Basing Index Investing on a Single Stock's Performance Is Not a Valid Strategy

May. 2.11 | About: Caterpillar Inc. (CAT)

Right at the open Friday, Brian Shactman made an interesting comment while reporting on Caterpillar's (client holdings) earnings. He noted that CAT was up 64% in the last year versus 16% for the Dow (I think those were the numbers he cited) and then asked rhetorically "what does that say about the indexers out there."

That he would take a shot at any group of investors like that is pretty funny but I'm not sure if I am laughing at him or with him. More seriously, there are all sorts of fallacies and behavioral nuggets embedded in the comment. The result of an index will obviously be a mix of components that do better than the index and that do worse than the index. Using the existence of a stock that has ourperformed the index as a reason not to be an indexer is pretty thin.

I am obviously not a big fan of indexing for quite a few reasons but that does not make it invalid. It can work for what some people need. To me this is no different than how I think about daytrading; it would be naive to think it can't work for other people but not for me.

One of the repeat ideas I try to convey here is taking little bits of process from various sources to create your own process. Whatever you prefer; indexing, buy and hold, stock picking, some form of very active trading or some combo of any and all it would be a mistake to believe that something other than what you think is best can't work. People have success with every form of investing and people fail with every form of investing.

With regard to Caterpillar's (NYSE:CAT) earnings; the network and the several articles I read about the earnings report all heaped an abundance of praise and adoration on the stock (including one $200-$300 price target) -- that stock that seemingly can do no wrong and for quite a while now it has done no wrong. I've owned it for clients since 2003 except for a brief hiatus from January 2008 to January 2009 as part of our defensive strategy.

The name has been one of my favorites for a reason that might not be so obvious. It is great when a stock does so well of course but the reason it is a favorite is that it does what I think (or hope) it should do over the course of the entire cycle. At some point it will stop working in this way but during the up part of the cycle it continues to outperform and during the down part of the cycle it does worse than the broad market which is why I sold it in January 2008.

True to form CAT bottomed out with a 71% decline versus a 56% drop for the S&P 500. I don't think the story underlying the company ever changed in 2008, the world is going to modernize and Caterpillar vehicles are going to move the earth needed for this to happen and this can last for many more years globally, in my opinion.

It likely that this theme for CAT will last much longer than this stock market cycle but when the next bear market starts I am quite certain that CAT will again go down more than the market and so selling it again as part of a future defensive strategy is very likely. This could be thought of as a type of pre-planning. I don't think there is any emotion here despite my labeling the stock as favorite, the history of the stock suggests it will go down more than the market in a large decline. Given the high likelihood of this repeating and my preference for taking defensive action, why wouldn't it be a sell the next time defensive action is called for?