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    Shadow Stock Portfolio Up 8.5% Year-to-Date Despite Market Weakness

    by James B. Cloonan

    Shadow Stock Portfolio Up 8.5% Year To Date Despite Market Weakness Splash image

    Over the last three months, the market in general continued its weakness, with smaller company stocks a bit weaker than large caps.

    However the Model Shadow Stock Portfolio is still up 8.5% for the year, compared to 5.7% for the Vanguard 500 Index Fund (VFINX). Figure 1 shows the comparisons with other indexes and for other periods.

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 8/31/06)
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Every so often we like to review the entire year-by-year history of the Model Shadow Stock Portfolio, and this is shown in Table 1.

    In looking at the long term, you can see that, not only has the Shadow Stock Portfolio had a higher overall average annual return than the market indexes (18.6% compared to 10.3% for the Vanguard 500 Index Fund, 11.2% for the Vanguard Small Cap Index and 14.4% for the DFA US Micro Cap Fund), but it has been fairly consistent in beating the market indexes in individual years. The Model Shadow Stock Portfolio has beat both the Vanguard 500 Index fund and the Vanguard Small Cap Index fund in nine out of the last 13 years; it has beat the DFA US Micro Cap Fund in seven out of the last 13 years. Clearly, the small capitalization and value criteria result in a portfolio that has provided significantly higher returns than the market indexes.

     

    Quarterly Portfolio Activity

    Table 2 highlights the activity in the portfolio over the last three months, and Table 3 shows the current holdings and their status in the portfolio.

    All American Semiconductor (SEMI) and BioScrip Inc. (BIOS) were on probation and had a subsequent negative quarter that required their sale. Navigant International (FLYR) was bought out at $16.50 a share.

    Bairnco Corp. (BZ) had a tender offer from Steel Partners that has not been approved by the Bairnco board. While I originally did not plan on selling, I decided to do so for several reasons: No better offer has been forthcoming, 48% of the shares have already been tendered to Steel Partners, and there are a number of new stock buying opportunities at this time. The offer is expiring (Sept. 28) while I am writing this but may be extended.

    We were able to add five new stocks to the portfolio: CPAC Inc. (CPAK), Blair Corp. (BL), Flexsteel Industries (FLXS), Hastings Entertainment (HAST) and Huttig Buildings Products (HBP). We have not had this many stocks available for quite awhile.

    The one good thing about a soft period in the market is that it is easier to buy stocks without having to chase them as they move up.

    Table 2. Third-Quarter 2006 Transactions
    Company (Ticker) Reason
    Sell
    All American Semiconductor (SEMI) negative earnings
    Bairnco Corporation (BZ) buyout pending
    BioScrip Inc. (BIOS) negative earnings
    Tender
    Navigant International (FLYR) acquired by Carlson Wagonlit Travel
    Buy
    CPAC Inc. (CPAK)
    Blair Corporation (BL)
    Flexsteel Industries, Inc. (FLXS)
    Hastings Entertainment, Inc. (HAST)
    Huttig Buildings Products, Inc. (HBP)

    For the Do-It-Yourselfers

    I frequently get questions from members who have either bought stocks that we list as “Passing Companies” on AAII.com in the months between the Model Shadow Stock portfolio changes or who have found stocks that qualify through the use of Stock Investor Pro, our fundamental stock screening software.

    We certainly encourage this do-it-yourself approach, but it means you will have to set up your own system for implementing the sell rules for these stocks. This is easy enough to do, particularly if you have Stock Investor Pro, but it is your responsibility.

    Overall, buying passing stocks on your own should increase your returns because you will pick up opportunities that will be gone by the time our quarterly activity takes place.

    The full set of portfolio rules appears in Table 4 and in the Shadow Stock Portfolio area of AAII.com.

     

    The Market Outlook

    In my July 2006 update, I mentioned that this is usually a mediocre year in the election cycle. But next year is the year before a presidential election, and that has always been the strongest year. The year before a presidential election has not been down since 1931 and has averaged +22.7%. A number of analysts are suggesting next year will be strong for other reasons as well. If there are enough predictions of a great 2007, then the initial move might come late this year.

    Predicting the stock market is always risky and the best approach, in my judgment, is to stay close to your normal asset allocation all the time; although a slight variation under different economic conditions is reasonable.

    The next Shadow Stock Portfolio column will be in January 2007, but monthly updates can be found at AAII.com in the Shadow Stock Portfolio area.

       Table 4. Model Shadow Stock Portfolio Rules

    Purchase and Sales Rules

    Stock purchases must meet these criteria:

    • No bulletin board or pink sheet stocks will be purchased.
    • Price-to-book-value ratio must be less than 0.80. (This figure will change gradually with changes in overall market values.)
    • Market capitalization must be between $17 million and $200 million. (This figure will change gradually with changes in overall market values.)
    • The firm’s last quarter and last 12 months’ earnings from continuing operations must be positive.
    • No financial stocks or limited partnerships will be purchased.
    • No foreign stocks will be purchased because of different accounting and/or withholding tax on dividends.
    • The share price must be greater than $4.
    • In order to reduce trading by avoiding stocks that are forever marginal, any stock that was sold within two years will not be rebought.
    • Note first item under stock order rules concerning spreads when buying shares.
    • Price-to-sales ratio must be less than 1.2. (This figure may change gradually with changes in overall market values.)

    Stocks are sold if any of the following occur:

    • If last 12 months’ earnings from continuing operations are negative, the stock is put on probation; if a subsequent quarter has negative earnings prior to 12-month earnings from continuing operations becoming positive, the stock is sold.
    • The stock’s price-to-book-value ratio goes above three times the initial criterion.
    • Market capitalization goes above three times the initial maximum criterion.
    • After two years, sell if not qualifying as a buy currently. (But do not sell until there is a qualified stock to buy.)

    Stock Order Rules

    • If the quoted bid-ask spread is more than 4% (ask price minus bid price, divided by ask price), the stock is eliminated from consideration. Better to stretch other criteria, if necessary, than pay high spreads.
    • Stocks are eliminated if the average daily number of shares traded is not four times the amount needed for the position—the spread will be too high and not negotiable either now or when sold.
    • Market orders are not used. Instead, orders are placed between the bid and ask prices unless the difference between the two is 2% or less, in which case purchases are placed at the ask price and sales are placed at the bid price.
    • For NASDAQ stocks, it appears to be better to use day orders. If the order is not filled, it is placed again with a slight adjustment. For NYSE and Amex stocks, good-till-canceled (GTC) orders are used to keep a place in line in the specialists’ books. If the market isn’t close to the desired price, the price is adjusted in a few days with a new GTC order.
    • If price changes cause a stock to become ineligible (due to changes in price-to-book-value ratio or market capitalization) when only part of the order has been filled, stocks already purchased are kept but the balance of the order is canceled.
    • All order rules can be adjusted based on your own judgment and experience.

    Management Rules

    • Equal dollar amounts are invested in each stock initially.
    • Decisions are made only at the end of each quarter. In order to react to the majority of earnings reports as soon as possible, quarterly reviews are made early in February, May, August, and November.
    • Best judgment is used for tenders or mergers, but all criteria must be obeyed.
    • At the end of a quarter, if receipts from stocks sold exceed requirements for new purchases, the excess receipts—up to 5% of the portfolio’s value—are kept in cash until the next quarter. If the excess receipts are greater than 5% of the total portfolio value, the amount above 5% is distributed to smaller holdings that still qualify as buys. Efficient quantities are purchased: If over 10% of the portfolio is in cash, the price-to-book-value ratio can be moved up, but never over 0.90.
    • At the end of a quarter, if receipts from stock sales are insufficient to buy all newly qualifying stocks, purchases are made in order of lowest bid/ask spreads.
    • Note that if you are managing your own portfolio, it should consist of at least 10 stocks. More than 20 stocks is not needed until the portfolio exceeds $1 million.


    James B. Cloonan is founder and chairman of AAII.


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