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Graham defines three groups of investors: ‘Defensive’, ‘Enterprising’, and ‘Speculative’. He argues in his classic intro to value investing that investors should attempt to be one or the other of the first two and none, or only a tiny bit, of the latter. That’s not advice I follow, because I invest across the credit-spectrum. But I do pay attention to weightings. Thus, about a third of my effort is directed toward finding ‘blue chip’ bonds (as a proxy for a ‘defensive’ posture). About half of my effort is directed toward finding ‘red chip’ bonds (as a proxy for an ‘enterprising’ posture). And about one-sixth of my effort is directed toward finding ‘white chips’ (as a proxy for ‘speculative’).

In reverse order, ‘speculatives’ are bought as singles. ‘Enterprisers’ are capped at 2.5% of AUM. ‘Defensives’ are allowed to be double that. So, for example, my current weighting of Sears at 1.5% of AUM is within my exposure and risk limits, or else I would need to sell it down (which I do not think needs to be done, no matter the likely Chapter 11 filing that lies ahead of us, due to my typical, average entry-price, which isn’t too far above the market’s projected workout-price of mid-50).

Where I’m getting bogged down right now is how to integrate “hedges” into that scheme. Bonds are puts and, by their very nature, defensive instruments (though, admittedly, some less so than others). But when markets tank, it can be assumed that all promises will be reneged, that correlations will tend toward one, and that the only true defensives are inverses. Therefore, the question isn’t whether to get short, but “How soon?” and “How much?”

As a working hypothesis, I’d guess 10% of AUM would be a good start, and toward that tend I went short this morning against one of my holdings this morning, plus its industry index. If conditions warrant, by the end of the year I’d like to be either 20% short, or in a position to do so quickly. Had that been my posture in late 2008 and early 2009, I would have emerged unharmed, or maybe even a few bucks to the good.

Yes, in 2009, I made 33.6% as bond prices recovered from their lows. But when that number is averaged against the prior year’s losses, as it has to be, my two-year, average gain drops to an underwhelming 26.75%. Yes, that’s better than the average stock or bond investor did from themselves. But, so what? The number should have been better, and when the next downturn comes --and it will, as the global debt deals unravel-- I intend to long what I can and short what I should.
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When Life Gives You Lemons
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