Model Portfolio rmcduff:RMG2

Stirred, not shaken.

The small and micro cap oriented RMG2 Value Catalyst model portfolio posted a loss of 26.65% for the quarter ending September 30th, 2008. As of the end of the third quarter, the year to date loss was 31.80%.

The portfolio is largely composed of small and micro cap securities, and the majority of the businesses, based upon portfolio weightings, operate outside of the United States. The public peer group that I benchmark against are also small cap oriented internationally themed mutual funds. Their returns as of September 30th were as follows:

Trailing Returns as of 9/30/08

Returns assume reinvestment of dividends and distributions. Performance data quoted represents past performance. Past performance is not a guarantee of future results. Investment returns and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.

1. All returns as of September 30, 2008
2. Mutual fund returns from Morningstar
3. RMG2 VC returns are from a model portfolio managed at www.marketocracy.com using virtual money. Returns include virtual transaction fees of 5 cents per share and virtual annual operating expenses of 1.95%

All of the peer group have posted negative results for the year to date. This is reflective of both market volatility, and the lesser liquidity generally attributed to small cap securities. However, for the first time in a number of years, RMG2 VC has soundly underperformed its peer group.

I believe that there are several reasons for the current level of underperformance.

1. RMG2 VC has a more focused and concentrated portfolio than many publicly available mutual funds. Most publicly available mutual funds will often hold several hundred securities, and seldom less than 50. They will also endeavour to distribute overall portfolio assets broadly, often limiting any specific holding to less than 5%. By way of contrast, I tend to hold no more than 25 securities in RMG2 VC, and often less. The portfolio also will overweight securities that I consider as having the potential for long term performance superior to small cap indexes in general.

This deliberate emphasis on concentration and overweighting of preferred investments will often magnify returns, but can also magnify losses periodically. Concentrated portfolios are generally used more among several well known value oriented hedge funds, rather than mutual funds. It is also the methodology of icons such as Warren Buffet.

Value oriented hedge funds and private capital (Buffett et al) are able to adopt this style. They are able to "lock" investors into timeframes sufficient to prove out an investment thesis. The risk of underperformance over shorter timeframes typically precludes most mutual funds from employing this methodology.

2. Most of the key investments in RMG2 VC are far less liquid than the median small or micro cap company. During periods of extreme volatility, illiquid securities often move in an exaggerated fashion. The top two investments in RMG#2 (by portfolio weight) generally only see a few thousand shares per day trade. Some days, no trades will occur.

Any portfolio that is overweight in illiquid, or less liquid securities, carries with it the potential (and risk) for greater than average volatility. This has certainly been the case for the virtual account. Economic recessions are always accompanied by reduced liquidity. Accordingly, during periods of broadly based decline, volatility will be more pronounced for illiquid securities.

This is not the first period of short term underperformance for RMG2 VC vs. peers, and certainly won't be the last.

Reflective of my investment methodology, I deliberately pay little attention to liquidity issues in the marketplace. In the last recession, RMG2 VC had another six month period whereby the returns were below peers. The portfolio fell off, and then muddled along for a while. I grumbled a bit, and wondered why great stocks traded for such poor prices. Then the turn came and liquidity improved. Values of key stocks rose to reflect the fundamentals.

While a concentrated and focused style carries the potential for short term underperformance, I have no intention of changing my stripes in this recession.

There are a host of simple reasons for this.

1. Global equity markets generally have far more "up years" than down. Downturns fill investors with angst, but they don't tend to last very long. Stock prices also generally lead economic turns. Those who move out of stocks during recessions run the "opportunity risk" of missing the new bull cycle. As I'm not smart enough to know with 100% certainly when we are going into recession, I certainly can't call the turn out. Therefore, I am generally fully invested at all times of the economic cycle.

Both the mainstream media and the investment industry are less than helpful in recessions. Most widely economic indicators supplied are typically "lagging". Leading indicators are mostly just guesses. It has also has been my experience that stocks often move up inexplicably, often while the media is still reporting doom and gloom. These broadly based historical moves, often without good news, often sneak up on investors.

2. Investors sometimes use the "50% down-100%" up rationale, as a reason not to ride out swings in equities. This is a mantra of market timers. If refers to the fact that when an investment falls 50%, it must subsequently rise by 100%, to get back to break even. The investor theorizes that it must take at least 2X as long for a stock to rise by 100% to recover the loss.

While I understand the principle, I don't subscribe to it. In fact, I consider this to be just another misconception. In my years of investing, I have seen a great number of stocks rise by far more than 100%; faster than they fell 50%. Market timers often miss the ten baggers, in their efforts to avoid downturns.

3. Great companies look to capitalize on downturns through transformative acquisitions, or with organic expansion. Some companies, such as American Pacific (APFC), have broadcasted their intention of making an accretive purchase for a while now, but were unwilling to pay high prices. I have little doubt that in this buyers market, management can do something substantial.

Other companies are more closely guarded with their long term strategies, for competitive reasons. However, I want to own a business before the transformative purchases are made, not after the fact.

Next week, I will start to rollout my specific investment thoughts on the companies contained within RMG2 VC. Like my recent blog for RMG1, I will start highlighting three companies per article. I'll supply my investment rationale, what I am looking to see from the businesses over the next 36 months, and also spell out what I consider to be the bear case thesis.