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Investing Lessons Learned from 2012

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I am not big on New Year's resolutions; they tend to be forgotten after the first few weeks of the year. But I do find it useful to look back on the last year, fully exploiting the 20/20 hindsight vision, to find out what worked and what didn't.

Internalizing such a "lessons learned" exercise provides a very useful framework for the New Year. This is as relevant for our investing lives as it is for our personal/private ones.

The best way for me to share these investing lessons is by telling you about the creation of our Zacks' Top 10 Stocks for 2012 portfolio. Gladly we did many things right with this portfolio, given its market topping +29.3% returns. However, we also had our shortcomings. The goal of this article is to learn from both the good moves and the bad ones so that we can invest even more successfully in 2013.

The Basic Approach

We use a blend of the top-down and bottom-up approaches in constructing the portfolio. This means that we start with the big picture of the economic landscape that gives us a good sense of the potential health of corporate earnings. This helps us narrow down the list of target groups that should have representation in the portfolio. By 'groups' I mean concepts like industry exposure, market cap bias, aggressive or defensive stocks, etc. Once this is in place, it becomes much easier to select the best stocks in the best groups to fill out the portfolio.

Lesson Learned: You may not always predict things correctly with this process, but no other method is as complete in order to construct a portfolio. Certainly this should be part of everyone's investment process in 2013 and beyond.

The Big Picture

In making forecasts, investors always tend to extrapolate the stock market's recent performance. The market had been all over the place in 2011, but ended that year at levels essentially where it had started. In late 2011 when I was putting together the portfolio for 2012, many expected the New Year to be no different. But I expected 2012 to bring in stock market returns in excess of 10%.

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I expected the U.S. economy and corporate earnings to do just fine, with Europe as the key overhang that divided the year into roughly two phases. In one phase, I expected Euro-zone fears to dominate investor psychology and market action. In the second phase, Europe would become less of a drag, enabling investors to start paying attention to market fundamentals. While visibility was quite poor at the time, I expected European leaders to build on their December 2011 agreement and move the region towards a closer union that over time would bring down the break-up fears.

Lessons Learned: Not to blow my own trumpet, but I got most features of the big picture right. There wasn't a 'neat' division of the year into two phases, but the steady lessening of Euro-zone fears has been a key driver of the market's positive performance in 2012. The main lesson is that we will never have the crystal ball to clearly see the future, but getting the broad outlines correct is often good enough in making informed investment decisions.

Target Groups Set to Outperform

To reflect this two-phased outlook, the Top 10 portfolio essentially had two distinct sub-portfolios in it. Needing to preserve capital in the uncertain backdrop of the Euro-centric first phase, I picked a number of defensive-looking stocks for the portfolio. But even our dividend paying defensive stocks had plenty of growth attributes. To play the second phase, we picked stocks that had cyclical leverage and/or enjoyed thematic secular tailwinds.

But the one thing that was common to both sub-portfolios was the deliberate effort to pick U.S.-centric stocks that had the least European exposure.

Portfolio 1 - Defense: A defensive mix of stocks to weather the macro uncertainties from the Euro-zone problems and questions about the global economic growth outlook. This defense was going to come from a concentration of quality dividend-paying stocks in less economically-sensitive industries.

Here are those stocks:

Portfolio 2 - Growth & Secular Themes: This part of the portfolio looked for stocks with secular growth and cyclical leverage to benefit from the expected end of macro overhang. Yet we didn't want to be too speculative with these choices either. So we chose quality names that offered the best odds of success.

Here is a look at that group of stocks:

Lessons Learned: In the broad scheme of things, this strategy worked well given the +29.3% return for the portfolio through the end of November, which compares to an +11.1% gain for the S&P 500 in the same time period.

But there is still plenty of room for improvement. Four of the ten stocks – two each in both groups – didn't perform the roles they were intended to play. Part of that couldn't have been foreseen at the outset, but it is quite obvious in hindsight that Humana didn't belong in the portfolio. Thankfully for us, we had set up the flexibility in the portfolio, starting in 2012, to make mid-course corrections. Relying on this new feature, I stopped the bleeding by exiting the Humana position and replacing it with Simon Property. We will continue with that useful feature in the Top 10 for 2013 as well.

Looking Ahead to 2013

This year turned out to be quite good for most investors. But irrespective of which way the 'Fiscal Cliff' issue gets resolved, the New Year promises to throw a number of challenges in the market's path. I am closely watching the situation as I finalize the Top 10 Stocks for 2013 portfolio. I will certainly be employing these lessons learned, but will continue to rely on the same framework that paid rich dividends in 2012.

The best way to start the new year strong is to get in on the ground floor of this long-term investing opportunity. After all, the sooner you invest in Zacks' Top 10 Stocks for 2013 portfolio, the more you figure to gain. Plus, you will be well positioned to withstand any market uncertainty with fewer worries in the year ahead. Be among the first to get in on these best-of-the-best stocks before they're released.

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Sheraz Mian

Sheraz Mian is the Director of Research. He determines which valuable data to use to assess winning stocks and funds. He is a contributor for Zacks Equity Research and Earnings Analysis, and is also the Editor of Zacks' Top 10 Portfolio.

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