Why You Shouldn't Act Like a Mutual Fund

 
Mutual Funds ...

And the Individual Investor

Value in the Emerging Markets

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Note: With markets flopping around like a hog on ice, it might seem unwise discuss any investment strategy that doesn't involve moving with all deliberate speed toward the shelter of cash. But in reality, a bear market, when buying is curtailed and cash is king, is the perfect time to think about how to approach the market when the bulls retake control. Rallies reward you with gains. Corrections reward you with time to think, refine your strategy and build your watch list.

At first glance, acting like a mutual fund might seem like a good strategy for an individual investor. After all, mutual funds have big research departments and plenty of intellectual firepower in their economic forecasting staff.

I know that lots of conscientious, responsible investors try to emulate the whales in their own investing strategies. They use a buy-and-hold approach with heavy reliance on exposure to major indexes and broad diversification to spread around risk. And that's exactly what their financial advisors have been telling them to do for years.

I'll explain later why I think this may be a bad idea, but here's a little background first.

First, if you're a mutual fund manager, you pick an index to use as a benchmark. This might be the Dow, the S&P 500 or the Nasdaq or an index that tracks a particular market or sector. The Dow is slightly more conservative, the S&P is taken to represent the broad market and the Nasdaq is weighted toward tech stocks, which gives it a little more volatility.

Mutual funds always use an index as a benchmark because they need a way to measure whether they're doing a good job. If they beat the benchmark, they get bragging rights, higher ratings from services that advise big investors like pension funds, and the fund managers get to keep their jobs.

But it's important for you to know specifically how mutual funds try to beat the indexes. That's because their methods play to their strengths, which are economic forecasting and in-depth research into companies.

So, first step for a mutual fund in beating the index is to essentially buy the index. Large mutual funds usually hold (almost) every stock in their benchmark index, matching both the holdings and the weightings of the whole shooting match.

Then the fun begins.

Once the index is matched, fund managers use their substantial research resources to identify the stocks with the strongest and weakest projected performance and then tweak their holdings. If the index has 1% of a certain stock (by market cap) and the wonks in research believe it's a winner, the manager might raise his weighting to 1.25%.

Or if the company's team of economic forecasters identifies a threat to a particular industry, the manager might trim a little from the stocks that look like they might be under pressure.

And once the roster of underweights and overweights is complete, some managers may opt to avoid a few index stocks altogether. They may even take a position in a stock that isn't in the index (a so-called "out of benchmark" bet).

Overseeing this ballet of micromoves there's usually a risk manager who keeps tabs on the potential risk generated by each of the moves. If the risk manager believes that the risk exposure has risen beyond what's authorized by the portfolio guidelines, he blows his whistle and the portfolio manager dials back his (or her) aggressiveness.

That's pretty much how mutual funds work, with the choice of benchmark dictating the portfolio's investment universe, aggressiveness and objectives.

This method works because the goal ("beat the benchmark") is clearly defined and the investment strategy is designed to find tiny ways to edge ahead of that benchmark. Any mutual fund manager who can consistently deliver performance that's just inches ahead of its index can have a long, happy career.

So what's wrong with this strategy for the individual investor?

First and foremost, especially with the market performing its rabid pit bull routine in recent weeks, it's wrong that there is no way to exit the market and go to cash.

One of the fundamental tenets of the Cabot philosophy of growth investing is that you should be prepared to ratchet down your exposure to the market when the bears take charge. We use a market-following system to identify short-, medium- and long-term trends, then trim our positions accordingly, moving to cash when the momentum is down and back into the market when conditions improve.

The ability to close a position in a minute or less is one of the individual investor's biggest strengths.

And on the upside, the individual investor also has the advantage when markets start rising again. Getting in early on a big rally is very enjoyable and very profitable.

Individuals also hold the advantage in portfolio concentration, making big gains in portfolio value from the action of a few stocks. Mutual funds, by contrast, hold dozens and dozens of stocks, which keeps a big winner from making more than a small contribution to total performance.

The usual approach used by most 401(k) and IRA investors follows the standard advice. Lots of index funds, wide diversification, never change a thing, and rely on the effects of time and continuing contributions to build value.

For many people, that's exactly the right answer, because they don't have the temperament or the expertise to buy individual stocks. The market can be a tough place to learn lessons, and those lessons can be expensive.

My advice (you knew I was eventually going to impart advice, didn't you?) is to take a look in the mirror. If the person you see has the temperament to accept some risk, the discipline to follow a few simple rules and a desire to improve on the results of the slow-but-sure methods that work for mutual funds and their investors, you should click this link right here. 

It will connect you with Cabot and our growth advisory newsletters that have 40 years of guiding individual investors through the jungle of the market.

And with the market winds raging away in the wrong direction, this is the perfect time to start planning your move. When the winds are once again at your back, we'll all be ready.

While I was screening stocks and looking at charts to pick the most-recent stock for Cabot China & Emerging Markets Report, I noticed that the recent correction had created some great opportunities for value investors.

Ordinarily, this wouldn't interest me much. I admire the cool patience of value investors, but value stocks can sometimes require holding on for years to see results.

But value investing is a lower-risk strategy, and value investors can make sensible investments even when the markets are in a foul mood.

So here are two emerging market stocks with market caps in the $10 billion range, excellent P/E ratios, positive earnings histories and stories that make sense. They may be just what you need to keep a little skin in the game during these dark days.

Companhia Siderurgica Nacional (SID) is a Brazilian steel maker with all the advantages that a former state-owned company can enjoy, including its own iron ore mine, its own hydroelectric power supply and its own seaport and connecting railroad facilities. The company's revenues dipped in 2009, but seven quarters of increases (including a 29% gain in Q2 2011) mark a convincing turnaround, not to mention the 48% earnings bump in the latest quarter, with a healthy 26.3% after-tax profit margin to boot.

SID peaked at 21 (split adjusted) in March 2010, and has been going over the falls since early April. Now trading below 9, SID sports an attractive trailing P/E ratio of 7 and a forward P/E of 4. Not bad for a solid company that just posted record net revenue on August 2 and whose stock pays a handsome dividend (forward annual dividend rate is 8.1%). Time to steel up for the long run?

Tata Motors (TTM) is an Indian auto and truck maker that has been showing some real expansion chops. Tata has traditionally made and sold boring trucks, buses and cars with all the zip of a motorized bathtub. But an aggressive internal development program has yielded the Tata Nano, a fully enclosed four-passenger car that's the cheapest in the world, and represents the first step onto the automotive ladder for many Indians. There are also development programs for electric and hybrid cars, and moves into foreign markets. Tata has also staked a claim to the upper end of the market with its takeover of the Jaguar and Land Rover marques.

Tata Motors is sensitive to economic trends, and India is as subject to hiccups as the rest of the world. But TTM, after a monster run from 3 in early 2009 to 38 last November, has now drifted down to 18 again, a price that should put a spark in many value investors' eyes. The stock trades at an attractive trailing P/E ratio of 6, and the forward P/E is 5. The stock's trailing annual dividend yield is 2.4%.

Obviously these stocks could both fall even lower if the market remains in its present wheezy state. But the appeal of value investing is that your longer investment horizon insulates you from the storms and lightning of short-term market moves.

Sincerely,

Paul Goodwin
Editor of Cabot China & Emerging Markets Report

P.S. Learn more about stocks like SID and TTM, as well as other top Chinese and emerging markets stocks, in Cabot China & Emerging Markets Report. Hulbert Financial Digest recently named it the #2 investment newsletter for five-year performance! With an annualized return of 17.2% for the five years ending June 30, Cabot China & Emerging Markets Report is stomping versus the Wilshire 5000's paltry 3.4% gain during that period. Click here to learn more.

Paul Goodwin can be found on Google Plus.

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