How to Build a High-Performance Portfolio

The Sky Is Not Falling

How to Build a High-Performance Portfolio

A Great Growth Stock

I don’t know about you, but I’m sick and tired of all this debt ceiling talk … the distortion of facts, the posturing and the brinksmanship. But that’s politics and I expect no less from the elected representatives of our oh-so-diverse country.

What bothers me more than that is the way the media is eating it up–even fanning the flames–by constructing terrible scenarios of what might happen if the debt ceiling isn’t raised.

What’s lacking is a rational voice.

So today I’ll provide it, by looking at this from a perspective most people haven’t considered.

We start back in 1999, when the whole world was preparing for the countdown to the new millennium, or Y2K. The big fear then was that computers that had been programmed to treat years as two digits might think we were back in 1900 when the calendar rolled over. And if those computers belonged to banks, airlines, electric and water utilities, etc., the resulting chaos, dubbed the Y2K crisis, might bring civilization to a standstill … at least until someone rebooted.

John Hamre, United States Deputy Secretary of Defense said, “The Y2K problem is the electronic equivalent of the El Nino and there will be nasty surprises around the globe.”

But nothing happened. There were a lot of parties, and life went on.

On a smaller scale, consider two weekends ago.

Residents of Los Angeles were warned that the Sepulveda Pass Improvement Project, in which 10 miles of normally congested highway were shut down for 53 hours, would result in massive gridlock. The potential nightmare was dubbed Carmegeddon.

Posie Carpenter, chief administrative officer of The UCLA Medical Center, said, “We see this as being a disaster–only it’s a planned disaster.”

But nothing happened. In fact, the construction project was completed in just 36 hours, 17 hours sooner than expected.

The similarities in both cases should be obvious.

There was a well-publicized threat. There were widespread warnings about the threat. There was wide-scale adaptation to the threat.

And as a result, there was little or no pain.

In fact, thanks to the Y2K threat, a lot of computers were updated, which provided a nice shot in the arm to the tech sector.

And in LA two weekends ago, a lot of folks walked, rode bikes or used public transportation, and if some of them stick with that alternate mode of transportation, everyone will benefit.

Coming back to the debt ceiling crisis, which still lacks a catchy nickname, I think we’ve had ample and widespread warning, and I see little chance that the parties in power won’t come up with a compromise before the time bell rings. But I also see that each party will refuse to compromise for as long as it thinks it can gain political advantage from doing so … which could be right up to the wire.

And what will be the advantage to us from this “avoided disaster?”

Ideally, a smaller deficit, and the start of a true trend toward an improved national balance sheet. I look forward it.

I can’t avoid repeating this message, which Cabot Wealth Advisory Editor Elyse Andrews brought you on Saturday: Concern Yourself Least When Others Fear Most.

The corollary, by the way, is this: Trouble comes from where it’s least expected.

So what should you worry about? Well, if you live in Southern California, and are happy to have avoided Carmeggedon, I suggest you think hard about an earthquake. I recently spoke with a seismic geologist who’d recently relocated from Los Angeles to Boston, and he told me he’s very happy to be on solid ground.

Moving on, last week’s email brought this from a reader.

“I have been reading the Wealth Advisories for about four years now and enjoy the down-to-earth approach of the authors. About two to three years ago I decided to pay for a subscription with Cabot Stock of the Month as I wasn’t sure which newsletter was best for me. I’ve enjoyed and profited from that publication. Not long after I also signed up for the Cabot Benjamin Graham Value Letter, which I’ve had a little success with. As time passed I found that I’m not really a value investor so I signed up for the Cabot Market Letter. I really enjoy that approach. This summer I decided that I also wanted to add the Cabot China & Emerging Markets Report, as it appears that there is so much room for growth there. This leaves me with the problem of having too much advice! I’ve decided that I will let the value letter expire and may do the same with Cabot Stock of the Month (although I like its simple approach). This will still leave me with the Cabot Market Letter and the Cabot China & Emerging Markets Report. Last winter I read Jesse Livermore’s book and enjoyed it very much. I tend to agree with him that having too many stocks at once is a problem and trying to buy all of the recommendations in various publications poses problems. My current limit is about $10,000/stock but when I try to follow all of the advice, I have too many stocks (25-35). I don’t find it easy to try to choose which of the recommendations in each letter to follow and which to ignore so I need a little advice on what to do. I do know that I am more of a growth and momentum investor. Any suggestions?

N.S.
Abu Dhabi
United Arab Emirates

I answered Mr. S. personally, but considered his question universal enough to expand on the answer for all readers who might have similar questions.

The fact is, most investors own too many stocks.

Value investors are justified in holding dozens of stocks if they follow a discipline like that of Cabot Benjamin Graham Value Letter, which features two recommended portfolios and monthly special features and lists Maximum Buy Prices and Minimum Sell Prices for the 250 Highest Ranked Wise Owl Stocks in every issue.

But few growth investors can justify holding more than a dozen stocks. For growth investors, it’s concentration on top performers that brings big profits, not diversification among a bunch of second-rate stocks.

So the question for N.S. is this: “What’s the best way to use the advice in multiple Cabot newsletters to construct a focused portfolio of top performing stocks?”

He’s already reading the right newsletters.

Cabot Market Letter
provides all-important market timing advice as well as invaluable education on topics that will make him a better investor. And Cabot Market Letter’s Model Portfolio is a perfect model of concentration, in that it has a maximum of 12 high-potential growth stocks in strong bull markets, but scales back to fewer when markets get challenging–today it has seven.

Cabot China & Emerging Markets Report helps subscribers spice up their portfolios with hot Chinese stocks. The newsletter boasts the second best performance of all newsletters over the past five years, with an average annual return of 17.1%. Of course, those returns come with higher volatility.

And Cabot Stock of the Month is valuable for its focus on just one stock per month, chosen by yours truly. But sometimes it’s a value stock, and that’s not what N.S. needs.

So how can he get his portfolio down to a reasonable size?

Mainly, by being more ruthless about selling.

In my experience, most investors are too forgiving of their stocks. And the reason is simple. When they buy a stock, their reason (ideally) stems from a combination of fundamental and technical factors. But when the technical factors worsen and the stock disappoints, the fundamental factors that helped persuade them to buy the stock are frequently unchanged! So a battle develops in the head that goes like this.

“The stock’s going down; you should think of getting out.”

“But the story is so great, and I don’t want to sell just before the stock turns up.”

“But the stock is going down, and every day it goes down, you lose money!”

“If I don’t sell, it’s not really a loss. Maybe it will bounce and I can get out even.”

That last one really gets me. Get out even. The goal is not to get out even! The goal is to always hold a portfolio that has the best potential to bring you large profits.

Without a referee, that discussion tends to go on far too long. Bad stocks tend to be held far too long. And they drag down performance.

What growth-oriented investors should do instead is continually weed out their worst stocks and buy more shares of their best performers. (Cabot Market Letter’s editor Michael Cintolo is really good at this.)

Once N.S. has done this selling and has his portfolio in good shape, then he needs to keep it in shape by adding new stocks only after he sells. He can’t buy all the stocks recommended in our newsletters, and there’s no need to. But if he uses them wisely, and remembers that the goal is to always hold a portfolio that has the best potential to bring you large profits–and not to get out even or have more winners than losers or to simply beat the market–then he’ll be an increasingly successful investor.

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As to the market, my sense is that the strength of the past few weeks means the market has already discounted the successful resolution of the debt ceiling crisis. So I don’t expect any particular strength when the crisis passes.

But I do see lots of good-looking stocks, and one that’s developing into a great long-term success story is Netflix (NFLX).

The company is well known, but what many observers fail to fully appreciate is the forward-looking strategizing of founder Reed Hastings.

First he crippled Blockbuster and other video stores by introducing the DVD-by-mail business model.

Then he improved on that (and goosed Netflix’s profit margins) by introducing a streaming video service. It wasn’t the first, but it was easy to use and it worked.

Recently, he introduced a new pricing structure that brought howls of outrage from customers because it penalizes those who want to retain the DVD-by-mail option. The stock market, however, liked it.

He’s expanding into Canada and South America with an unlimited streaming service, skipping the DVD step totally.

And now Netflix is getting into the content business, to become a competitor of TV networks and movie studios!

Financially, the company has been a great success. The company has grown revenues every year of the past decade, and grown earnings every year since 2005. In the last quarter, Netflix saw revenues grow 46% to $719 million, while earnings soared 88% to $1.11 per share. The after-tax profit margin was a record-high 8.4%. And analysts have once again raised their earnings forecasts, projecting growth of 54% in 2011 and 47% in 2012.

As for the chart, it’s been in a long-term uptrend since the market bottom of late 2008. Most recently, it pulled back from a high of 300 to touch its 25-day moving average at 270, and I think that offers a decent entry point.

Now, there are two common complaints that some investors will make about this recommendation.

One is that Netflix’s stock price is too high; they’d rather have 1,000 shares of a $3 stock than 10 shares of a $300 stock.

On a primitive level, owning 1,000 shares of something feels good. Plus they dream that the $3 stock might easily jump to $6 and double their money.

Sadly, the truth is that most low-priced stocks wither on the vine. And if they don’t actually inflict losses they’re an expensive parking place. (But if you want guidance on finding those rare good low-priced stocks, I recommend Cabot Small-Cap Confidential.)

The second criticism some people have with a NFLX investment is that it’s too expensive on a valuation basis.

It’s got a price-to-earnings (P/E) ratio of 79, and a forward P/E ratio based on forecast earnings of 61.

To investors stuck in the old paradigm of hunting for P/Es under 20, or even in the single digits, those are nosebleed numbers.

But what these bargain-hunters don’t recognize is that the best growth stocks always have high P/Es. In fact that’s one way to recognize them! Growth stocks generally sell at an above-average multiple of earnings to reflect the strong potential growth of those earnings.

Back in May 2008, for example, Baidu (BIDU), nicknamed the Google of China, was trading at 360. Its P/E was 133, and its forward P/E was 91 … all numbers that are higher than Netflix’s corresponding numbers today.

Well, BIDU has had a 10-for-one split since then, and it now trades at 156, which means its stock is up 333% in those three years!

Now, I don’t think Netflix will do as well, mainly because it’s not growing as fast as Baidu was then. But it might, particularly if Reed Hastings can find a way to get Netflix into the Chinese market. And it’s a no-brainer that this forward-looking wizard is thinking about it!

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Publisher
Cabot Wealth Advisory

Editor’s Note: Are you looking to get started investing, but unsure of where to begin? Cabot can help! Tim Lutts is not only Cabot’s publisher, he’s also the editor of Cabot Stock of the Month, which does exactly what the name says: It brings you the best stock across all Cabot sectors for current market conditions each and every month! And these stocks are hand-selected by Tim from across Cabot’s advisories. You could get a fast-growing Chinese issue or a high-quality undervalued stock that’s poised to help you profit. Click here to start building your portfolio today!

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