Pockets of Opportunity in the Stock Market

The trends that boosted our portfolios ahead of the indexes this year are likely to last another quarter or more. As more and more investors notice our returns and invest with us, it will become time to move into other investments. We aren’t at that point yet, but I’m already drawing up a short list of candidates for our portfolios.

Many of our positions are defensive, and are paying off. By insisting on a margin of safety and diversification, we avoided major problems and owned some hidden gems that have paid off. Too many investors and advisors restrict themselves to the major U.S. stock and bond indexes. That approach won’t pay off in the face of rising interest rates and the downward valuation of stocks. In this part of the cycle, an investor has to seek investments other than straightforward stocks and bonds. That is what we have done.

Let’s review our strategy and positions.

Sector and Balanced Managed Portfolios

Balance and caution have been the guiding principles of these portfolios. We have been cautious about U.S. stocks and optimistic about other opportunities.

We have not entirely ignored U.S. stocks. Hussman Strategic Growth holds almost a full portfolio of stocks of growing U.S. companies that are selling at reasonable valuations. In addition, the fund has an array of indicators that capture market valuations and trends.

The stock portfolio will be hedged against market declines as warranted by the valuation and trend indicators. In recent months, the portfolio often hovered around fully hedged as the indicators said stocks are overvalued and have market trends are negative.

The combination of good stock selection and effective hedging has worked well. The fund is up over 6% while the market indexes are down a few percentage points. This fund practices the kind of nimble, fundamental investment strategy we want to follow in this market cycle.

We also are investing in U.S. stocks through two focused stock funds. Chase Growth buys growth stocks, but it buys them with caution. It won’t buy overvalued stocks. It also pays attention to technical market action and will sell a stock when the trends are unfavorable. Chase also buys only the managers’ favorite stocks, usually owning 30 or fewer stocks in the fund. It is up over 5% this year.

Oakmark Fund, the laggard in this portfolio, also owns a small number of stocks. (Its even more focused sibling fund, Oakmark Select, recently re-opened to new investors and is a good fund to own.) Oakmark looks for companies that it believes are selling for less than their intrinsic value.  Oakmark pays much less attention to technical trends and often will hold a stock for years, until the market recognizes the value Oakmark identified.  That approach also can lead to short-term losses.

Since neither fund is hedged, each likely will decline when market indexes decline. But because of their cautious investment approaches, they should decline less than the indexes and than more aggressive funds.

We also benefit from spotting early the relative value of international stocks. Tocqueville International Value and Third Avenue International Value have double digit returns for the year, and they have had especially strong returns since their lows of this past May. You won’t find many well-known companies in these funds. They concentrate on companies and sectors in which the markets are less efficient.

International stocks are well ahead of the U.S. indexes in 2005. That is attracting a lot of attention. We spotted the value in overseas equities early. As usual, the solid returns are drawing the hot money and “return chasers” to the sector. As fund flows to international funds soar, the value gap between U.S. and international stocks will close. One sign that a top is nearing is that Third Avenue International Value recently closed to new investors.

Maintain these positions, but I’m keeping a close eye on them.

PIMCO Commodity Real Return is one of the top-performing funds for the year. Expect high volatility in coming months as investors debate where we are in the inflation cycle and whether the surge in commodity prices is due to inflation or to demand exceeding supply.

This fund uses part of its cash to buy contracts that will track the Dow Jones-AIG Commodity Index. The rest of its portfolio is invested in Treasury Inflation-Protected Securities (TIPS). The result is that we get the return of the commodity index, plus whatever return is generated from the TIPS.

Most other commodity funds track the Goldman-Sachs Commodity Index, which is 60% or more weighted to energy commodities. The Dow Jones-AIG index is more diverse. The direction of oil and natural gas prices still will affect our returns. But other commodities have more of an influence than they do in other indexes.

My belief is that worldwide economic growth is pushing demand above supply for most commodities, and it will take some time for demand to catch up. An economic downturn could change the picture, so I’ll be on the lookout for a decline. Absent that, any decline should be short-lived and more than offset by advancing commodity prices.

Income Growth and Income Managed Portfolios

The last few months brought a lot of action in the sectors in these portfolios, and there is more volatility to come.

The Income Growth Core Portfolio has benefited quite a bit from its utility and natural gas investments the last few years. Because of uncertainty over rising interest rates and natural gas prices, we could see downward pressure on FBR Natural Gas Index and American Century Utilities Income. The returns in these funds have been so strong that, though normally only for conservative investors, they are attracting return-chasers. These investors tend to sell as soon as an investment hits a rough patch.

We will hold these funds for long-term growth and income through these normal investment cycle moves. We will continue to do so absent fundamental changes in either the sectors or the funds.

Interest rates finally are rising. This generated losses in many bond funds. Fortunately, we already moved most of our Managed Portfolios into money market funds a couple of months ago in anticipation of this move. With rising rates and a flattening yield curve, money funds continue to offer a better risk-return trade off than the alternatives.

But that situation won’t last long. We are coming to a time when income investors can safely earn higher yields and have the potential for some capital gains. I’m closely following values among income investments. For now, the key is to avoid the large losses that other income investors are going to incur as Federal Reserve actions and inflation fears push rates higher.