Don't be hasty, young Jim Cramer (more on the dangers of chasing cycles and short-term performance)

On Wednesday, the frenetic CNBC host Jim Cramer suggested an investment strategy for his viewers -- buy shares of stocks held by a mutual fund whose performance is likely to attract new money, causing it to invest more money in its existing holdings and thus drive up their prices.

In the video above, he says:

"What should you be thinking of doing, when you have a bizarre, mechanical selloff at the end of a strong day as we just had? [. . .] If you know where the money's flowin' [cash register sound effect], you know which stocks are going higher -- and sometimes it's downright simple to figure out where all that cash is headed. Right now, for example, there's one mutual fund that is pantsing everybody else: the redundantly-named American Growth Fund of America, which is up a miraculous 9.5% year-to-date. That is fantastic performance, relative to everyone else, and that's how you have to think about it, relative. The fund is run by James Rothenberg and Gordon Crawford -- Gordie Crawford, to everybody who knows him in the business -- and it already manages 126 billion dollars. The symbol, if you want to look it up, play along at home, is AGTHX. Whenever one fund is beating all the others so soundly -- and this is just, I mean, an amazing, amazing outperformance [boxing speed-bag sound effect] -- the guys running it will get gobs of money [cash register sound effect], from regular people who want to ride the hottest mutual fund. Believe me, the guy'll be on the cover of all these different publications, there'll be interviews, there'll be articles, and it's gonna send money to the American Growth Fund of America, which will be rolling in dough -- a lot of dough, as in April equity mutual funds experienced the largest monthly inflow of dollars [. . .] in twelve months, receiving twenty billion smackers. Overall, mutual funds that invest in stocks are still down for the year, but the money is coming back, and because of the outperformance of this fund, we know where a decent chunk of it is gonna go."

Mr. Cramer then argues that investors should use that logic to invest in the individual stocks owned by the American Growth Fund of America.*

While we applaud Mr. Cramer's emphasis on owning companies rather than mutual funds, we would caution investors that we believe they would be far better served by an investment philosophy of owning great companies through market cycles, rather than an investment philosophy based on timing this or that market cycle, the way Mr. Cramer does.

In this episode, Mr. Cramer is using his redoubtable creative imagination to come up with yet another market cycle -- in this case, a market cycle based on the year-to-date performance of a single mutual fund -- although in other places he has recommended catching stocks that are ready to go up based on all kinds of other market cycles, from the activities of the Fed to the approach of the Super Bowl.

We would warn investors that, while these kinds of cycles may indeed move stocks temporarily in one direction or another, the difficulty of timing these kinds of short-term moves makes such a strategy very difficult to follow successfully for thirty or forty years in a row (a length of time that is not unrealistic for an investor's lifetime, and may in fact be a couple decades too short for investors who are in their twenties or thirties, or for investors who are considering the investment of assets by their descendants from successive generations).

The problem with investment disciplines that are based on trying to time this or that cycle -- as we have explained previously in posts such as "Gambling, Speculation, and Investment" and "Drawbacks of sector rotation" -- is that you are basically in the same position as a gambler in Las Vegas who is playing against the house: you have to pay to play (in this case, via trade commissions and other Wall Street fees every time you jump in or jump out), and one bad call can wipe out all your previous hard work.

We would also point out that, while Mr. Cramer is not specifically encouraging the flow of investment dollars to mutual funds based on their short-term performance, his exuberant praise of the performance of the American Growth Fund of America year-to-date is an example of the kind of short-term focus on performance that has directly contributed to the miserable long-term returns earned by the average mutual fund investor as chronicled by Dalbar, Inc. year after year.

In this segment, Mr. Cramer practically grants the fund's managers "rock-star status," calling their returns "miraculous" and "amazing, amazing," and he bases his investment thesis on the prediction that the media will anoint them with the same sort of adulation as well.

We would advise readers that making such judgments based on short-term numbers covering a few months -- when you are trying to measure the investment value of a business, which may not realize the rewards of its business model for a few years -- is not wise.

As we pointed out long ago in a piece entitled "What hasty investors could learn from an Ent," businesses live and move over a different time-frame than our hectic, individual lives. We note in that article that a Morningstar study of investment managers who beat their benchmark for a period of ten years found that "almost every outperforming manager (greater than 90% for large-cap equity managers) trailed his benchmark for a period of at least three years, often by significant amounts."

Lest someone try to diminish the force of this logic by saying that the only managers who use such arguments are those who have been doing poorly in the short-term, we would offer that our own Taylor Frigon Core Growth Strategy, in which we own the kinds of companies that we occasionally discuss in this blog, has performed even better year-to-date (after fees) than the fund highlighted on CNBC through May 20, 2009.

Nevertheless, we will be the first to emphasize that short-term market returns are not the way that individuals and families build and maintain multi-generational wealth, but that such wealth must be built and preserved on the sure foundation of a sound investment philosophy focused on well-run, growing businesses over a long period of years.

Investors would do well to consider these important issues.

* The principals of Taylor Frigon Capital Management do not own shares in the American Growth Fund of America (AGTHX).

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