Two out of Three Ain’t Bad

12/08/2011 6:30 am EST

Focus: STRATEGIES

Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Heritage Corporation

Most investing strategies are attempts to simplify, but don’t forget the principles of your system or you’ll lose out, writes Paul Goodwin of Cabot China & Emerging Markets Report.

Investing in stocks involves a huge number of variables—so many, in fact, that the whole system simply defies complete analysis.

Think about it. Even the most sophisticated organizations (mutual-fund houses and hedge funds), with battalions of analysts and rooms full of computers, can’t get the business of making money by investing in stocks down to a science.

That’s why most stock investment strategies are exercises in simplifying, seeking to gain an edge on the market by reducing decisions on buying and selling to a manageable system. And the essence of most systems is that there are only three things (or four, or five, but nowhere near double figures) that you need to pay attention to.

The Cabot growth investing strategy certainly does this. Here are the principles:

  • Invest in stocks whose charts show increasing investor interest.
  • Increase your market exposure when markets are advancing, and reduce exposure when markets are declining.
  • Cut losses short, especially in negative market environments.
  • Let winners run.
  • Stick to stocks trading above $14 and that average 400,000 shares traded per day.

That’s about it.

And the implementation isn’t all that simple. You have to learn at least the rudiments of technical analysis of charts. You need a reliable indicator of the direction of the market, especially when indexes are soaring and swooping like a flock of starlings. And you need to develop guidelines on when to sell.

By contrast, value investors can ignore most of these things and just look for undervalued companies with good prospects.

Of course, even here, the implementation is far from simple. You need to learn how to analyze truckloads of data on assets and liabilities. And you must develop techniques for projecting the future of a company’s revenue, earnings, free cash flow, margins and market share, management, and competition.

There are stock investment techniques that are simple—dead simple. You can, for instance, buy stocks that your brother-in-law recommends. Or you can only buy stock in the company at which you work. (That’s what my father-in-law did, and his holdings in Amoco—which is now British Petroleum (BP)—provided years of dividend income for him.)

You might try to emulate Noel Constant, a character in Kurt Vonnegut’s book The Sirens of Titan. Constant achieved enormous wealth by buying stocks whose names corresponded to the successive letters of the King James Bible.

Although fictional, Constant’s system is simple and easy to understand. All you need is a massive amount of luck (or divine intervention).

You might also consider the venerable Dogs of the Dow strategy, which involves a once-a-year buy of the ten top dividend payers from among the 30 members of the Dow Jones Industrial average. The strategy beats the performance of the S&P 500 index in the long run.

But if beating the S&P 500 is your benchmark for success, you’re not really aiming very high, are you?

Personally, I find the Cabot growth discipline is just right for my investment personality (my level of aggressiveness, tolerance for risk, and need for mental stimulation).

I’ve always enjoyed "Two Out of Three" rules. One favorite says that food can be fast, cheap, and nutritious, but you can only have two out of three in any one food. A Twinkie, for example, is fast and cheap, but fails miserably at nutrition. You can fill in the other categories.

In investment, I’m not sure what the three categories would be. How about simple, high potential, and consistent?

Simple and high potential might be penny-stock investing, where the upside is huge, but the volatility cuts both ways. Simple and consistent would be an index fund, which lacks big upside chances. And high-potential and consistent could, at least in theory, be hedge-fund investing, which is anything but simple.

So where would growth investing fit in this scheme? Well, despite the implementation difficulties I ventured above, the principles are indeed simple. And the potential is genuinely high.

But growth investing, at least as the Cabot system practices it, looks to make the bulk of its annual returns from a small number of successful stocks that deliver big gains. You have to cut off a lot of losers in pursuit of a few big winners.

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