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Dane Bowler
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2nd Market Capital Advisory specializes in the analysis and trading of real estate securities. Through a selective process and consideration of market dynamics, we aim to construct portfolios for rising streams of dividend income and capital appreciation.
  • Portfolio Allocation – Knowing When To Sell Your Favorite Stocks

    There is an overwhelming volume of discourse about initiating positions. Investors are encouraged to buy or short stocks for various reasons. There is, however, a paucity of discussion about when to close out a position. This article will examine the optimal time to sell long positions and to cover shorts.

    Ideally, an investor should have a larger long position in a stock the further its market price is below the price target. Similarly, we would want a larger short position the further the market price is above the price target. Assuming that an investor wants to maintain a certain amount of diversification, maximal allocations must also be established.

    Here is a graph of optimal position size for any given market price.

    (click to enlarge)

    Allow me to explain aspects of this graph in more detail.

    The line represents the ideal allocation of a portfolio into a specific stock at a given market price. There are reasons that the line of optimal allocation looks like this. Let us detail the reasoning behind each portion of the graph, from left to right.

    Assume there is a stock that is priced massively below its fair value. To fully capitalize, one would want to buy as much of it as their risk tolerance can handle. This is the position size that defines the "maximal long allocation". Opportunities of this magnitude come up fairly often, but how long should one hold this position?

    Well, it's not so much a question of when as what triggers the sale. Once the market price appreciates to a certain percent of the target price, we hit the 1st downward slope. While depicted as a straight line, it would theoretically be a curve with the slope decreasing asymptotically as the market price approaches the target price. It is when the market price is on this curve that investors should take profits, selling more and more of their position. As the market price hits the "no touch zone" investors would ideally be selling the last of their shares. ." While these could be phenomenal companies, there is little opportunity in the stock. Consequently I would advise having absolutely no allocation to stocks trading in this range.

    Why?

    A stock trading at its intrinsic value has no room for capital appreciation. Sure a volatility event could push the market price higher, but it would be just as likely to drop. The truth of this statement requires a correct price target. In other words, stocks trading below their price target would be pulled up and those trading above it would be pulled down. It is this force toward proper valuation that establishes the price target. The further a stock's market price deviates from the price target the greater the magnitude of value there is in holding that position. For stocks trading below the target, this value is positive so we want a long position and for those trading above, this value is negative which promotes a short position.

    Establishing proper price target is a substantial subject of investment theory. It is highly debated and sufficiently complicated that it falls outside the scope this article. Instead, this discussion is about proper allocation around a given price target.

    Continuing from left to right, when a stock's market price hits the 2nd downward slope, holding it begins to have meaningful value. Of course, this value is negative, so it can be unlocked through a short. With only a slight negative value, investors would be wise to take only a small position as the force pulling it to the price target is still rather weak. If this force is overwhelmed by the prevailing market perception and the price rises even higher investors can respond by increasing the size of their short position. Given the inherent risk associated with shorting, I would recommend a fairly conservative maximum short allocation.

    If and when the price moves to the price target, investors should begin covering as it hits the right side of the 2nd downward slope and fully cover the position once market price returns to the "no touch zone".

    Apr 03 10:17 AM | Link | Comment!
  • Fundamental Techniques Of Investment Micromanagement

    As investors, we spend a fair amount of time deciding which stocks to buy and when. In the presence of an overwhelming amount of information it can be easy to forget some basic micromanagement techniques which create better performance regardless of the portfolio. Thus, the focus of this article will not be on what to buy, but rather on how to maximize whatever it is that you do buy.

    Arbitrage is typically thought of as the harnessing of a disparity in price of the same asset on different markets. This article will illustrate a different kind of arbitrage in which we harness a disparity in prices of different assets trading in the same market. By accurately evaluating what stocks are intrinsically worth, we can compare their relative opportunity. We will begin with a generalized example to clarify the process, then move on to showing recent usage of this technique in the 2nd Market Capital portfolio.

    While a real portfolio would be far more complex, we will use the following as our example portfolio.

    Stocks W, X, Y, and Z each with respective base values $10, $15, $20, and $25. Using stocks in the same sector will eliminate the variables associated with inter-sector comparisons.

    Base value, for the purposes of this article, will refer to the price that a given stock will fluctuate about and trend toward. It changes in accordance with the internal financial performance of the respective company, so it must be continually updated. Determining a stock's base value is a tricky subject and extends beyond the scope of this article. While a stock does not always return to its base value, the further its current price deviates, the stronger the pull toward the base value is. Therefore, averaged across an entire portfolio, stock prices will have the overall tendency to return to base value if this value was correctly determined. Manipulation of this basic principle through the techniques described below can create capital gains from ordinary price fluctuations.

    Timestate one

    Stock

    Base Value

    Price at time 1

    % deviation from base value

    # shares owned at time 1

    W

    $10

    $10.05

    0.5%

    2500

    X

    $15

    $15.01

    0%

    1666

    Y

    $20

    $19.92

    0.4%

    1250

    Z

    $25

    $24.89

    0.4%

    1000

    At this point no action is necessary as the stocks are trading very near to their base values. Since opportunity is derived from significant deviation, we wait.

    Timestate two

    Stock

    Base Value

    Price at time 2

    %deviation from base value

    #shares owned at time 2

    W

    $10

    $9.50

    -5.0%

    2500

    X

    $15

    $15.05

    +0.3%

    1666

    Y

    $20

    $20.08

    +0.4%

    1250

    Z

    $25

    $27.40

    +9.6%

    1000

    Now that the prices vary significantly from their base values we must verify that this difference is in fact attributable to market fluctuation and that the intrinsic value of the stock has not changed. If this is the case, we can sell off a portion (in this example 50%) of the appreciated stock (NASDAQ:Z) in exchange for the deflated (NYSE:W). The increased account value is realized once the prices normalize about their base value.

    Timestate 3

    Stock

    Base Value

    Price at time 3

    % deviation from base value

    #shares owned at time 3

    W

    $10

    $10.05

    0.5%

    3942

    X

    $15

    $15.01

    0%

    1666

    Y

    $20

    $19.92

    0.4%

    1250

    Z

    $25

    $24.89

    0.4%

    500

    Despite market prices returning to precisely the same as at time 1, the account has gained value.

    Account value at time 1 $99,921

    Account value at time 3 $101,968

    Recent application

    On June 21st, we were long FR-K (a high yielding First Industrial Realty (NYSE:FR) preferred) and the price of Agree Realty (NYSE:ADC) fell well below what we have internally deemed its base value. While FR-K provides an excellent dividend, it has little room for capital appreciation, so through selling it to purchase ADC we can glean the capital appreciation as ADC returns closer to its base value and catch the upcoming dividend. As this was done in my Roth IRA account, tax consequences were not an issue. Application of this technique is ubiquitous throughout our portfolio, and opportunities arise on a daily basis which investors can capitalize on by using this themselves.

    While this technique promotes consistently obtaining above market returns, it has aspects which preclude many investors from successfully using it.

    Minimum account size

    Frequent trading with small percentage gains per trade requires the account to be large enough such that the gains meaningfully outweigh trading commissions.

    Heavy Workload

    In addition to the research involved in determining the base values of each stock, these values must be constantly and accurately updated to maintain efficacy. For maximal growth, market prices must be constantly watched to capture fleeting opportunities. Some of the workload can be reduced through the use of programs which execute the trades automatically, but these programs can be expensive and require some degree of monitoring as well.

    Difficulty

    Success of this strategy is directly tied to the accuracy of base value estimations. Even with extensive research these can be quite challenging to obtain within an acceptable margin of error. Diversification further adds to difficulty as the investor's knowledge base must extend to cover more sectors.

    Taxation

    Frequent trading can create tax penalties as the immediate capital gains tax may be higher than that associated with long term positions. Use of a tax sheltered account such as an IRA circumvents this complication, but it can slow the pace of trading.

    Investors able to overcome these barriers are rewarded with the ability to achieve capital growth in a flat market. Since this technique keeps the account fully invested at most times, it allows for full dividend receipt. Particularly astute and fleet investors can take advantage of variance in the different dividend payment schedules and catch multiple stock's dividends.

    2nd Market Capital and its affiliated accounts are long FR-K and ADC

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Jun 25 9:59 AM | Link | Comment!
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