REAP in action – post #100

Another milestone!  My 100th blog post – and on an unsettling day.  Today Benazir Bhutto, the front-running opposition leader for the next Pakistan election, was assassinated.  Unfortunately, the destabilization scenario of my 18 July 07 blog post “Watch Pakistan” seems to be playing out. 

REAP IN ACTION
REAP is the acronym I use for my investment program – Relational Equity Allocation Program.  Basically you set up fixed groups of 6 non-correlated stocks, (“six-pack”) and  periodically re-allocate within each based on the relative price movements of the component stocks.  It is a mechanical buy-low/sell-high program conceptually not unlike the “Dogs-of-the-Dow”, except that instead of replacing stocks outright from a broad list, you stay in the same stocks, and the overall portfolio grows from the compounding effect of this “recycling” of some profits from the leaders into the laggards of the moment.  (The main effect is that you’re progressively creating more shares in companies that you want to accumulate over a long period.).  I’m running 4 six-packs at the moment (and drinking the odd one now and then as well   )

To illustrate a little more how it works, as recently as December 12th, I managed to chip off some Thornburg Mortgage (NYSE: TMA) after it spiked to $10.88, and cycle it into extra shares of Cree Inc (NASDAQ: CREE) at $23.76.   Cree at the time had declined the most in its six-pack group of  Thornburg, Cree, Buffalo Wild Wings (BWLD), Nvidia (NVDA), InVentiv (VTIV), and Credo Petroleum (CRED) over the measured period (since Dec 12).

Since then , Buffalo Wild Wings dropped sharply, and in the past two days Cree has surged by about as much, creating a 30% price differential between the two.   So today I sold 30% of Cree at $27.47 and re-invested the proceeds in BWLD at $24.40.  That’s basically the gist of REAP. 

Right now, because of the increased market volatility and because I’m getting signals so frequently, I’m using a variant of the program.  Normally, you wait 4 months and then re-allocate from the two strongest into the two weakest.  Right now I’m just re-allocating between the top and bottom stock whenever they hit a 30% differential.  At the end of the day, the new reference prices for the six stocks become the trade prices for the ones that trade, and the closing prices for the ones that don’t.   As the stock prices drift apart again, sooner or later, a 30% price differential again appears between two of the stocks, and you repeat the process.  The direction of the market or the absolute values of the six stocks don’t matter, since you are trading solely on the relative price movement alone.  Another way of looking at it is re-allocating on the spread between the stocks that are the furthest apart.

By reference price, I mean the price against which you calculate how much each stock has moved.  On Dec 12, Cree was at $23.76, and the other five stocks’ reference prices were fixed as of that date as well.  Today when I sold some, Cree was at $27.47 for a + 15.6% rise from $23.76.   BWLD was down about 16%, so if you remember grade 3 math, 15%-(-16%) = +31%.   So that tells me to sell 30% of the Cree position and buy more BWLD with the full proceeds.   (I don’t quibble over +/- a percent or two - it’s in the noise.)  You repeat this many times over, and you have a calculable and very meaningful compounding effect – which I mathematically isolated in my research and testing.

Another recent re-allocation that seems to be working out well for now was a recent (Dec 18) switch of some Horizons Beta-Pro Gold Bear ETF (TSX: HGD)  at $15.23 into FormFactor (NASDAQ: FORM)at $31.25.  As of a few minutes ago (noon), HGD was at $14.17, and FORM was at $34.34.

REAP PORTFOLIO ADJUSTMENT – SUN HYDRAULICS
Based on the cash analysis of two posts ago, I also decided to replace Mattel with something a little more energetic – Sun Hydraulics (NASDAQ: SNHY) out of Sarasota, Florida.   They are apparently a leader in “high-performance screw-in hydraulic cartridge valves and manifolds, which control force, speed, and motion as integral components in fluid power systems.”  They’re relatively small, but have a fairly broad international presence.   Their balance sheet and earnings numbers look good, and they complement their 6-pack with a unique flavour.  My issue with Mattel is the negative free cash-flow.  It’s basically OK too, but I think I have something with much better long-term potential (and take-over appeal) in SNHY.

REAP SYSTEM LAID OUT IN DETAIL – YOURS FOR FREE
The whole REAP method, researched and designed my myself, is described on the following 3 posts.  It is a gold-mine for fund managers, because in the long run, it’s a guaranteed way to beat the S&P500 hands down – with the S&P500 stocks themselves!  The smart ones would get it.  But I don’t think any pros will bother – especially since it’s out here for free. 

#1  http://stockadventures.wordpress.com/2007/06/14/reap-1-the-concept/ 

#2  http://stockadventures.wordpress.com/2007/06/18/reap-2-more-on-the-concept/ 

#3  http://stockadventures.wordpress.com/2007/07/02/reap-3-designing-a-six-pack/

Cheers,
Allocator

a.k.a George Parkanyi
gparkanyi@hotmail.com