Become a Smarter Seller, Part 2

A Reasoned Rebalancing

The two smaller purchases were done for a different reason than the other trades. I already owned Petrobras (PBR - commentary - Cramer's Take) and Dycom (DY - commentary - Cramer's Take), but both had been performing badly. Their weight had shrunk to be the smallest in my portfolio. After a review of their fundamentals, I did what I call a rebalancing trade.

When I interviewed fund managers, I would often ask how they would rebalance positions in response to market movements. Many of them would do nothing; others had no fixed strategy. However, three of them had really worked on refining their strategies, and to my surprise, their outcomes were similar -- even though other aspects of their styles were different. One was value, one was growth, one was core, but they each had evidence that their approach improved their returns by a few percent per year. That caught my attention.

One cost of trading comes from whether a trade demands or supplies liquidity to the market. When a trader posts a limit order, he or she offers other market participants an option to exchange shares for liquidity at a known price. In offering liquidity, the trader hopes to get an execution at a favorable price.

The approach that the three managers use -- and that I employ in my personal account -- is as follows:

Define a series of fixed weights for the stocks in the portfolio.

Do a rebalancing trade when any position gets more than 20% away from its target weight. The 20% figure is arbitrary, but I think it strikes a balance between excessive trading and capturing reasonable trading profits by providing shares and liquidity to the market when it wants them.

Use this time as an opportunity to re-evaluate the thesis on the stock. If the thesis is no longer valid, exit the position and buy something that you like better.

If the rebalancing trade generates cash, invest the cash in the stocks that are the most below their target weights, to bring them up to target weight.

If the rebalancing trade requires cash, generate the cash from selling stocks that are the most above their target weights, to bring them down to target weight.

This discipline forces you to buy low and sell high and to re-evaluate your holdings after significant relative market movement. This method works best with companies that possess low total leverage relative to others in their industries. This helps avoid the problem of averaging down to a huge loss.

It also works best for diversified portfolios with 20 to 50 stocks, with reasonably even weights. In my portfolio, the weights range from 3% to 7%, with 33 companies altogether.

The incremental profits add up as companies and industries fall in and out of favor, and the rebalancing system buys low and sells high.

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At time of publication, Merkel and/or his fund was long Precision Castparts, Petrobras and Dycom, though positions may change at any time.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.