How to Invest in Emerging Markets the Cabot Way

Here’s a quick review on how to invest in the emerging markets the Cabot way.

Allocation: The Rule of 10

Cabot Global Stocks Explorer aims at the construction of a portfolio of 10 stocks from emerging markets countries. When the EM portfolio has 10 stocks, it is considered fully invested—although it has occasionally had as many as 12 during ultra-strong market moves.

If you are attempting to follow the portfolio as closely as possible, you will determine the amount of your investable cash that you wish to allocate for the purpose and then mentally divide it into 10 equal-dollar positions. Each full position you buy, then, will represent about 10% of your emerging markets allocation. The portfolio always uses equal-dollar positions, without regard to numbers of shares.

A 10-stock portfolio is an aggressive portfolio, one diversified enough to avoid being devastated by a single failure, but concentrated enough to get a significant benefit from a winner.

Buying: Full vs. Partial Positions

Some of the stocks recommended will be in strong uptrends. Uptrends are good, as they are the best evidence available that investors are hiking their perceptions of a stock. They are also tricky, as stocks at new price highs can be volatile, often correcting 5%, 10% or more in the blink of an eye, even without negative news.

While the portfolio typically buys full positions—recommending a new stock (usually on a Thursday), then buying for the record at the average of the high and low prices on the next trading day—as an individual, you can either follow suit or use a more sophisticated buying technique.

Partial-position buying, especially of stocks at new highs, can lower your risk. To do this, you calculate either a third or a half of your usual dollar position and buy that amount immediately. When the stock confirms your buy by rising 5%–10% or more, you buy another chunk. Eventually, you wind up with a full position…if the stock keeps rising. If the stock heads the wrong way, you’ll only have a small loss on a small position.

Thus, progressive buying is a good risk-reducing mechanism. Of course, it also slightly reduces your potential return on a fast-moving stock, but finding the right balance between risk and reward is what becoming a savvy investor is all about.

Selling: Cutting Your Losers Short

Our SNaC approach to investing (Story, Numbers and Chart) allows us to insert information from many sources into the buying decision mix. By avoiding strict reliance on any one type of data, we seek a kind of convergent validity in which all signals agree.

Sometimes it works, and sometimes it doesn’t.

When it doesn’t, and a selected stock heads for the canyon floor, your job is to cut the offending stock loose before it drags your whole portfolio’s results down with it. More than any other factor, a strong, consistently applied sell discipline is what sets the successful investor apart from the perennial amateur.

There are substitutes for a rigorous sell discipline: wishful thinking, denial and liberal applications of pixie dust come to mind. They don’t work, of course, but they’re quite popular among the class of investors that we think of as the donor class. That doesn’t include any subscribers to the Cabot Global Stocks Explorer, we’re sure.

Here are the rules for a sell discipline. If a stock gives you a 20% loss from your purchase price, sell it. (Most times we get out when our loss reaches 10% to 15%.) In a bear market, tighten that loss limit to 15%. Period.

You should note that this is a very personal limit. If the portfolio has purchased a stock and you buy it at a higher price, you must be prepared to exercise your loss limit even if the portfolio has not. The portfolio will follow the rules at its own prices. You must take personal responsibility for your own selling.

Everyone will occasionally violate these rules…even the portfolio. We all suspect big institutional investors of pushing prices down just low enough to force a sell and then scooping up the discounted shares, so we occasionally hold through a selloff. But for every eventual winner that we triumphantly hold onto through a rule-violating correction, we will have our head handed to us four or five times. It’s not worth it. Follow the rules.

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