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When Funds Are Better Than Stocks

Investing can be very frustrating and complicated – even for the most sophisticated investors.

Sometimes investors can be right about a market’s direction, but get poor or even negative results because they used the wrong investment tool to exploit the deep value opportunity.

Unfortunately, with the explosion of exchange-traded funds (ETFs), the constant lure of picking individual stocks, and the continued dominance of mutual funds, making choices seems to be getting harder rather than easier.

So I’m going to share an area of opportunity for capital gains, and then explain how I choose the best investment to increase the likelihood of success.

Taking Advantage of “Maximum Pessimism”

If you scour the world right now, most stock markets have had a pretty good run, so valuations seem pretty stretched. This includes markets in the U.S. and much of Asia, with the exception of Hong Kong and Singapore.

To me, this is a sign that I should be taking some profits off the table and deploying this capital to lagging, cheaper markets.

I do this for two reasons:

  1. Lower downside risk.
  2. Capture the inevitable rise of these beaten down markets as they rise.

This was the strategy of the legendary global investor Sir John Templeton, who scored consistent gains by looking for markets that most investors spurned.

I remember an occasion when, after a speech on investing, an attendee approached to ask him what part of the world looked good right now.

“Forgive me, but you are asking me the wrong question, you should be asking me where in the world it looks absolutely terrible,” he said. Templeton called this finding stock markets mired in “maximum pessimism.”

Just where is this pessimism right now?

A good bet is a Europe stuck in anemic growth, dysfunctional politics, ineffective monetary policy, and the looming threat of Britain leaving the European Union.

European markets usually trade at a discount to U.S. markets, but the numbers show that this discount has recently widened – significantly.

Aside from Spain and Denmark, all the continent’s major markets are trading at significantly higher discounts to their usual relationship to U.S. market multiples.

Notably, Germany, which over the past 10 years has traded at an average 18% discount to the S&P 500 Index, now trades at a surprising 32% discount. This is a clear arbitrage opportunity, though it may take a bit of time to fully develop.

So now comes the moment of decision: Which investment tool should you use to take advantage of a Europe on sale?

The first step is to be realistic about your knowledge and abilities.

I’m very comfortable with Asia and emerging markets, but don’t follow European stocks as closely. So it’s probably a mistake for me to try to pick a couple of European stocks from a hat.

Any Europe ETF is the easy way to go, but do I really want just a basket of European stocks weighted by their market value? No thanks.

I like the idea of getting more bang for my buck by investing in smaller European stocks through an actively managed mutual fund such as the Invesco European Small Company Fund (ESMAX).

It’s beginning an uptrend so far this year, and with 19% cash position, its portfolio manager has some dry powder to put to work on my behalf.

Now, let’s zero in on Germany.

The iShares MSCI Germany ETF (EWG) is a possibility. But again, I’d prefer someone who follows this market every day trying to pick the winners, so I would go with a closed-ended fund – the New Germany Fund.

The New Germany Fund Inc. (GF) has a net asset value per share of $15.27, but is trading at $13.59 – an 11% discount.

It has outperformed its peers and focuses on traditional German strengths with 45% allocated to industrial and basic materials. Airbus is its top stock, with 12% of assets.

Find quality value, pick the right investment tool, and then show some patience. All will be well.

Good investing,

Carl Delfeld

Carl Delfeld

, Special Correspondent

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