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# 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.

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.