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Author: TMFMmbop Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 151  
Subject: Re: Basket cases? Date: 5/10/2011 12:02 PM
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Here's some of the original scenario analysis surrounding how I was thinking about it. Obviously, these are exercises in futility in some respect because if we could predict the future, we would invest 100% in GMCR or some such. Since we can't, we play with probabilities and diversify.

I find it helpful in situations like this to try and work in specifics rather than abstracts, so I'll use the Rural Boom basket as originally constructed. Here was how we laid it out (assuming $1000 total invested).

YONG $400
CGA $200
CMFO $100
KO $150
CHL $150

Those weightings were chosen at the time to represent our assessment of total return potential and risk profile, with KO and CHL serving to help ballast more volatile elements of the portfolio. As for KO being equivalent to US market risk, note that we believe we are analyzing KO differently than other analysts and that it is not the proxy for US market risk that others might believe given its massive EM exposure.

Here were my best guesses at the likely best and likely worst case return scenarios for these stocks (leaving fat tails aside):

YONG -100% to 25% annually for 5 years
CGA -100% to 20% annually for 5 years
CMFO -100% to 20% annually for 5 years (though we didn't know the company as well as CGA)
KO 8% annually for 5 years to 10% annually for 5 years
CHL 5% annually for 5 years to 12% annually for 5 years

Given the weightings above here's how the returns might have unfolded over a 5 year period.

Best case (everything achieves its best case scenario): +147.8%
Worst case (China small caps all go to zero, KO and CHL underperform: -58.8%

Realistic case (one China small cap goes to zero, two underperform best case, but do well, KO and CHL do 10% each): +75.8%

If we run those same scenarios using an equal weighted portfolio, here are the results.

Best case: +128.5%
Worst case: -45.1%
Realistic case: +57.3%

And if we just invested in KO and CHL:

Best case: +68.6%
Worst case: +37.3%
Realistic case: +57.5%

All of this is to say that I thought our construction would give us a chance at significant upside without magnifying our downside risk provided you accepted the premise that we should invest in some Chinese small caps. If you reject that premise outright and don't have a sufficient time horizon, then the right move is to build an equal-weighted portfolio of blue chips with EM exposure.

As for the results thus far of the basket (including the re-balancing we recommended on 11/9/09 and the switch from CMFO to CMGHY), here they are approximately 1.75 years in:

Rural Boom Basket: +11.8%
FXI: +5.1%
SPY: +38.6%

My observations here are that while we are beating our China benchmark, perhaps that gap is not wide enough to compensate for the additional risks we are taking. The argument against that is that there are some market forces acting against us and that the fact that we are outperforming despite our exposure to small China actually lends credibility to our approach -- and we should expect that gap to widen if we have chosen wisely in small China.

The other meta force here is US outperformance. Obviously, that hurts us, but hopefull you are 40% to 60% invested in the US and have benefited from this and are not relying on China to fuel your portfolio growth every year. This is where country diversification comes in -- and I encourage people again to read our global asset allocation report.

I'd be lying if I said I thought this basket would be up just 12% almost 2 years in, but given where we are and how we've gotten here, I am contemplating throwing out our approach.

Tim
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