I?m working on my quarterly reshaping ? where I choose new companies to enter my portfolio.? The first part of this is industry analysis.

My main industry model is illustrated in the graphic.? Green industries are cold.? Red industries are hot.? If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted??? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.? Yes, things are bad, but are they all that bad?? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

If you use any of this, choose what you use off of your own trading style.? If you trade frequently, stay in the red zone.? Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?? Why change if things are working well?? I?m not saying to change if things are working well.? I?m saying don?t change if things are working badly.? Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.? Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then.? This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.? It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

I like technology names here, some utilities, and healthcare-related names, particularly those that are strongly capitalized.? I?m not concerned about the healthcare bill; necessary services will be delivered, and healthcare companies will get paid.

I?m looking for undervalued and stable industries.? Human resources ? sure, more part time workers.? Healthcare information?? A growing field, even with the new ?health bill.?? Same for Biotech.

Even in a double dip, phone calls will still be made, and the internet will still be accessed.

I?m not saying that there is always a bull market out there, and I will find it for you.? But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive.? I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.? The red zone is more highly cyclical than I have seen in quite a while.? I will be very happy hanging out in dull stocks for a while.

This report I will continue to publish after my firm commences operations at the start of 2011.? But I will delete my portfolios at Stockpickr.com, and will only report trades after all of my clients have their orders filled.? More to come on all of that.

Rebalance the portfolio whenever a stock gets more than 20% away from its target weight. Run a largely equal-weighted portfolio because it is genuinely difficult to tell what idea is the best. Keep about 30-40 names for diversification purposes.

Let me begin with the last part of the rule.? I’ve gotten different reactions over the years from holding 30-something names my portfolio.? From some friends who run concentrated hedge funds they say, “Why so diversified?”? From those that run mutual funds they say, “Why so concentrated?”

Since I concentrate industries, owning 30 to 40 names my portfolio is relatively undiversified, compared to an index fund.? My view is that industry performance is the main driver of stock performance.? I also think that owning industries in proportion to the index is a recipe for mediocre performance.? If you don’t break free from the industry weights of the index, you will never achieve index beating performance.

Now, some may criticize the idea that I don’t know what my best ideas are.? Good, go ahead and criticize.? My experience has been that ideas that I thought were marginal often did quite well and ideas that were highly promising sometimes did marginally.? On the whole I think there was some rough positive correlation between how well I thought it would do, and how it actually did, but not enough to make me change this rule.

I do occasionally make a name for my portfolio a double-weight, or once even a triple-weight, but those are rare.? To have a high weight in my portfolio means that it must be exceptionally cheap, and be exceptionally safe.? In other words, it must be very, very, misunderstood.

At present I have 34 names my portfolio.? Ordinarily I like to have 35.? But, I don’t change the number rapidly.? I have a greater tendency to raise the number when the market is cheap, and I add equity exposure.? That said, during the bear market from 2000 to 2002, I decreased the number of names as the selloff got worse, concentrating into the names that got hit the hardest that still deserved to be invested in.? As the market began to rise, I added to the number of names that I invested in.

Keeping the number of names relatively fixed in the short run helps to facilitate swap transactions.? Swap transactions are a more intelligent way of managing an equity portfolio, because people are reasonably good at doing binary decisions, and not at doing decisions that have a lot of degrees of freedom.

I can’t tell you at any given point in time that I have the best set of stocks in the world.? But, it is relatively easy for me to look at the stocks that I am buying versus the stocks that I am selling, and conclude that I am coming up with a better portfolio as a result.? More on that when I discuss portfolio eight.

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Now, on to rebalancing.? I have gotten some criticism over the years, arguing that my rebalancing discipline leads me to pump money into losers that lose yet more.? Part of the misunderstanding is that when a stock falls by 20%, it doesn’t trigger an automatic buy, but an automatic review.? If my review comes the conclusion that the stock is fundamentally okay, then I rebalance up to the target weight.? I don’t double the position; that would be lunacy.? I only add to bring it up to target weight.? This is a moderate and disciplined way to buy weakness.

If my review finds that I made a fundamental mistake, I sell the position out.? Now, all that said, my worst losses typically came from cases where I rebalanced down and rebalanced down, and never caught the fundamental error.? Hey, I’m human.? But I can say that my gains more than paid for my losses.? Also, most of the companies that hurt me had balance sheets that were less strong then I thought.

When I was on the other side of the table, choosing investment managers, I ran across three managers with excellent track records that used this strategy.? They felt that it added on 1-3%/year.? Surprisingly, one was a growth manager, one was a core manager, and one was a value manager.

My sense is this: markets oscillate, and performance by industry and company oscillates.? This simple strategy catches some of those oscillations, buy low and selling high.

It also helps portfolio management from a psychological standpoint, because you realize that by realizing gains partially, and buying lower selectively, you don?t care so much about day-to-day fluctuations.? Rather, you realize that on average, fluctuations are working for you, and so, you focus on fundamentals, not the noise.

At least, that is what I have experienced.? And that is why I rebalance.

For those that have e-mailed me about equity management, I will get back to you soon; I have been tied up in details of getting my assets management business going recently.

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If you have read me for a while, you have heard of my eight rules of stock investing.? Recently some people have been e-mailing me regarding my plans to start Aleph Investments, and one asked if I could write a series of pieces to explain how I manage stocks.? I thought it was a good idea, so this is the first of what is likely to be eight episodes.? Here’s portfolio rule one:

Industries are under-analyzed, relative to the market on the whole, and relative to individual companies. Spend time trying to find good companies with strong balance sheets in industries with lousy pricing power, and cheap companies in good industries, where the trends are not fully discounted.

I always get a little look of surprise the first time that I mention my main idea to consultants or other equity managers. I sometimes say, “Some managers are top down, others are bottom up — I am middle out.”? The idea is that I don’t rely on a view of the economy to drive my investing, nor do I just look for cheap stocks, wherever I might find them.? Instead, I look for industries that are hated, either absolutely or relatively.

In my view, paying attention to industry fundamentals is always superior to viewing the economy as a whole, because:

• The industry cycles as compared to the overall economic cycle are not exact comparisons, both with respect to timing and amount.
• Among other reasons, demand outside the US can be decidedly different than demand inside the US.
• New entrants and company failures and acquisitions can affect the industry economics more than the general economy.
• Major innovations like the Internet can turn stable cash flow generators like newspapers and parts of the telephone industry into permanent losers.

If I were allowed to turn back the clock, and teach those who allocate equity assets how it really works, I would have told them to ignore value and growth, large and small.? I would replace those with industries.? Industries tend toward value and growth, large and small, but the aggregation hides a lot of valuable information.? But the consultant community is a sucker for simple explanations that explain little of a more complex reality.

Think about it, ideally, when to you want to buy shares in an industry?? When the hatred is thick.? Valuations are crushed to the degree that they can’t go much lower.? And at such a point, the risk lover buys the dodgiest company in the industry — high fixed costs, bad balance sheet.? Clever, but what if the recovery takes too long, and it goes broke?? Such a strategy makes a short-term bet.? Those with a longer time horizon, and reasonable expectations, buy the high quality company.? If the downturn prolongs, more competitors will fail, and they will pick up pricing power.? If the downturn ends quickly, and pricing power returns, the high-quality company will still do very well relative to the market as a whole, though a lower quality name that might have died under other circumstances will do much better.

The second-best place to buy are industries in the midst of improving pricing power that will persist, but many think it will not persist.? In that case, since there is only a low threat of companies going into financial stress, buying cheap companies of moderate quality will result in very good gains.? The risk is that I am wrong in my estimate of continuing pricing power, but if I am wrong, the cheap name typically won’t do that badly, and I can trade away for the small gain, or not much of a loss.

All of this means spending time watching industry economics, looking for places that will outperform market expectations.? This isn’t always easy, but there aren’t so many players asking those questions, compared to those doing top down or bottom up investing, and so I have a better chance of profit, in my opinion.

PS — For those with access to RealMoney, some of my best articles on portfolio management are listed here.

New Buys:

• 5/19/2010????? Petrobras
• 7/9/2010??????? Goldman Sachs Group Inc
• 8/31/2010????? American Electric Power
• 8/31/2010????? Corn Products International
• 8/31/2010????? Zhongpin
• 8/31/2010????? PC Connection
• 8/31/2010????? Stancorp Financial

New Sales:

• 8/31/2010????? Goldman Sachs Group Inc
• 8/31/2010????? Dominion Energy
• 8/31/2010????? PPL Inc.
• 8/31/2010????? Sempra Power
• 8/31/2010????? Safeway Inc.

Rebalancing Buys:

• 5/19/2010????? Ensco International Inc
• 6/1/2010??????? Noble Corporation
• 6/29/2010????? Computer Sciences Corp
• 6/30/2010????? Industrias Bachoco
• 6/30/2010????? Northrop Grumman
• 6/8/2010??????? Safeway Inc
• 7/6/2010??????? National Presto
• 8/12/2010????? Constellation Energy Group

Rebalancing Sales:

• 8/2/2010??????? Noble Corporation

Thoughts

1)? I try not to trade too much.? For those that are new to my writings, rebalancing buys and sells are meant to bring the positions back to target weight after they have moved 20% away from the target weight.? As it is, for three months, I have not made a lot of trades.

2) I reduced utility exposure, it seems to have gotten relatively expensive amid the yield craze.? I have added cheap, well-financed names in a number of areas.

3) Assurant and National Western are double weights.? The rest of the portfolio is equal-weighted aside from that.? Note that National Western is quite illiquid.? Do not place market orders to buy or sell.

4) I flipped my momentum factor from small negative to moderate positive.? I have concluded that in a touchy macro environment like this, it is wise to consider return momentum.

5) I still don?t trust the financial sector aside from insurers here.

6) I had some runners-up in my analyses: AXS EDS TRH DFG

7 ) Some thoughts on the 8/31 buys:

• PC Connection is a net-net, illiquid, but makes money.? Unusual to have a company that trades for less than its net assets, and makes money.? THIS IS ILLIQUID.? NO MARKET ORDERS.
• Stancorp Financial is a well-run insurer trading at a discount.? Issues: Commercial mortgage exposure high, and disability may prove problematic during recessionary conditions.
• American Electric Power was cheaper than the utilities it replaced.
• Zhongpin sells pork in China.? Seems cheap, and has a decent amount of growth potential.? The financials look clean, but I am still reviewing it.
• Corn Products seems cheap, and its products are needed globally.

8 ) I have roughly 11% in cash.? If I find a really good idea, I might bring that down to 8%.? At present, my stocks are nearer to the high end of their rebalancing bands, so I am more likely to be doing a little selling than buying of my existing stocks in the short-run.

9)? Here was the last update.? Comments welcome.

Full disclosure (here is the whole portfolio): COP SBS DIIBF IBA VLO NTE SAFT RGA ESV ALL PRE PEP GPC LNT AIZ ADM CVX NE ORCL NWLI CB CSC NOC NPK SCG TOT SENEA CEG PBR AEP HOGS PCCC SFG CPO