouths are: Nearly half of the equity investments in the FPA Capital fund are in the energy sector.

Taking “long-term” to a rarely seen extreme, Grantham contends that commodity prices have been falling (after inflation) for “hundreds of years,” and he sees that trend reversing for the next few centuries. “We are running out of everything,” he says. The bullish view on energy is consistent with managers’ enthusiasm for emerging markets, since they tend to be resource-rich. So while those countries may not sell as many tank tops to American consumers, the thinking goes, they will continue to sell natural resources abroad while using more themselves to provide energy to a growing middle class.

Ron Muhlenkamp, manager of the Muhlenkamp Fund

When the credit markets froze last fall and investors stopped buying any bonds that were not guaranteed by the government, the prices of those bonds plummeted, sending yields upwards. The payouts got so high that some stock investors couldn’t resist jumping in. Ron Muhlenkamp, manager of the Muhlenkamp Fund, used to dismiss bonds with the argument that any company that issues them wants to minimize investors’ returns (by paying as little as possible in interest). But he can’t resist a bargain, so recently he bought the Loomis Sayles Bond Fund and the Vanguard Intermediate-Term Investment Grade Fund, which are now among the top-10 holdings of his fund.

Two Warren Buffett disciples, Christopher Davis and Bruce Berkowitz, manager of the Fairholme Fund, also couldn’t resist a trip to “bond land.” Davis is a long-term owner of Harley Davidson stock who recently bought the company’s bonds, while Berkowitz is both a lender to and an equity holder of Hertz.

For investors focused on minimizing taxes, some managers made the case that municipal bonds also offer opportunity right now, since they’re under pressure from investor worry over state and local finances. In a good reminder of the value of investing through a fund rather than trying to do it yourself, Christine Thompson, director of muni bond managers for Fidelity, noted an anomaly that her firm had taken advantage of: California, she said, was paying investors 9 percent (annualized) for seven-day notes, while investors who bought two-year bonds were getting a 3 percent yield. Turning over an investment every seven days would be tough for an individual, but it’s a nice way for a fund to get a sweet payout on the fairly low-risk bet that the state won’t default in the next week.

Investors at the Morningstar conference also warned against a several investments that could bite back. Both Grantham and Rodriguez see danger ahead in commercial real estate, which could hammer real estate investment trusts, despite their attractive yields. Rodriguez pointed out that the problems facing homeowners and homebuilders are well known and that the empty subdivisions are only part of the problem. Just down the street from those subdivisions sit strip malls that have no tenants, and Rodriguez expects builders will default on their loans over the next two years.

While there was no consensus on when, or even if, the government’s massive borrowing spree would result in inflation, no one was recommending that investors load up on Treasury bonds. Treasuries have had a big run-up as investors fled to their perceived safety when nearly all other assets collapsed. But recently, government bonds have pulled back, and Rodriguez echoed a recent warning from Warren Buffett in declaring that they were in “bubble territory.” In an informal discussion after his prepared remarks, Grantham said his firm was shorting the long bond, or betting that prices would fall.

Rather than invest in “risk-free” bonds that will be hurt if interest rates rise, Grantham said he’d rather be invested in high-quality stocks that have been buoyed by the massive government stimulus. The U.S. government, he said, is “basically saying that if anything goes wrong, we will do anything — including throwing money out of helicopters — to bail it out.”

• More on the Morningstar conference: The World's Best Investors on Three Ways to Avoid the Next Crisis.