Balance Your Assets for a Choppy Market

08/16/2011 10:05 am EST

Focus: FUNDS

Dave Demming, Jr. joins the chorus of advisors urging caution amid market volatility. He likes funds that are buying large-caps with stable businesses, such as MasterCard or Nestle. He also suggests taking a look at some small-cap Asian funds.

Kate Stalter: We’re speaking today with Dave Demming, Jr. of Demming Financial Services Corp. in Aurora, Ohio. It’s so great to have you speaking with us today, Dave.

Dave Demming, Jr.: My pleasure Kate.

Kate Stalter: I want to start out by asking you sort of the obvious question that’s on a lot of people’s mind, which is, of course, about the current market volatility. What do you see as the crucial points for individual investors to be aware of right now?

Dave Demming, Jr.: One of the first things that investors need to keep in mind is that market gyrations shouldn’t necessarily dictate your outlook on life, or just your demeanor throughout the day. I think you want to realign a few things, and focus on the fact that you can control only what you can control. Things like establishing a process and also remaining disciplined to that process.

That’s something that we as a firm have been doing for many years. We try to find active managers who fit the mold of our philosophy. Generally speaking, we find those in certain types of asset managers, similar to balanced funds and global allocation managers and people who are going to be active in this type of environment for us.

I think lots of our clients hope that we’re making decisions based on what we’re seeing out there, and yet want to be active. When you’re sitting there thinking about what you should be doing on down days or when there are opportunities out there, you want to be a buyer when others are sellers.

It’s easier said than done, and when you decide to hire a manager to do that, you expect a little bit of basic activity when there is opportunity. That’s what we’ve been hopefully trying to do here over the last couple of weeks.

I can get specific on a few types of maneuvers that we’ve been making. We’ve definitely been planning for the typical sell-off. More often than not, summer tends to be weak. It surely happened last year, and that’s nothing new.

So, you always want to have some cash on hand. We like to think of it as dry powder. That cash, or some very conservative, limited bonds, give you that cushion in this volatile last couple of weeks’ stretch, but it also gives you ammunition to be adding and rebalancing back into some of those asset classes that have been negatively affected.

All the way across from the commodity market to even the small-cap market, this wouldn’t be a terrible time to be trying to add a couple of percentage points to those positions. So that’s part of what we’ve been doing actively, by not making huge decisions and trying to get too caught up in the day-to-day.

Because obviously even the last four trading days have been wild swings, and you just don’t want to overreact to the day-to-day noise, as we like to think of it.

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Kate Stalter: Now, you had alluded to maybe giving us specifics about areas that you do see as showing strength. Give us some detail about that.

Dave Demming, Jr.: Sure. I would like to think that we’ve been cautiously adding to dividend payers. I can speak to a couple of managers who have been adding to positions like Nestle (NSRGY) or MasterCard (MA).

Not necessarily adding—I’m not as comfortable saying I know for sure they’re adding in this environment—but the reasons why they own these types of durable businesses is because you’re trying to get an inflation hedge, and you’re also trying to find assets that you think are durable.

When you think of the business model of somebody like MasterCard: If prices of things go up and you’re using a credit card to make those purchases, well they basically have the ability to take a percentage of that.

Depending on what price you pay for the business, it’s an alternative way of getting an inflation hedge, as opposed to some of the other strategies out there, such as just buying gold. Because no one would argue that gold hasn’t done quite well, but you do have to wonder if there is a little bit of speculation in there.

I think that you’re going to have some volatility in certain types of hard assets. That’s the price you’re going to pay to be invested there.

So, we try to look for alternative places to try to create value over time, and to mitigate some of the risks that are out there, be it inflation or be it interest-rate risk.

Another area that we have been nibbling the last few months—and they have not been sold off the same way as the broader market—is the convertible bond market. Just the general concept of trying to make 85% to 90% of the upside, with historically 50% to 60% of the downside volatility in the equity market. That’s another place where we’ve been adding over the intermediate term.

Kate Stalter: What about some areas, Dave, of the market that you believe are showing weakness, and individual investors should really just avoid at this point?

Dave Demming, Jr.: As a contrarian, I’d like to think that certain areas where many investors have fled over the last few years is financials. We do have a few managers that have been very specific in the financials that they’re looking at.

Particularly in Europe, a few managers of ours do own Banco Santander (STD) and a few others that we believe are just getting painted with the same brush as some other European banks, that they believe have a lot of exposure to some of the sovereign credits over there.

Conversely, you want to be looking in some of those areas that have been recently weak. I don’t think anybody would argue that financials haven’t been a place of consistent weakness over the last few years. I’m not saying to go head over heels into that sector by any means, but I think that selectively, unless the banking system globally deteriorates into something that looks nothing like it is today, I think there will be some winners and losers there.

But you do have to be selective and patient. I think that that’s really what you want to focus on.

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Kate Stalter: Give us some other examples of vehicles that you are putting clients into at this point, or that you believe individual investors might want to take a look at in terms of their research.

Dave Demming, Jr.: Sure. Coming back to something I mentioned earlier: At our firm we use a core-and-satellite philosophy, where we try to use some core asset classes that we’re always going to own, or certain styles of management. We come from a value bias and we generally try to fill our core with competent, balanced-fund managers, equity incomes and the historic global-allocation managers.

I don’t like to try to put a lot of restrictions on managers that I think are quite bright, that tend to have the bulk of their net worth invested alongside ours. You want to give them the free rein to find value wherever they find it.

That kind of the core area where you want a large percentage. For us, over 50% of our capital base is generally in those two or three major food groups, and then you look to start adding to the peripheral.

Do you want a small-cap stock fund in Asia? I think there are plenty of other places that you can put other assets, but you don’t want to get too wedded. You’re not trying to speculate with the bulk of your assets, because you could really get burned being wrong.

That’s what true diversification is all about: Trying to mitigate a lot of the ups and downs, and trying to create alpha with some of your smaller positions that may not necessarily always go in the direction that you’re hoping for.

Kate Stalter: Any examples of particular funds that might achieve that?

Dave Demming, Jr.: Well I know that there are some fund families out there that are specific to the Asian region. I can recommend in general a couple of the smaller boutique firms, such as the Matthews Fund family.

If you look at the larger global players in the mutual fund world, you will find a number of the value firms out there that have long track records. I really prefer fund families that have a history of closing funds when they get to asset levels that are starting to get into real numbers where—it’s a nice sign when a fund family respects their fiduciary duty to shareholders, and you want them to close a fund before it gets too large.

I wouldn’t want to necessarily mention individual names, simply because unfortunately a lot of the funds that we do use tend to close, which is a good sign for stewardship, of course.

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