Year end is a time for reflection (this year it seems rather to be nursing wounds) but also spirited resolutions (this year probably more along the lines of we have to do better next year). Last year we made some predictions but this was an exception. This year we want to structure the opportunities and add dynamic rationality to our actions.

Reflection on 2011 is riddled with bad news. By the end of the year, not that this date has any particular meaning except for most annual accounts, stock markets are substantially down. Of the major markets, solely the US Dow Jones Industrial Average (DJIA) index managed a gain of 5.5% (+10.8% in 2010). All other major indices, the S&P500 (-0%), the NASDAQ (-1.8%) and the Russell 2000 (small cap US equities, -5.5%) were down. In 2010 they were up by between 11% and 26%. Not a pretty picture this time around for US investors.

International equity investors fared worse: all major international markets are down -10% to – 20%, the BRIC (Brazil, Russia, India and China) markets generally in excess of -20% as were emerging markets overall. Painful for many. Hedge funds (they are supposed to hold or gain when markets fall) are down around -5 to -9%, always depending on the index chosen. Makes you wonder why they are still allowed to be called hedge funds – maybe the word hedge has lost its meaning and now stands for taking money from investors and earning management fees by turning a (relatively) big fortune into a (relatively) small fortune.

Bonds did well both in developed and emerging markets. Overall their indices advanced between 5% (developed) and 8.5% (emerging). Credit default spreads rose strongly – so what? This is not a routine investment you can hold and if you need to buy insurance then the cost has risen strongly.  Not good news either. Commodities overall did not fare much better than equities. Most indices are down -10% to -15%. The only shining knights in armor are gold and oil, some precious metals and some food stuff.

Currencies are volatile and unpredictable and properties are all over the place – very location specific. What a sad world to be invested in unless you take a very different perspective on investing.  This time last year - although overall predictions are not our theme - we proposed a cautious bet on US stocks, no general view on commodities except long agricultural, industrial metals and precious metals ETFs, buying a weak Euro, investing in managed futures and volatility.  Overall, this portfolio did not do too bad at all.  US equities, agriculturals, precious metals and managed futures were flat to ok, the Euro made a return during the year – if you follow the intervention points - and volatility (VIXX) did well.  A balanced portfolio will have made a positive return – better than most indices. We will only know for good when all data is reported during January.

What to make of this year in a very confusing investment world where everyone under the sun claims to have a winning investment strategy and yet the overall results are not pleasant.  We seek refuge in nature and look for some guidance and analogy – there we find the bamboo.

The bamboo is a much revered and used tree plant. The size of bamboo varies from small annuals to multi year giant timber bamboo. There are hundreds of different species with widely differing characteristics. Bamboo can be the fastest growing woody plant in the world or grow at moderate pace. It can grow up to 5cm (2 inches) per hour, it can exceed 40cm (15 inches) in width or remain a simple houseplant. Some bamboo have edible leaves and some can be harvested annually, some only after many years.  All bamboo is exposed to weather and associated agricultural risks depending on their location. When we select to grow a bamboo, we have four factors to consider: rate of growth, time to harvest, nature of harvest and risk. Now this sounds like a great analogy to the global investment landscape.

Let us look at the rate of growth: The very fast growing bamboo has a short high growth phase until maturity and decelerates thereafter. Some internal strengthening occurs followed by decay and the next wave of growth of new bamboo – if nature does not consume them earlier. However, some reach good age generally those that are not easily accessible.

Investing follows a similar pattern: rapid daily/annual growth is for say high frequency trading, emerging markets, derivatives, alternative investments and high yield instruments, essentially volatile investments. If we choose these high growth securities, we need to watch them like a hawk – they can turn at any time.  Any unfavorable event can destroy our gains for good.  We need to be supremely confident in our judgment about their rate of growth. They cannot grow endlessly – we need to time our exit carefully. Our exit can be rapid or prolonged, the market dictates our exit. There is no endless high growth in nature or in man made systems – eventually its either slow growth or dinosaur extinction.

Slower growth tends to go hand in hand with more stability. Short term events such as one bad year do not profoundly undermine the value of the investment. Our exit timing is not so critical and we require less monitoring. Very slow growth builds lasting foundations and remains a winner long term with a superior intrinsic value against most market conditions.

Exit is our target harvest time: when we select a very fast producing bamboo, we accept weakness in its growth and great exposure to short term external factors.  We also have to accept that the harvest (wood) is lesser or smaller but more frequently than those that grow over several years and even leaves may be lesser and exposed to shorter term fluctuations. We need to watch our crop carefully and intervene when required.

It is the same in investing or wealth management. We should have an exit target. A one year exit horizon is considered a speculative investment, one to three year exit plans are cash flow management and above three years we are talking about an investment, in them selves short or long term. Investing in the real sense needs to focus a part of the portfolio primarily on slower growth opportunities. It smoothes volatility, avoids the anguish of continued reinvestment and allows for unexpected declines without causing havoc. This needs has also to do with fees: a one year managed investment will have to yield additional 3-6% to return some profit due to management fees and transaction costs. One year punts require a return above 10%. That is why one year expeditions are speculative trades. This is a market for well informed participants (insiders) and direct transactions. We only participate if we have compelling reasons to do so, say BP or the volatility index. We also have to sell as soon as our target return is met.  A time consuming strategy.

Third the nature of the harvest: while bamboo produces both wood and leaves, they differ significantly in their value and marketability.  Nature offers great variety. Some leaves are edible and some wood is highly sought after. Not all produce is economically attractive.

For investors the choice is between repeated dividends or interest and/or one time capital gains. Regular income reduce our risks but equally tend to reduce the final payout in terms of capital gains.  As in agriculture, we must make conscious decisions about the nature of our income goal. Growth and exit timing are dictated by nature or the market but the return characteristics of our investments are largely within our purview.  They should be selected to match our cash flow requirements.

Finally, the location: some species only grow in exotic locations prune to weather or other risks and some grow in our protected backyard. That is our geographic focus.  We need to understand weather conditions (politics, country ratings etc) or so called exogenous factors to gauge risks properly.

The diversity of Bamboo is giving us some order in the world of investment opportunities. Various investment alternatives, asset classes, indices and sub-indices or individual securities are nothing but the world of bamboo species. They can be categorized according to their growth, target exit, type of return and location character. Few other organic matters have the variety of bamboo and hardly any other man made system has the variety of investments and securities. We can learn from nature!

If we have an investment horizon well above three years, 2011 was not a catastrophe – simply a bad year in our multi year horizon. We simply chose slower growing bamboo, some with dividends, interest or small yields and some for the longer term capital gain. They are all still growing albeit at a more modest pace.

Update
Let us look at what we proposed during 2011 and carried over from 2010. We shall the try to structure this into an overall investment strategy and portfolio.

All speculative trades paid off with more than 25% annualized return and we had either a backstop or low risk.  This was the fun part and for those who want more activity in their portfolio.

Our cash flow management positions bring on average around 10% annual yield and even Greece still pays handsome interest depending on the specific security.  With an extension of maturity, we may have a longer term investment that yields good money and potentially a foreign exchange profit on top.

Longer term investments are all moderate in performance, flat or slightly loss making but they are meant to perform over an entire 3-10 year period.  We are not concerned about any of them at this stage. They have compelling arguments going for them and we got in at attractive prices.

Overall, the contrarian portfolio did well with short term capital gains, received some good income and the longer term investments are not meant to be looked at more than once a year unless something dramatic happens. One poor year or even two poor years do not discourage us. Enjoy the short term profits you made on speculative trades if you are active as investor and take a back seat for the investments, they are coming around and will continue so even in a harsh world.

Remember, our strategy is to benefit from distress events that cause a sustained decline but demonstrate a valid back stop for individual securities only.  We do not plan for a portfolio.  Some securities are speculative, some for cash management and some for investing.  All of them fall outside the regular investment strategies and all of them were doing what they were bought for – they weathered the storm in a tea cup. For us this reinforces the point we often made: there is no one market or geography or industry that consistently outperforms others. So, if you like specific markets, geographies or industries, buy a fund and live with probably moderate long term returns. You do not need to follow this column. If however, you like themes, be they high growth, abrupt distress, long term trends, anything that is nor in the ordinary course of business and may apply only to one security, there are abundant opportunities in specific counters. This column is meant for you.

May you enjoy good investment fortunes in 2012 in the short term and as a base for longer term gain.

Yours sincerely

Poisonous Pen

Disclaimer: this column does not purport to give investment advice or provide accurate figures.  Everything may be purely indicative or freely invented to make a point that may also not be true. We may or may not make the investment described ourselves or maybe the opposite. You must undertake your own due diligence on anything mentioned in this column and source your own research and data or preferably ask your financial advisor.

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