Get ready for ho-hum stock returns for years

February 27, 2012, 11:36 PM UTC

FORTUNE — While most investors were transfixed with Warren Buffett’s annual shareholder letter this weekend, smart Wall Street types also picked through the latest letter from another value investing whiz.

Jeremy Grantham, who oversees $100 billion of institutional money at Boston-based GMO, titled his missive “The Longest Quarterly Letter Ever,” and it clocks in as advertised, taking up 14 mostly single-spaced pages. Grantham has earned the right to be long-winded: the 73-year-old correctly called the last decade’s market bubbles and famously told investors to jump back into stocks at the market’s bottom in March 2009.

The most compelling section in Grantham’s latest letter expands on his belief that capitalism is ill-suited for the coming population boom. “Capitalism, by ignoring the finite nature of resources and by neglecting the long-term well-being of the planet and its potentially crucial biodiversity, threatens our existence,” he writes. It’s truly fascinating stuff, but because you can read the full note at GMO’s site after registering, and because Grantham is foremost an investing strategist, we’ll skip to Grantham’s recommendations for investors.

Like Buffett, Grantham probably feels he can give out his secrets to successful investing because, simple as they are, the average investor finds them impossibly tough to follow.

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Grantham’s biggest one today: don’t dive headfirst into U.S. stocks, especially after the S&P 500 has risen nearly 9% this year. According to GMO’s forecast, which relies on long-term average profit margins and PE-ratios, the S&P 500 is priced to return just 1% annually after inflation over the next seven years. The one highlight in this otherwise boring forecast is the expected return of the S&P’s highest-quality companies, such as Microsoft (MSFT), Johnson & Johnson (JNJ), and Cisco Systems (CSCO). That top quartile of companies should return 5.5% annually after inflation, Grantham predicts.

Grantham is slightly overweight other global equities, which are priced to return about 6% a year after inflation over the next seven years. “This is not exactly whoopee time, but compared to the typical overpricing of the last 20 years, it’s not bad at all,” Grantham says. “The majority of global equities are within spitting distance (a technical term) of fair value.”

Maybe his simplest advice to follow is related to natural gas. After a production boom in North America, natural gas prices have fallen to around $2.50 per million British thermal unit from $10 per million BTU in 2008. With oil prices rising, the disparity in oil and natural gas prices is nearing a 50-year high—a compelling opportunity, he says, for long-term investors.

“Natural gas is, for most purposes like home heating and electric utility plants, a better and cleaner fuel than oil or coal, but is for technical reasons in distress,” Grantham writes. “There have been several recent decades in which the BTU equivalent price for natural gas did, at least for a second, reach parity with oil. But now it is at just 14% of BTU equivalency, the lowest in almost 50 years. Everyone who has a brain should be thinking of how to make money on this in the longer term.”

Grantham includes this graph to illustrate the disparity:



Grantham’s other recommendations:

-Underweight long-terms bonds as much as you can.

-Buy natural resources, forestry, and agricultural land, but because short-term prices can fluctuate wildly, investors should buy in steadily.

Grantham puts it in context: “So in asset allocation there is one great opportunity—avoiding duration in fixed income—and one pretty good opportunity—down weighting most of the U.S. market. Not such a bad opportunity set, really.”