Two Building Blocks of a Sound Growth Portfolio

Two Principles I Believe In

Building Blocks of a Sound Portfolio

Broad Exposure to the Chinese Market

“Simplify, simplify.”–Henry David Thoreau

“Seek simplicity, and distrust it.”–Alfred North Whitehead

The search for simple solutions to complex problems has been going on for a long time.  And with Thoreau on one shoulder encouraging you to pare down and Whitehead on the other telling you to dig complexity, you could easily go totally insane.  First you would look for big, underlying principles to explain things; then you’d start working out the exceptions and adaptations that always pop up when big principles meet the real world.

Anyone who has ever tried to get a straight answer from a politician knows the kind of frustration that can result.

Even with all this in mind, I’d like to put forward two big principles that I really believe in.  I’ll deal with the footnotes, caveats and exceptions later.

Principle One:  Everyone should pay the same percent of their income in taxes. 

This one is getting such a workout these days that I don’t have a lot to add.  Even when I hear myself say it, I automatically amend it to, “Everyone who makes more than a certain amount of money a year should pay the same percent in taxes.”  Then it’s not a simple rule any more and we’re off to the races. 

The only way to get a truly simple tax code involves shooting way too many people, and I’m not going there.

I would say, however, that when your tax code is so complex that you can’t tell tax cheats from the honestly confused, something should be done.  There are lots people out there for whom cheating on their taxes is a second religion, and that’s wrong in my book.

Principle Two:  The way to pull the U.S. out of our present economic quicksand/doldrums/cesspool is to lower the short-term capital gains tax.  That’s it.  Period.  Simple.

A few years ago, I would have laughed at such a statement, maybe even snorted.  I’ve been a Laffer Curve skeptic for as long as napkin-based economic theories have been popular.

In the present circumstances, the reality of things is that people are scared spitless.  Banks don’t want to lend and buyers don’t want to buy much of anything, from houses on down.  Fear and greed are always the prime motivators of market activity, and fear clearly has the upper hand at the moment. 

Lowering the short-term capital gains tax would encourage capital to come off the sidelines and get back in the game.

It’s great that the politicians in charge of shaping the stimulus package are so focused on creating jobs.  Jobs are good.  But they also cater to the politicians’ need to prove to their constituents that they are looking out for their welfare.  No doubt job creation will begin to fatten tax receipts and encourage more purchases of paper towels and hamburgers.

Keep in mind, however, this is a capitalist economy, and it runs on capital investments.  If someone drops $20 at a pizza joint, the effect is local and limited.  But if that same person invests $20 in Dominos Pizza (DPZ), which has doubled off its November low, the effect will show up on charts around the world. 

(I don’t think DPZ is a great stock, but work with me here, I’m trying to make a point.) 

By lowering the short-term capital gains tax, which can be substantial if you add the Federal and state bites together, you would signal to the capitalists of the U.S. that it’s genuinely worth it to put some money to work.  Money that goes to work in the stock market works very hard indeed.

That’s about as simple as I can make it.

I’m obviously not an expert on taxation, and I agree with the brilliant Peter Drucker that “Anyone who tells you that he understands the American economy ought to be sent to teach modern dance.”

Still, if someone gave me the magic wand and told me to get to work on fixing things, a cut in the capital gains tax would be one of my first acts.  The second would be a World Series victory for the Chicago Cubs, but my selfish needs are another story. 

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With pressure building underground, there hasn’t been a real breakout to the upside by U.S. markets.  The Nasdaq has put in some nice gains; its chart looks like it wants to build a cup that began its left side on January 6 when the Index topped at 1,666. 

But whether it happens this week or this month or a few months from now, the stock market will be coming back.  It’s the only thing about the stock market that I’m willing to predict.  It always does.  Always.

So, as we’ve said here a dozen times or more, you should be working on a Watch List.  Even if you’re not buying now, you should have a list of stocks that you would be buying if market conditions were better.  Having this kind of list keeps you sharp and forces you to think like a buyer even when buying isn’t a good idea.

Here’s another idea for when we finally get the green light. 

Controlling risk in your portfolio is important to avoiding the big losses that can sap your results. 

For most people, risk control means diversification.  You’re taught to have some assets in growth stocks, value stocks and income stocks.  Investment texts tell you that your stocks should also cover the spectrum from large-cap stocks to small-cap stocks.

But you don’t get much advice about how to allocate the money within your growth portfolio.  Today I’m going to remedy that.

The more holdings you have, the lower your risk.  If you have 50 holdings, it will be hard for the failure of any one of them to deep-six your results.

The problem is that it will be correspondingly difficult for a big rally by one of your stocks to make you a lot of money.  For maximum results, you need a concentrated portfolio. Cabot Market Letter–which is considered to be moderately aggressive–is fully invested when it has 12 stocks in the Model Portfolio. Cabot China & Emerging Markets Report is even more aggressive, with a hypothetical portfolio of just 10 stocks when it’s fully invested.

If you decide to go with this kind of concentration in your growth portfolio, you need to follow two rules to keep risk under control.

First, you must set loss limits based on the price at which you bought each position.  When markets are challenging–as they are now–your sell discipline should kick in at a minimum of 15% below your buy price.  No exceptions.  When markets are supportive, you can push that loss limit to 20%.  The limits kick in only at the close of a trading day.  Intraday moves don’t count, unless a stock is clearly in free fall after bad news.  In that case, the quicker you get out the better.

The second risk rule is to use equal dollar positions to build your portfolio.  The number of shares you own is totally irrelevant.  If you are working on an aggressive portfolio, you should divide the amount of money you have allocated to that portfolio into 10 equal-dollar positions and buy just that amount of each stock.  Having 100 shares may be neat, but if you have 100 shares of a stock that trades at 25 and 100 shares of one that trades at 50, your risk exposure in the second stock is twice a big.

Two great building blocks for a sound growth portfolio: Loss limits and equal dollar positions.

My investment idea today is more of a macro play than I usually recommend.  It’s an exchange-traded fund called iShares FTSI/Xinhua China 25 Index (FXI).  The name is a mouthful, so I’ll just keep calling it FXI.

The FXI follows the Dow Jones Industrial Average of China, representing the performance of 25 of the largest and most liquid Chinese stocks that trade here in the U.S.  As such, it serves as a snapshot of the health of the market, not rising as fast as the hottest Chinese stocks, but not falling as quickly either.

It’s a macro play because owning it gives broad exposure to China.  It’s a good choice for right now because the issue has been rising strongly since the middle of January and recent volume clues–specifically, above-average volume on February 4 and 5–indicate increasing institutional interest in the future of Chinese blue chips. 

Investments like the iShares ETF provide a chance to benefit from a macro story like the continuing growth of China without doing the detail work to select likely winners from among all of the Chinese stocks that trade as American Depositary Receipts, or ADRs, on U.S. exchanges.

In mid-January FXI was trading at 23.  Now it’s at 28.  There is possible resistance at 31/32 from December and January, but another piece of good news to silence the China doubters could sweep that all away.  I think it’s a reasonable bet.


Paul Goodwin
For Cabot Wealth Advisory

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