3July07 Letter

The SweetSpot Investment Letter*

July 3, 2007

Subject: 2007 mid-year review

Greetings,

The S&P 500 gained 6.9% in the first six months of 2007. Every one of our 13 SweetSpot and HotHands holdings did better than that, gaining a combined 14.9%. We outperformed the market by 8.0 percentage points, a margin greater than the market's entire gain.

The changes we made to our methodology this year seem to be working for us. Our first HotHands trade is up 12.6%, or 5.3 points better than the market. This is also the first year we bought also-rans, or sectors within a hair's breadth of the top-three SweetSpot or HotHands picks. Continuing the weird trend that last year's back-test uncovered, our also-rans are our best performers this year: [One] is up 31.5% and [the other] is up 19.6%.

2005-2007 Trade

The SweetSpot trade due to be sold next January has outpaced the market by 18.5 points since January 2005. Autos, materials, and industrial equipment are up a combined 48.6% compared to the market's 30.1% gain. Automotive began the year trailing the market by several points; now it leads by several points.

So far it's been easy to maintain our discipline. We have yet to suffer an extended period of poor performance. It looks like we won't be tested any sooner than January 2009 when it's time to complete our 2006-08 trade. How is that one doing?

2006-2008 Trade

We replaced four Fidelity holdings with PowerShares exchange-traded funds (ETFs) this year, including two of the three positions in our 2006-08 trade. [One] PowerShares ETF is pummeling [the corresponding Fidelity fund], but [another Fidelity fund] is clobbering its PowerShares counterpart. As of now it's a wash...

Looking at the performance of the Fidelity funds we originally purchased in January 2006, this trade is trailing the market by 5.9 percentage points. Is this cause for concern? Maybe... Let's suppose for a moment that our 2006-08 trade ended today. We made a profit but, for the first time ever, we failed to beat the market. We're wondering if the party's over... So, let's look around for clues. What better place to look than the next trade?

2007-2009 Trade

We already know that HotHands is off to a fast start. What about this year's SweetSpot picks? [Those holdings] are up a combined 18.8% in six months, or 11.5 points better than the market. Annualized, that's 23 points of outperformance. No worries...

Being grounded in rolling three-year trades makes it unlikely we will be shaken out of our investments in the face of short-term hiccups that mean nothing. And if something does change that affects our true expectations, we'll see it coming. Maybe the pace of human evolution will pick up. We might see the rational part of the brain grow a new layer that allows the masses to overcome their tendency to make bad trades from which we can benefit...

Or, in a desperate revenue grab Congress could decide to confiscate any investment returns that are deemed to be "excessive." We could rebel, but is our strategy worth going to jail for?...

If our 2006-'08 trade ends up losing to the market, we might chalk it up to last year's discovery [via back-testing] that SweetSpot may not work every time (although we can hope). Disappointing, but no big deal. In this case, however, I think we can identify the culprit.

We made significant changes to our methodology this year mainly because we lost confidence that the cash flows associated with Fidelity funds would mimic the dynamics of the broader market. That loss of confidence occurred gradually over a period of years. Our 2006 trade was the last one we made using the old methodology, making it less representative of reality than any other trade. (If we had used our old methodology this year, we would have bought Fidelity Select Construction & Housing, up 3.2% year-to-date, instead of [a current holding], up 31.5%).

Last year I tried but failed to verify that our 2006 picks would have been selected under the new methodology. My difficulty seemed to have something to do with the technical term that is used to describe the funds we buy at the time we buy them: "crappy." Fund sponsors are not eager to make available the historical numbers associated with crappy funds.

The beauty of this answer is that, if it was broken, we've already fixed it!

All Black

I remain 100% invested in SweetSpot. How did that happen? Here's how: Both fidelity.com and yahoo!finance report winning trades in black and losing trades in red. Sometime during the bear market I developed an intense aversion to the color red.

I had noticed that my SweetSpot holdings were consistently "in the black." Then one day I had an epiphany: If I only held SweetSpot investments, I wouldn't see any red... So I made the shift, which so far has accomplished its purpose.

Cheers,

Neil