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Why Diversification Is An Important Tool Of Managing Risk

Summary Even the famous investors sometimes get it wrong. Pershing Square and Herbalife and Valeant Pharmaceuticals. Greenlight Capital and CONSOL Energy. Casablanca and Cliffs Natural Resources. Icahn Capital and Chesapeake Energy and Transocean. Introduction Diversifying an investment portfolio is more than just buying stocks in unrelated industries. It can also mean portioning a portfolio between multiple asset types such as equities, bonds, real estate, currencies, etc. And then, there is another layer of diversifying within each asset type. Bonds can be diversified many ways: government versus corporate, investment grade versus high yield (otherwise known as junk), Treasuries versus municipals, and domestic versus foreign. On top of that, investors need to consider holding a variety of maturities that will meet income needs today and in the future. Think of laddering the bond portion of a portfolio as a key element to be considered. The point of this article is to encourage investors to consider diversifying to reduce the risk inherent in holding too large a percentage of any on assets. The secondary theme is that every investor needs to do some due diligence on their own to satisfy themselves that each investment made is appropriate for that investor. Some investors like to follow the investing decisions of high-profile investors that have successful track records. But even then, diversifying against risk is important. Even the famous investors sometimes get it wrong Some of the best-known and most knowledgeable investors can be wrong or way too early. Sometimes even the smartest investors outsmart themselves by taking a large position that they believe in and holding onto it well beyond a reasonable period of loss, unwilling to admit a mistake. It can be a matter of pride and ego. Those are terrible reasons to hold onto an investment. Here are a few examples of mistakes made recently by some high-profile investors in the hedge fund arena. Pershing Square ( OTCPK:PSHZF ) and Herbalife (NYSE: HLF ) and Valeant Pharmaceuticals (NYSE: VRX ) Pershing Square is led by Bill Ackman and has recorded some excellent returns in the past. Lately, though, things have not been going Mr. Ackman’s way. I wrote an article about another multi-level marketing (MLM) company and got slammed by some of Ackman’s disciples. Here is an example comment: “Do you even own a passport? BTW they are not but are receptive to good skin care products. MLM is scrutinized in China. Have you ever studied Amway and AVP? When the Ackman atom bomb burns HLF to ashes NUS USANA and the likes will be part of the inferno.” – LeMarJackson. The article was written in May 2014. HLF’s shares have not fully recovered from the public frontal assaults by Ackman, but the shares also have not tumbled. In the end, the Pershing Square hedge fund investors (and Mr. Ackman) have lost money; a lot of money being short in a concentrated bet. Valeant has also been a losing position for Ackman. Thus far, Pershing Square has lost about $2 billion on this one investment alone according to this Wall Street Journal article. That one investment accounted for nearly 20 percent of the fund’s assets at one point, and the stock fell in value by 65 percent. These are just two examples of why we need to keep our emotions out of our investment decision-making process, why we need to diversify our holdings, so that we do not risk losing too much on any one position, and why we all need to do some research to confirm the investment thesis of those whose leads we like to follow. Greenlight Capital (NASDAQ: GLRE ) and CONSOL Energy (NYSE: CNX ) Greenlight Capital is managed by David Einhorn, another admired billionaire hedge fund investor. He has also been right a lot, and made his investors a lot of money (but probably not as much as himself). According to this article from money.cnn.com, Greenlight Capital is down about 12 percent this year, primarily due to investments in energy. One of his large position, CNX, is down about 65 percent this year. Just another reason not to follow blindly and to not concentrate too much into one position. The effects can be devastating. Casablanca and Cliffs Natural Resources (NYSE: CLF ) Another activist investor who had done a lot of homework was Donald Drapkin, a former protégé of Ron Perelman and head of Casablanca. Casablanca purchased about 5.2 percent of CLF’s shares outstanding for an average price of about $25 per share. The plan was to oust senior management and replace the CEO with a veteran who had managed turnarounds before, cut costs and close unprofitable mines to improve margins. CLF’s stock now trades at about $2.34 per share. That is a loss of more than 90 percent so far. I am glad I did not follow Casablanca into this mess. Icahn Capital (NASDAQ: IEP ) and Chesapeake Energy (NYSE: CHK ) and Transocean (NYSE: RIG ) Carl Icahn has a net worth of over $20 billion the last time I checked. So, he must be doing something right. He also has a long enough time horizon and the wherewithal to withstand temporary setbacks. He has made significant investments in the energy sector. He may be right in the end, but so far, some of his large positions in that sector are sucking wind. CHK is down almost 70 percent this year while RIG is down only 21 percent since January 1st, but off more than 43 percent in the last 12 months. IEP is down in value over 24 percent since the beginning of the year. It has made some good investments that partially offset the blunders. This is the case with all of the above investors/funds. They did a lot of homework/analysis before making these investment, and still got it wrong. Conclusion Diversification may have saved the respective bacon of these outstanding investors keeping them alive to fight/invest another day. We may not all be able to avoid making mistakes over our investing lifetimes, but we can take precautions to minimize the risk when we are wrong. For those who might be interested, I published a series on Seeking Alpha recently that explains ” How I Created My Own Portfolio Over A Lifetime ” by that same name. I take a rather unique approach to investing that those who have already stumbled onto the series seemed to really like. Likewise, I also use an approach to hedging that is different but keeps costs low. It is not for everyone, but so far my experience has proven very favorable. I have captured gains of 600 to over 2,700 percent on some positions to help defray the cost and protect my core holding through the recent turbulence. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge.

Apple Supplier Qorvo Could Stoke Chip M&A Frenzy

Apple’s (AAPL) iPhone “elephant in the room” clouded Qorvo’s (QRVO) otherwise upbeat analyst day, an MKM analyst wrote late Tuesday as he suggested that the chipmaker might be considering a hefty M&A play. Qorvo stock closed up 5.6% in the stock market today at 54.74. March-quarter expectations for a 10%-15% depression in iPhone sales remained unchanged, MKM analyst Ian Ing noted in a research report. Ing retired his 71 price target and buy rating

401(k) Fund Spotlight: Loomis Sayles Small Cap Value

Summary LSSCX is really a small cap “core” or “blend” fund. LSSCX has consistently beaten the Russell 2000 Index by at least 2% over all relevant, historical periods. With almost 1/3 of the fund in financials and little exposure to utilities, consumer staples, and REITs, the fund is well positioned for a rising rate environment. Introduction I select funds on behalf of my investment advisory clients in many different defined contribution plans, namely 401(k)s and 403(b)s. I have looked at a lot of different funds over the years. 401(k) Fund Spotlight is an article series that focuses on one particular fund at a time that is widely offered to Americans in their 401(k) plans. 401(k)s are now the foundational retirement savings vehicle for many Americans. They should be maximized to the fullest extent. A detailed understanding of fund options is a worthwhile endeavor. To get the most out of this article, it is helpful to understand my approach to investing in 401(k)s . I strive to write these articles for the benefit of the novice and professional. Please comment if you have a question. I always try to give substantive responses. Loomis Sayles Small Cap Value Fund The Loomis Sayles Small Cap Value Fund has the following share classes: If the fund is an option in your 401(k), it will likely come in the form of the I (institutional) or R (retail) shares. These two share classes are also much older and hold most of the overall fund’s assets. The expense ratio for the I shares is 1.04% and for the R shares it is 1.29%. For the purposes of this article, I will assume the I shares are being discussed and name the fund by its ticker – LSSCX . The fund is closed to new investors. Most readers, if they have access to the fund, will have it only through their 401(k). LSSCX is best classified as a small capitalization (“cap”) core (or blend) fund. Small cap companies are loosely defined as having a market capitalization of less than $2 billion. The “core” or “blend” description means that the fund owns stocks described both as growth and value. Performance Evaluation Loomis Sayles is a mutual fund outfit best known for its prowess in the bond market and their flagship Bond Fund, the Loomis Sayles Bond Fund (MUTF: LSBDX ). The immediate question for us is, “Can they pick stocks?” and “Can they pick small cap stocks?” I’ll let the numbers do the talking. The following table compares the performance of LSSCX to its benchmark index, the Russell 2000: as of Sept 30, 2015 1 Year Return 3 Year Return 5 Year Return 10 Year Return Loomis Sayles Small Cap Value – Inst 1.2% 11.7% 12.3% 7.6% Russell 2000 Index -1.6% 9.2% 10.2% 5.4% Excess Return 2.8% 2.5% 2.1% 2.2% The fund has beaten the index by at least 2% over the last 1, 3, 5, and 10-year periods (as of September 30, 2015). This is a consistent record of excess returns which clearly makes the fund a better option than owning the index. The following table compares the performance of LSSCX to its peers, as represented by the Lipper Small Cap Core Index. This data was taken from Barrons . as of Oct 31, 2015 1 Year Return 3 Year Return 5 Year Return 10 Year Return Loomis Sayles Small Cap Value – Inst .7% 14.3% 13% 8.6% Lipper Small Cap Core Peer Index .7% 13.4% 11.7% 7.5% Excess Return 0% .9% 1.3% 1.1% Over the last year, the fund is even with its broader peer group, but has out performed the average over the last 3, 5, and 10-year periods (as of October 31, 2015). Over the last 5-year period the fund finished in the 22nd percentile of its peer group and over the last 10-year period it finished in the 15th percentile. This means that it outperformed 85% of all other small cap core oriented funds over the last 10 years. From a performance standpoint, LSSCX can best be described as a superior option to the index and an above average option when compared to its peers. Additional Performance Considerations It is important to realize that LSSCX is not going to give you any sort of exceptional performance (e.g., 5%+) over its Russell 2000 index benchmark over a longer period of time. This is because the fund typically holds 150 to 180 different stocks (152 right now), with no one stock comprising more than 1.5% of the fund. The fund is just too overly diversified to vastly outperform the index. That being said, I view the consistent 2% excess returns as very good. Loomis Sayles “rigorous fundamental, bottom-up analysis” (as they describe it) adds value and makes the fund a better option than an index fund. It would be interesting to see Loomis Sayles launch a more concentrated small cap fund that owns what they think are their very best ideas. I am thinking of the Invesco Select Companies Fund (MUTF: ATIAX ), which I recently wrote about, which invests in the managers best 25 small cap ideas. Well Positioned for Rising Rates Here is how LSSCX’s assets were distributed across sectors, as of September 30, 2015: Financials – 31.5% Industrials – 18.4% Consumer Discretionary – 18.3% Information Technology – 14.8% Healthcare – 4.2% Consumer Staples – 3.5% Materials – 2.9% Utilities – 2.6% Energy – 2.3% Telecom – 0% Almost one third of the fund is invested in the financial sector. In fact, the fund’s 2 largest holdings are Signature Bank (NASDAQ: SBNY ) and Cathay General Bancorp (NASDAQ: CATY ). These small banks would benefit from a rising rate environment as their net interest margin expands. By this I mean they could continue to pay depositors 0% to .25% while at the same time increasing their rates on auto loans, mortgages, and commercial loans, netting more profit. The fund has little exposure to utilities and consumer staples stocks that could suffer as their high dividends become less appealing in an environment of higher bond yields. Furthermore, digging through the holdings I can see that the fund also has minimal exposure to real estate investment trusts (“REITs”), which could also suffer for the same reason. I am not expecting substantially higher rates for several more years, but wanted to point this out for some investors who may have a more immediate concern. Rising rates in the U.S. would also imply a strengthening U.S. economy which would benefit U.S. small cap stocks. Valuation If LSSCX has a weakness in the current environment it is the low dividend yield, which currently only runs about .6%. However, the fund is attractive from a valuation standpoint. As of September 30, 2015, it had a forward price to earnings multiple (“P/E”) of 15.96. This is slightly below the index and gives credence to the fund’s “value” slant. (It does call itself small Cap Value, even though it is really a small cap core or blend fund.) I have no problem sacrificing dividend yield for lower valuations. Strategic Positioning I have really warmed to U.S. small cap stocks over the last few months in the 401(k) plans I manage for clients. It seems little noticed, but valuations have come down substantially to the point that they are now broadly inline with U.S. large cap stocks. Furthermore, the 2-year chart of the Russell 2000 Index looks compelling: ^RUT data by YCharts The index put in a higher low in 2015 than it did in 2014 and appears ready to break out to new highs. Am I predicting this? No. I am just considering a scenario where the U.S. dollar continues to rise, putting pressure on the earnings of U.S. multinationals but buoying the attractiveness of U.S. small cap companies with little international exposure. In such a scenario, I could see the S&P 500 index treading water while the Russell 2000 index logs some high, single-digit gains. Conclusion The Loomis Sayles Small Cap Value Fund is a good option in the current global macroeconomic environment. 401(k) investors may want to consider giving it the nod, or at least a higher weighting, over comparable small cap fund options and especially over small cap index funds. Investing Disclosure 401(k) Spotlight articles focus on the specific attributes of mutual funds that are widely available to Americans within employer provided defined contribution plans. Fund recommendations are general in nature and not geared towards any specific reader. Fund positioning should be considered as part of a comprehensive asset allocation strategy, based upon the financial situation, investment objectives, and particular needs of the investor. Readers are encouraged to obtain experienced, professional advice. Important Regulatory Disclosures I am a Registered Investment Advisor in the State of Pennsylvania. I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment adviser.