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Computerized Investing > Fourth Quarter 2013

What Members Are Asking Online

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by CI Staff

Starting a Model Shadow Stock Portfolio

How does one start to build [or mimic] the AAII Model Shadow Stock Portfolio? I don’t have funds to buy all 30 stocks. How do we further select from the 30 available stocks in the portfolio?

—Pannaga via Web inquiry

CI Editor’s Response:

This is one of the most frequently asked questions for members of AAII. The Model Shadow Stock Portfolio, which was founded in 1993, has been performing very well for over 20 years. Naturally, an ongoing portfolio with a significant number of holdings (around 30) may seem daunting for individual investors to manage themselves. The hardest part is starting the portfolio. As much as we hate to say it, there really is no right or wrong way to begin.

The easiest way to build to the portfolio is to mimic the entire set of holdings. The main downside is that some of the holdings may have performed very well, so their prices are significantly higher than when AAII purchased them. In addition, members may not find it feasible to invest in 30 stocks.

Therefore, for members who only want a portion of the portfolio, we suggest two things. First, AAII has specific sell rules for the Model Shadow Stock Portfolio. The portfolio is a micro- and small-cap value portfolio, so if a stock gets to a certain valuation (price-to-book-value ratio of 2.4) or a certain market capitalization ($720 million), a sell is triggered at the time of the quarterly portfolio review. We suggest avoiding companies that are closing in on either of those figures. We also look at financial strength in the form of earnings. We would suggest avoiding companies that are noted as being on earnings probation, which means they have negative earnings for the trailing 12 months.

Finally, out of the stocks that are left, choose stocks in different sectors or industries. This will help with diversification. You can start your portfolio with as few as 10 stocks.

Breaking Down Total Market Funds

When investing in a total market index, how can I find approximately how the total market fund breaks down by percentage into the various categories of large-cap, small-cap, mid-cap, international exposure, etc.?

—Fisherman via Web inquiry

CI Editor’s Response:

Morningstar.com is your best bet. The easiest way to get this information is to type the fund’s ticker symbol into Morningstar.com’s ticker search bar at the top of the page. At the fund page, click on the Portfolio tab and you will find a bevy of portfolio information.

The breakdown provided not only includes a holdings style chart (percentages of the holding in large-cap value, small-cap growth, etc.), it also shows how the breakdowns compare to benchmark and category averages. Morningstar.com also provides sector weightings and international exposure.

Online Retirement Calculators

Where can I find a good calculator that will tell me how long my retirement account will last?

—Tjwbubba via Web inquiry

CI Editor’s Response:

What you are looking for is a retirement calculator, and there are many good ones available on the Internet. We suggest the calculators at FINRA (www.finra.org) or Kiplinger (www.kiplinger.com) as good ones to start with. For most investors’ purposes, these calculators should allow you to enter inputs such as current portfolio amount, how much money you will need on an annual basis in retirement, your expected retirement age and your current age. They should show you whether you will meet your retirement goals; if you are falling short, it should tell you what your annual contribution needs to be to reach your goals.

A Different Look at the Payout Ratio

Regarding the Fundamental Focus column on the payout ratio in the Third Quarter 2013 issue, can you add a discussion of the payout ratio using cash flow and free cash flow in lieu of earnings per share? Are there specific industries where this is valid? If so, how does one determine when it makes sense? If not, why not? All this said, the obvious point of the article is well-taken: As soon as one sees the payout ratio go above 100% (or some other safety point one might define), find out why and prepare to make a change.

Good article and timely.

—John Carsten via email inquiry

CI Editor’s Response:

Thank you for your suggestion; we will definitely take into consideration publishing a Fundamental Focus column on free cash flow payout ratios going forward.

Using the free cash flow payout ratio is not necessarily dependent on industry. Simply put, it may be a more accurate representation of a firm’s ability to keep their dividend payments on track. Without getting into too much detail, net income is different from cash, and cash is the element that is required to pay dividends. Therefore, many investors compare a company’s dividend payments to their free cash flows. Free cash flow is calculated by subtracting capital expenditures from cash flow from operations. In essence, it represents the cash available to shareholders that can be used to pay out dividends or buy back shares, or that can be kept by the company in the form of retained earnings. Many investors and analysts believe that the free cash flow payout ratio is a better measure of how safe a company’s dividend payments are.


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