The Bailout Index

The Bailout Index

Advantages to Being an Individual Investor

An Emerging Markets Stock

Last Thursday, in a financial story that you may have missed, Nasdaq OMX Group announced that it had created a new index.  It’s called the Nasdaq OMX Government Relief Index and it is now trading under the symbol QGRI.  The components of the index will be the companies that receive $1 billion or more under the Troubled Asset Relief Program (TARP) or any other government handout program.

There’s a kind of twisted logic to this new index, whose initial roster of companies includes Bank of America, Citigroup, General Motors, Goldman Sachs, J.P. Morgan and Morgan Stanley.  After all, if a company hasn’t actually gone bankrupt and the government has topped up its financial tank with a hundred thousand large, you’d think things might be looking up …

Or maybe not.  QGRI went live on January 5, and as of one week later, was down to about 850 from its opening price of 1,000.

Creating and updating indexes like The Bailout Index (my term) is one way financial services companies make a living.  Firms like Nasdaq, Russell, MSCI/Barra, Standard & Poors and Dow Jones find ways to de-stratify and un-weave the markets that they hope will prove useful to investors and analysts.

When I was working in the mutual fund industry, we used to use a 3 x 3 box to describe equity-investing styles.  On one side the box the categories were small, medium and large caps.  The other axis had growth, blend and value style.  The theory was that by throwing an equal number of bucks into each box, you could, over time, diversify enough to weather market fluctuations.

But the proliferation of indexes is a whole different galaxy from that kind of rough-and-ready asset allocation scheme.  By allowing sophisticated investors to target smaller and smaller segments of markets, these indexes are the midwives of the derivatives industry.  If you’re going to make a bet on something to do with the market, you need an objective measure of what that something is doing.

I don’t know if QGRI looks like a useful tool or not.  By aggregating the fortunes of all companies receiving bailout money, it will certainly appeal to an investor who has a strong opinion of the program and its chances of success.  This is also the perfect vehicle for anyone who has a strong opinion about the macroeconomic future of the U.S. market.  

For myself, as a long, growth investor, I prefer to look at the history, products, management, stock charts and earnings of individual companies.  With the information available online, I believe I can gather enough information to make buying a stock a reasonable bet–not a sure thing, mind you, but reasonable enough that I can come out on top.

Given my skepticism about the probability of successfully predicting the future–whether it’s the economy, unemployment, housing, consumer spending or football–I think I’ll give The Bailout Index a pass.

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If you’ve ever thought about how you–one lone individual out there making your investment decisions on your own–can possibly hope to beat the results of a large mutual fund, here’s how.

Yes, it’s true that a big investment company has enormous resources.  Analysts can chop and count every number about the target company, figuring out the history of the company’s revenues, earnings, cash flow, free cash flow, working capital, debt, overhead, liabilities, taxes, expenses, productivity, raw materials, etc.  They can figure every valuation ratio in the book and even invent more.  They can also visit every company whose stock is under consideration, getting face time with management and taking the temperature of employees.  In other words, they have access to lots of information.

In the final analysis, however, big mutual funds have three disadvantages that give a small, individual investor a fighting chance.

First, most mutual funds operate under guidelines that require them to remain invested at all times.  Investment guidelines are contractually binding and specify what money managers may and may not invest in.  Most stock funds are required to have 95% or more of the fund’s money invested in the prescribed asset classes at all times.

The advantage for you, the individual investor, is that you can jump out of the market and go to cash when stocks are diving like a rock.  The manager of the small-cap value or large-cap growth fund, on the other hand, can only move toward the best stocks in that class.  As your 401(k) results may have told you, this hasn’t been a very good allocation during the last six months or so.

The subscribers to Cabot growth stock newsletters, by contrast, have been sitting in cash for much of the worst of the Big Bear of 2008.  Much better than the alternative.  

Second, mutual funds are big.  When they buy, stocks go up and when they sell, they go down.  This is a problem for a big fund that wants to dump a stock.  But they have very skilled people who can unwind a position over a period of weeks without having the market notice.  

Unfortunately, the stock market often doesn’t wait weeks to knock a stock off its pedestal and grind it into the dust.  So while you’re pushing the button to sell a plunging equity, the big investor has to decide whether to join you in selling immediately (thus pushing the stock lower and probably scaring off potential buyers) or trying to parcel out sells in hopes of avoiding a price collapse.

The real disadvantage for the big investor here is that they must try to predict the future, steering their funds toward where they think markets will be months from now.  As I’ve said here many times before, predicting the future is not something anyone has ever been able to do consistently over time.

So, your first two advantages are that you can go to cash and you’re nimble.  

Your third advantage is that you’re really trying to make money, while the mutual fund manager is just trying to beat an index.

This may not sound important, but it’s actually a ginormous difference.  

The mutual fund manager has an index that has been designated as the benchmark for the fund.  So a large-cap growth fund manager is trying to earn a few basis points more than the S&P 500 Index, which will put the fund into the top quartile of funds in that asset class.  

To beat a benchmark, the manager uses most of the fund’s money to buy exactly the same stocks in the same weighting in the relevant index, right down to the 10th of a percent, stock for stock.  Then the manager makes bets by under- or overweighting the fund’s holdings of a few stocks versus the index.  Some managers, especially those of small-cap funds, will sometimes make out-of-benchmark calls by buying stocks that aren’t even in the benchmark.

Ultimately, however, it’s the benchmark that’s setting the course, with the manager just trimming the sails a bit.

As an individual growth investor, your advantage is obvious.  Not only are you not charging yourself a management fee, you’re free to buy whatever you want, regardless of any index, sector, industry, country, capitalization or style.

So what are your advantages as an individual investor?

You can go to cash when market conditions turn adverse.
You can move in and out of issues quickly.
You can manage your money to make money, not to beat a benchmark.

It’s still not easy, but you have some powerful factors on your side and a powerful ally in Cabot growth letters–Cabot Market Letter, Cabot China & Emerging Markets Report, Cabot Green Investor, Cabot Top Ten Report and Cabot Small Cap Confidential–to help you make use of them.

My investing idea for this week is fairly far off the radar.  It’s an emerging markets company called Chemical and Mining Company of Chile (Sociedad Quimica Y Minra) (SQM).  This medium-sized chemical and fertilizer company (last year’s sales were $1.68 billion) produces potassium nitrate, iodine, and lithium carbonate and distributes them around the world.

The company is thriving because it has a rich source for its minerals.  But even more important, it has worked to create value-added products from what it mines, avoiding the extreme fluctuations that the commodity markets are prone to.  Its other products include specialty plant nutrition products and the lithium that helps to power batteries and is useful in the ceramic and enamel industries.

In Q4 2007, the company achieved a robust 55% gain in earnings on a 15% bump in revenues.  Since then, quarterly earnings growth has been 56%, 153% and 350%, leading to an after-tax profit margin of 32.3% in the latest quarter.  There’s nothing commodity-like in those results.

SQM had a great year in 2005 and then it slowed down somewhat in 2006 and 2007.  In 2008, the stock took off on a run that blasted it from 13 to 59 in just five months.  The Big Bear of 2008 then mauled the stock, pushing it right back below 15 in less than four months.  

The stock is now recovering, and has already topped 25.  With a P/E ratio of 16, it’s not cheap, but it has the potential to react well to any good economic news.


Paul Goodwin
For Cabot Wealth Advisory

Editor’s Note: The emerging markets are a combination of big risks and big rewards.  After months of holding nothing but cash, Cabot China & Emerging Markets Report is dipping a toe into this exciting area again.  We may or may not ever recommend Chemical and Mining Company of Chile for our subscribers, but you can receive up-to-date advice and commentary on emerging markets stocks every week with a subscription.  Click the link below to get started in this exciting area today.


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