Classic: Become a Smarter Seller, Part 2 by David Merkel, CFA of Aleph Blog
The following was published at RealMoney, but I don’t know when, but I do know that this is the first draft, not the finished product — my editor did not want me to mention that I was unemployed.
“I always sell too soon.” – Baron RothschildThis Hedge Fund Believes The New Real Estate Cycle Is “Well Underway”
In 2003, when I was briefly unemployed, I noticed that my personal account was starting to underperform. Partly to give myself more confidence at interviews, and partly to get rid of a distraction, I went over my portfolio to tune it up.
I started out by ranking my portfolio from top to bottom in terms of expected returns. Nothing complex – I just went my price targets and compared them to current prices. Highest percentages are at the top; lowest are at the bottom. My next step was to do the same for a list of replacement candidates. I then looked at the second list, and found that my top three replacement candidates beat the expected returns for the median company in my portfolio. I bought those three companies for my portfolio, and funded it by selling the four stocks in my portfolio with the lowest expected returns. At the same time, I added a small amount to two underperforming names in my portfolio. Here were my actions, and the results through 7/14/03, the date that I sold Pechiney:
With the exceptions of Pechiney and Nucor, I still hold positions in all of the purchases. When Pechiney hired the investment bankers, I tossed in the towel; I thought they were fighting for their cushy jobs, not enhancing shareholder value. I was surprised to see them sell out to Alcan. I sold Nucor in late 2003, over the rise in scrap steel prices; even though Nucor can raise its own prices, its profits will not increase as much as other steel firms. I also goofed in my evaluation of Adtran. It had much better prospects than I thought.
There were other companies on my purchase candidate list with expected returns that beat the expected returns of companies remaining in my portfolio, but did not beat the median expected return. I set the bar at the median in order to avoid excessive turnover.
The price return on the purchases versus the sales was better by more than I would ordinarily expect, and faster as well – I look for returns on my portfolio to beat the S&P 500. This series of trades certainly helped.
The two smaller purchases were done for a different reason than the other trades. PBR and DY were already in my portfolio, but had been performing badly. The weight that each had in my portfolio had shrunk to be the smallest in my portfolio. After a review of the fundamentals, I did what I call a rebalancing trade.
When I was interviewing managers at Provident Mutual, another question that we would ask managers is how they would rebalance positions in response to market movements. Many of them would do nothing; others had no fixed strategy. A few had really worked on this aspect of portfolio management, and to my surprise, their strategies on this topic were similar, even though other aspects of their portfolio management 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 couple percent per year.
There is a growing academic literature on market microstructure; one thing it addresses is measurement of the total costs of trading. One of the costs of trading comes from whether a trade demands or supplies liquidity to the market. When a trader posts a limit order, he 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 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. Use this time as an opportunity to re-evaluate the thesis on the stock.
- 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 stocks that are the most below their target weights, to bring them down to target weight.
This discipline forces you to buy low and sell high, and also, to reevaluate 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. This also works best for diversified portfolios with 20-50 stocks, with reasonable even weights. In my portfolio, the weights range from 2 to 7.5%, with 33 companies altogether.
The 20% figure is arbitrary, but in my opinion, it strikes a balance between excessive trading, and capturing reasonable trading profits, by providing shares and liquidity to the market when it wants them. The incremental profits add up as companies and industries fall in and out of favor, and the rebalancing system buys low, and sells high.
Long DY, PBR, PCP (at that time, at present  I have no positions in companies mentioned)
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