Blog 8 - Contrarian Rebalancing

"The beauty of periodic rebalancing is that it makes investing decisions objective."— Benjamin Franklin

In active portfolio management, the first opportunity to create value is identifying high-quality businesses and buying them at a discount (QARP¹). The second opportunity is the art of rebalancing—sell high, buy low—as stocks gyrate around intrinsic valuations.

Caveat: In The Investing Oasis, rebalancing is deployed tactically between stocks and cash, not as a realignment across the traditional asset categories: stocks, bonds, and cash.

The Investing Oasis Rebalancing Methodology Requires:

• Conviction to choose quality compounding stocks

• Equal weight applied to each security

• Belief in "reversion to the mean" theory

Reversion to the Mean

All market-valued assets have an intrinsic value that fluctuates due to market factors. Periodically, valuations rise above calculated levels, yet inevitably revert back—and often below—expected valuations.

As growth stocks advance, prices ebb and flow around an intrinsic, but typically increasing, valuation. Rebalancing offers the opportunity to capture unrealized value from this market "dance."

Two Critical Questions

Which Stocks to Rebalance?

With an equal-weighted portfolio, the process is infinitely simplified. Leaders and laggards will be visually apparent on your trading screen. Once a share price rises above or falls below the portfolio average, it becomes a potential rebalancing target—though some may never cross your arbitrary threshold.

At What Threshold?

Picking a rebalancing threshold is a function of risk tolerance. Growth stocks typically vary ±40% annually (Figure 1). Lower risk-tolerant investors uncomfortable with wide gyrations might set a lower threshold (±10%), but more frequent rebalancing means more trading commissions. With time and experience, investors should develop a higher tolerance for greater ranges of volatility before rebalancing.

Figure 1 Source: JPMorgan

Rebalancing Depends on Market Conditions

i. During Ordinary Markets

Trimming Leaders: As a share price drifts up to the target threshold, consider trimming back to the core portfolio average by setting a Trailing Stop-Loss (TSL) order at 1-2% below the current share price. This allows the position to continue advancing until an eventual pullback triggers the trim order. Calculate the number of shares to be sold to bring the stock back to core average (selling high).

If a stock has been setting new record highs and is vulnerable to a pullback, consider trimming more aggressively—bringing a target stock's allocation below the portfolio average.

Buying Laggards: When a stock has been trending down, wait until the share price stabilizes before initiating a buy trade. Use a DCA process staged over several sessions (buying low). Consider setting incrementally higher Limit Buy orders to confirm that a stock has begun to recover. All the better, if these higher buys are still below the position's ACB.

Contrarian Philosophy: trim on green days, DCA on red days.

Note: The Oasis Growth Fund trimming thresholds are +20% and buying thresholds are ~15+%. This reflects that the market's general direction is positive. Waiting for an equivalent -20% discount may result in missing subsequent rebounds. Better to be somewhat early in a DCA buy-in than miss the recovery altogether. The market waits for no one. But that is where the incrementally higher Limit Buy orders can help to capture a recovery.

ii. During a Market Correction

During corrections, most stocks suffer, yet they all eventually hit individual nadirs from which recoveries are born. The bottom is only known in hindsight.

"You can have clarity, or you can have undervaluation. You cannot have both."— Vitaliy Katsenelson, CFA, CEO at IMA

The best buying decisions require chaos to gain advantage. Once a downturn surpasses 15-20%, it's time to consider averaging down. Resist the temptation to liquidate. Instead, recognize those panicky fear sensations as the sign of opportunity. Buying great companies at reduced prices should be irresistible. Unfortunately, most do resist.

Begin nibbling. Don't worry about getting the best prices. Set a series of incrementally lower limit buy orders. No trade will be perfect, but getting exposure on either side of a market bottom proves more valuable than letting the opportunity slip by. Your future self will thank you. The true essence of being contrarian involves embracing your fears.

Note: Confirm that no material event has transpired for a discounted target stock.

Consistency is Key

"A DCA policy will ultimately pay off provided it is adhered to conscientiously and courageously…under all conditions."— Benjamin Graham, Author of "The Intelligent Investor"

To be successful in ordinary markets, rebalancing needs consistent application on both trims and buy-downs—though rarely simultaneously. Implement rebalancing each time a stock meets your pre-determined threshold, up or down. This is particularly important when markets sell off. Despite feeling fear, continue averaging down. It's the right thing to do.

Note: As your portfolio value grows, the average stock value rises. Some medium-growth/medium-volatility stocks may never require rebalancing if they grow at a similar rate as the overall portfolio.

Technical Analysis Tools: Use with Caution

Stock traders often use Relative Strength Indicators (RSI) combined with other technical tools (MACD or Bollinger Bands²) to identify opportunistic timing points. These can be beneficial when trading for profits but problematic for portfolio management.

Limitations of MACD³

One main problem with the MAC Divergence is it's false signals. It predicts many reversals that don't occur and misses other true price reversals. Successfully deploying MACD takes personal judgment to rule signals in or out, likely inducing unnecessary trading for less experienced investors.

Note: Technical analysis tools are further explained in Chapter 14 of The Investing Oasis: Buying with Purpose.

A Built-In Relative Strength Indicator

In an equal-weighted portfolio, rebalancing is simplified because outperformers and underperformers stand out on the trading screen. Since all quality compounding stocks are eventually expected to deliver growth, the portfolio itself becomes the relative strength indicator.

Dealing with Laggards

Eventually, most growth stocks experience periods of underperformance. Having a buy threshold allows you to remain objective about when to begin infusing new cash (DCA). Yet if a share price continues deteriorating, it deserves greater scrutiny.

Either this position has become an even better bargain (lower P/E ratio, higher ROE) or it may be sinking into a value trap. Review recent corporate reports and news media to identify adverse issues. A decision to continue rebalancing depends on whether the matter is transient or material (Table 8.1).

Table 8.1: Material vs Non-Material Matters

Non-Material Matters

Non-material issues are typically transient and more often associated with operational issues and traditional business cycles. They often surface during quarterly earnings announcements. Averaging down should still be a function of the corporation's outlook, maintaining competitive advantages within its industry, and confidence in its leadership.

Material Matters

Companies experiencing material problems require deal-breaker consideration. The company will likely need transformation. Yet, even with a major trauma, there could still be life for the business if leadership handles the situation well. However, such transitions often require outside influences and resources.

Material matters managed poorly result in value traps⁴. They require your best detective skills. Triangulate with several sources to confirm or deny suspicions. Hold-off on rebalancing until the corporation publicly announces its action plan to address deficiencies. If doubts linger, better to sell and review new choices.

Five Tangible Benefits of Rebalancing

1. Simplicity – In an equal-weight portfolio, outlier stocks are quickly identified and rebalancing amounts are easily calculated.

2. Time Efficiency – Pre-setting rebalancing trades according to targets reduces the need for daily vigilance.

3. Raising Cash – Trimming positions regularly adds to the cash reserve for eventual DCA deployment on laggard stocks.

4. Dampens Portfolio Volatility – As overweight stocks are trimmed, cash increases. Both actions contribute to reducing portfolio variance.

5. Improves Investor Behavior – Rebalancing is entirely discretionary. Using pre-established target thresholds (sell @ +20% / buy @ -15%) invokes discipline. Each trade has purpose—realizing gains, increasing cash. Less ad hoc trading equals fewer mistakes. Learning to deploy rebalancing develops contrarian instincts to buy lower and sell higher.

Summary

Once core stocks are chosen and capital allocated, maintenance should be relatively modest. In an equal-weight portfolio, the most deviant performers stand out. Rebalancing is most effective when performed proactively and contrary to the market. As stock prices rise, trim the leaders. As individual stocks lag, buy more shares.

Yet as simple as this sounds, it requires discipline to deploy consistently. Your better self will appreciate raising cash when times are fruitful.

"An intelligent investor is a realist who sells to optimists and buys from pessimists."— Benjamin Graham, 'The Intelligent Investor'

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Resources:

• The Investing Oasis - Chapter 15: "The Art of Rebalancing"

Footnotes

1. QARP = Quality at a Reasonable Price ↩

2. Bollinger Bands are a technical analysis tool measuring market volatility ↩

3. MACD = Moving Average Convergence Divergence ↩

4. Value trap: A stock that appears cheap but continues declining ↩

Jay T. Mason, CFA, CFP manages the Oasis Growth Fund and is the author of

“The INVESTING OASIS: Contrarian Treasures in the Capital Markets Desert”,

as well as the blog series: ‘More Buck for Your Bang’.

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The Oasis Growth Fund is Series O of the Fieldhouse Pro Funds Inc trust series available by Offering Memorandum in Canada through select Financial Advisors. This education series is not intended as a solicitation for investment in the Oasis Growth Fund nor is it sponsored by Fieldhouse Capital Management Inc.