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Author: BrokeInTheBurgh Three stars, 500 posts 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 9:57 AM
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So with a likelihood of potentially large losses (e.g. fraud) and a correspondingly low weighting in the basket your overall return benefits very little from extraordinary returns, should the long thesis be right. Another way to look at is that for cases where the extremes are fairly likely, you don't really benefit from diversification as that is an 'on average' concept, whilst you care for the one binary outcome only. Reverting back to frequentist thinking one could say that the expected payoff is too small to be worth the bother.

Hi No Fate,

Although, as described below, I do not necessarily agree with you on all points, I welcome your thoughts and discussion.

In 1939 Sir John Templeton bought 100 shares of each stock that was trading for less than $1. One could make a “frequentist” or “inconsequentiality” argument about each of these purchases, but one probably wouldn’t at this point, because Templeton earned massive returns from this strategy in four years.

I mention this because I have been taking a different “basket” approach to risky small caps (including Chinese companies such as CGA and YONG) – namely, I invest in baskets of such stocks that have met certain quality criteria (such as being vetted by TMF). And, quite honestly, I take the advice of the three GG advisors very seriously; of course there are no guarantees, but the odds shift dramatically in our favor, I think, in cases where the GG team has really looked at a company over a period of time.

Anyway, my baskets do not typically include companies such as YUM and KO (although I do invest in such companies, actually in fairly sizable chunks, using my options/dividend strategy, which an interested Duke Street member could find at http://boards.fool.com/1228/the-bitb-stock-rejection-machine... ).

Instead, I have two “Templeton baskets” – one consisting of dividend-paying small caps and the other consisting of other small caps, all meeting certain quality criteria.

I emphasize income production in my portfolio (not because I need the income, but because I think it is a good total return strategy in what I think might be a long muddle-through “New Normal” period). Thus, my Templeton Basket strategy is as follows:

1. When I identify a company that meets my criteria, I make a small initial investment.

2. For companies in the dividend-paying basket, I add on dips.

3. For companies in the other basket, I add (i) usually on whole-market declines that are significant and (ii) occasionally on large individual company declines if my investigation (generally consisting of reading Morning* and TMF analysis) suggests it is not a merited decline. I have added to my YONG holdings on this basis.

4. The baskets as a whole remain a small portion of my portfolio, but I am prepared to let them rise to up to 30% in total if there is a major correction. I imagine there may ultimately be well over 100 stocks in the two baskets, combined.

Again, I recognize that one could make frequentist arguments against this strategy. I have little theory to offer in response, but can instead point to Templeton’s success and my own returns from this strategy over the past few years. (I invested heavily in my small cap baskets in Mach, 2009 and sold almost all of the basket stocks recently. Here is some evidence to support the preceding statement: http://boards.fool.com/1008/politics-opportunity-27491810.as... )

All of the foregoing was just describing an alternative basket approach for discussion. Now let me revert to your particular criticism of the MF GG basket approach.

The theory of these GG baskets is much more of a “rifle shot” theory than would apply to a Templeton basket. The GG team identifies a particular secular trend and then designs a layered approach to investing in that trend, with a large safe component and a smaller risky component.

I think your “game is not worth the candle” argument against these GG baskets suffers from the same problem that would be present if you applied it to a Templeton basket approach – namely, it considers each risky element separately without summing their aggregate effects. There are a number of different baskets, and the aggregate contributions of the riskier elements thereof could easily be quite significant (as in a Templeton basket experience).

Also, I think your argument might be more compelling at a time when returns from other strategies were higher. These days an extra half a percent return might be a 50% increase in returns for a year (sadly).

Finally, sure there is fraud risk in companies such as YONG, but risk is risk – I care less about the adjective in front of the word “risk” than I do about the risk-adjusted return from an investment, as best we can calculate it. As Bill Gross points out at every opportunity, investing in US treasuries for 20 years is likely to result in the loss, in real terms, of maybe 60% of the invested amount. To me, that is in some sense riskier than a basket of YONGs!

So, I am quite happy with the GG basket approach. Of course, there are members of the GG community that I have come to like personally who I fear are heavily overinvested in the riskier components of these baskets, and I actually find myself worrying about them from time to time. I am not sure what more the advisors could do to avoid this problem, but perhaps this is an argument in favor of your approach.

Rich
BITB
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