When No Shadow Stocks Qualify as “Buys”
Thursday, January 23, 2014
Charles Rotblut, CFA
AAII Journal Editor

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  1. “Model Shadow Stock Portfolio: Purchase Guidelines and Rule Changes”
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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 38.1%, down 0.9 points
  Neutral: 38.1%, down 1.4 points
  Bearish: 23.8%, up 2.3 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

One effect of the rally in micro-cap stocks is the lack of any Shadow Stocks qualifying as “buys.” Qualifying stocks are those held within our Model Shadow Stock Portfolio and meeting our strict rules for purchase. These rules include a maximum price-to-book (P/B) ratio of 0.8, a maximum price-to-sales ratio of 1.2 and a maximum market capitalization of $300 million in addition to restrictions regarding profitability, minimum share prices, exchange listing and company characteristics.

The P/B rule is based on upon highly regarded academic research showing that aggregate groups of stocks with low P/B ratios outperformed groups of stocks with high P/B ratios. The best-performing group had a P/B ratio among the lowest 10% (decile) of NYSE-listed stocks. The Shadow Stock portfolio’s P/B rule roughly corresponds to the lowest decile, and we adjust it upward and downward over time to reflect prevailing market valuations.

The cap on market capitalization is based on academic research showing a size premium. Over the long term, performance is inversely related to size, with small-cap stocks outperforming large-cap stocks. The size restriction also is designed to exploit a key advantage individual investors have over institutional investors: the ability to go into the shadows of the market. Institutional investors are generally forced to avoid micro-cap stocks because there is not enough liquidity to buy them in meaningful amounts or sell large quantities quickly without moving the share price. Hedge funds also generally avoid these stocks because the low level of liquidity makes it costly to trade them frequently. Individual investors who are willing to follow a buy-and-hold approach, conversely, do not incur these problems.

The objective of the Shadow Stock approach is to construct a portfolio from the 1% of stocks that has both a low price-to-book value and a low market cap. These stocks carry higher spreads and should not be traded, but rather bought and held. Much of the Shadow Stock portfolio’s success, including its 61% gain last year, comes from its low levels of turnover.

Even with the aforementioned restrictions, in a typical month there are at least a few stocks listed as qualified. You can identify which these are by looking at the “Notes” column of the portfolio holdings. (We also designate those stocks that are approaching one of the sell rules in the same column. These notations are updated on about the 15th of each calendar month based on data from the end of the previous month.) This month is not a typical month, however, and no stocks currently qualify under a strict interpretation of the rules.

Investing is messy, however, and there are technicalities you can consider if you desire to follow the Shadow Stock portfolio. In the current AAII Journal, AAII founder and chairman Jim Cloonan, who runs the portfolio, says if there is a shortage of eligible stocks, the maximum price-to-book (P/B) rule can be relaxed from 0.80 to 0.90. You could even increase it to 0.92. Under this looser standard, LMI Aerospace (LMIA) and Rocky Brands (RCKY) qualify as buys. As of this afternoon, LMI Aerospace traded at a P/B of 0.84 and Rocky Brands traded at a P/B of 0.86.

The other technicality is to not require earnings to be positive for the last reported quarter. The rationale for doing so is to open for consideration companies with either one bad quarter or repeating seasonal factors. Loosening this rule would qualify International Shipholding (ISH) and Willis Lease Financial Corp. (WLFC) for purchase, which trade with P/B ratios of 0.61 and 0.72, respectively. If you choose to invoke this technicality, use extra scrutiny to ensure one bad quarter does not turn into several bad quarters or a full 12-month period of negative earnings. Shadow Stocks with two consecutive quarters of negative 12-month earnings from continuing operations are sold. (For full disclosure, I personally own shares in LMI Aerospace, International Shipholding and Willis Lease).

You could also consider stocks on the Passing Companies list. This is a quantitative list of companies meeting the portfolio’s buy criteria as of the beginning of the month, as opposed to an actively managed portfolio. Since the Model Shadow Stock Portfolio is a fully invested portfolio run through an actual brokerage account, a stock can appear on the Passing Companies list and never make it into the actual portfolio. If a stock held within the portfolio “qualifies,” however, it will also appear on the Passing Companies list. This means it is possible to build an alternative portfolio using stocks within and outside of the actual Shadow Stock Portfolio. Doing so means you won’t have Jim’s shoulder to look over and your returns will be different (possibly better or possibly worse).

Regardless of how you choose to follow the Shadow Stock rules or any other strategy, adhere to a disciplined method of implementing it. Follow the rules and do not violate the spirit of the strategy. Mr. Market will tempt you to do otherwise, but success comes in part from developing and sticking to a well-defined and consistent approach.

More on AAII.com

The Week Ahead

Approximately 130 members of the S&P 500 will report earnings next week. Included in this group will be Dow Jones industrial average components Caterpillar Inc. (CAT) on Monday; AT&T (T), Du Pont (DD) and Pfizer (PFE) on Tuesday; Boeing (BA) on Wednesday; 3M (MMM), Exxon Mobil (XOM) and Visa (V) on Thursday; and Chevron (CVX) on Friday.

The last Federal Open Market Committee meeting under Chairman Ben Bernanke’s tenure will be held on Tuesday and Wednesday. The committee’s statement will be released on Wednesday afternoon. Dr. Bernanke’s chairmanship will end on Friday. We wish him well in his new endeavors.

Elsewhere on the economic calendar, December new homes will be released on Monday. Tuesday will feature December durable goods orders, the Conference Board’s January consumer confidence survey and the October Case-Shiller home price index. The first estimate of fourth-quarter GDP and December pending home sales will be released on Thursday. Friday will feature December personal income and spending, the University of Michigan’s final January consumer confidence survey and the January Chicago PMI.

The Treasury Department will issue $15 billion of its new two-year floating rate securities on Wednesday. The interest rate on these notes will reset daily. The Treasury Department will also auction $32 million of traditional two-year notes on Tuesday, $35 billion of five-year notes on Thursday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

Neutral sentiment is above 38% on consecutive weeks for the first time in nearly 11 years, according to the latest AAII Sentiment Survey. Optimism slipped below its historical average, while pessimism remains at low levels.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 0.9 percentage points to 38.1%. This is the first time in nine weeks and just the fourth time in the past 20 weeks that bullish sentiment is below its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, declined 1.4 percentage points to 38.1%. This is the first time neutral sentiment has been above 38% on consecutive weeks since February 6 and February 13, 2003. The historical average is 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 2.3 percentage points to 23.8%. Even with the improvement, this is the 15th consecutive week and the 18th out of the past 20 weeks with pessimism below its historical average of 30.5%.

Regarding this week’s results, the current consecutive streak of below average bearish sentiment readings is the longest since the 28-week period of August 14, 2003, to February 26, 2004. Neutral sentiment is near the upper limit of what we consider to be its typical range of normal readings (within one standard deviation of the historical average.) Bullish sentiment and neutral sentiment were last at matching levels on October 11, 2012. Since reaching a short-term peak of 55.1% on December 26, 2013, optimism has fallen by a cumulative 17 percentage points.

The market’s bumpy start to the New Year has curtailed some of the short-term optimism AAII members have had. Nonetheless, many individual investors remain hopeful about the six-month direction of stock prices because of earnings growth, economic growth, the record highs established by the large-cap indexes and the Federal Reserve’s tapering of its bond purchases. Limiting the extent of the optimism are worries about the pace of economic growth, elevated stock valuations and frustration with Washington politics.

This week’s special question asked AAII members which industries or sectors they like right now. Health care was the most popular, named by 30% of respondents. Technology and banking/financial came in second and third, picked by 23% and 22% of respondents, respectively. Energy was fourth, with slightly less than 20% of respondents selecting it. When we asked the same question last June, respondents named (in order of popularity) energy, technology, health care and industrials.

» Take the AAII Sentiment Survey