A Quandary for Investors
The stock market shrugged off a poor first quarter and made solid returns for the second quarter of 2007. For the latest three months, the S&P 500 gained 6.3%, the Dow gained 9.1%, and the NASDAQ gained nearly 10%. More impressive is the fact that the S&P 500 is up about 21% over the past 12 months. This trailing one year gain accentuates the strength in the market over just a calendar year comparison.
It begs the question: How do investors protect gains that we have enjoyed over the past twelve months? This quandary can be further illustrated in an example. Suppose your portfolio gained 21% over the past twelve months and then loses 7% over the succeeding six months. It is reasonable to use 7% since the market had corrections of this magnitude during each of the past three years. Then assume the stock market was flat for another six months after the correction. Cumulatively, over this two year period, the stock market would have advanced 14% which was would be last year’s 21% gain less a correction of 7%. The average annual return over this period would be less than 7% by compounding growth. Since the return on two year treasury notes is slightly above 5%, this doesn’t appear to be a big enough premium to reward investors for the risk of investing in stocks. This example shows how strong returns can erode into mediocre returns if strong returns are not preserved.
The problem with Mutual Fund allocation
Let’s say Peregrine Asset Advisers took a different approach. Suppose, instead of selecting stocks and carefully constructing a portfolio, we decided on appropriate asset allocations and then allocated each of our client’s financial assets amongst a group of mutual funds. Suppose our analysis centered on choosing mutual funds with the objective of diversifying by capitalization, industry group, and global presence. After making these selections and investing the money, our management firm would then sit back and observe the progress of these mutual funds. Suppose, furthermore, that the market made a sharp advance as in the past second quarter. What should our next move be? How would we be able to preserve the gain that we had just made over a three month period and protect against a decline like we saw in February and March? Would we actually sell our funds and then hope to adeptly re-enter at a supposedly lower point? This would be very difficult to employ successfully.
Owning individual stocks provides a solution to this problem. Investing in stocks instead of mutual funds allows investors to realize profits by selling stocks individually. Once a stock is sold the proceeds can be reinvested into companies that might best weather a downturn in the overall market. By holding individual stocks, an investor is able to harvest gains from selling, yet remain invested in the stock market by reinvesting in different companies. Mutual fund investors do not have this flexibility to protect against a downturn.
This is the reason that we manage investment portfolios the way we do instead of employing a myriad of mutual funds. Our philosophy is that over the long term, returns from managed individual stocks will be better than the collective returns from a group of mutual funds. We display the average mutual fund return as an index on the first page of our Performance Reports to our clients.
Peregrine Returns and Strategy
The Peregrine Equity Composite, which is the average return for all of our equity portfolios, finished up 6.72% for the quarter. Our Balance Composite, which represents all of our portfolios with fixed income investments, was up 2.53%. For the year 2007, our Equity Composite is up 8.15% and our Balance Composite is up 4.09%. It is worth noting that the S&P 500 fell 1.7% for the month of June. Peregrine Composites were up over this period which underscores our belief that the market indices will start to lag groups of carefully selected stocks.
Long term interest rates rose steadily throughout the quarter and this hurt all of our bond valuations. The total return for the Lehman bond index was -.5% including interest. Our Balanced accounts enjoyed strong growth from stock holdings during the quarter but poor bond returns ended up dampening the total return for our Balanced portfolios.
Due to the apparent summer rally that has continued into July, we are adopting a cautious approach to the overall market which differs from our outlook at the beginning of April. Rises in interest rates, oil prices, and deterioration in the housing markets, lead us to look for selling opportunities and to brace for a mild correction during this third quarter.
Past performance is no guarantee of future results. Investment management involves the possibility of losses. Significant general stock market moves up and down can influence the performance of client portfolios. Composite returns are based on client portfolios of over $100,000. Not all clients are included in the composites. All returns include the reinvestment of dividends. All returns are net of fees. Composite returns are derived from aggregated, time-weighted returns for clients of Peregrine Asset Advisers. Individual client returns can deviate from the composite returns. While Peregrine uses the S&P 500 as a benchmark, Peregrine does not attempt to mimic the structure of this index. Individual client portfolios vary. The number of securities held also varies per client.
Do you have questions or would you like to know more, contact Dan Botti.