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    The AAII Beginner's Portfolio: An Annual Performance Review

    by James B. Cloonan

    As of December 31, 2002, the Beginner’s Portfolio completed its 10th year. The portfolio—a real portfolio, and not a hypothetical one—was started in January of 1993, with several objectives.

    First, we wanted to test in practice the historically simulated results that showed that, on average, the smaller the capitalization of a company’s stock, the higher would be the return over the long run; and, the lower the ratio of a company’s stock price to its book value per share, the higher the long-run return. There has been considerable research showing that smaller capitalization stocks provide higher returns, and the excess returns are more than might be explained by any additional risk. Two well-known researchers confirmed this result and also showed that the lower the price-to-book-value ratio, the higher the return.

    Second, we wanted to examine and share with our members the real-world problems of dealing with a portfolio of smaller-company stocks.

    Third, we wanted to show that it was possible to manage a portfolio, following precise procedures with a minimum time requirement—in this case, about four to six hours each quarter. For the Beginner’s Portfolio, we only look at and adjust the portfolio once a quarter, and the time requirements are usually under the allotment.

    Defining the Terms

    Since terminology has changed somewhat over the past 10 years, we should define some terms.

    Small Cap
    A company’s capitalization is the product of the current share price and the number of shares outstanding. Originally, a capitalization in the lowest 20% of stocks on the New York Stock Exchange (NYSE) was called a small-cap stock. To be considered a small cap, the stock did not have to actually trade on the NYSE, but the size was determined by the NYSE capitalizations. However, today, this lowest 20% capitalization is now called micro cap, and the term small cap encompasses the lowest 40% of all stocks ranked by market cap. The absolute value of these percentages will change as the stock market moves up and down. The current criterion of the Beginner’s Portfolio—capitalization between $17 million and $125 million—favors stocks closer to the smallest 10%, but eliminates extremely small companies.

    Value Stocks
    Value is determined for our purposes, and much other research, by the ratio of stock price to book value per share. There are no accepted terms for high versus low value. I, personally, only consider stocks that are in the lowest 20% on a price-to-book-value scale as being truly value stocks, and the Beginner’s Portfolio concentrates on the lowest 10%.

    Portfolio Management

    Over the 10-year period of managing the Beginner’s Portfolio, we have made adjustments in the practical aspects of portfolio management. We have shared these with our membership over the years, and the current rules are reflected in Table 1.

    An important difference between the real portfolio we manage and the numerous historical studies done on small stocks is that we incur transaction costs, and because these can be significant, we took steps to keep them to a minimum. Consequently, we do not rebalance the portfolio on a regular basis and we do not drop stocks simply because they no longer meet the criteria for purchase. This is reflected in the sell rules in Table 1.

       TABLE 1. Beginner's Portfolio Rules
    Purchase and Sale 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 0.60. (This figure will change gradually with changes in overall market values.)
    • Market capitalization must be between $17 million and $125 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 1.00.
    Stocks are sold if any of the following occur:
    • If last 12 months’ earnings are negative, the stock is put on probation; if a subsequent quarter has negative earnings prior to 12-month earnings becoming positive, the stock is sold.
    • The stock’s price-to-book-value ratio goes above 2½ times the initial criterion.
    • Market capitalization goes above 2½ times the initial maximum criterion.
    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 specialist’s 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.
    Management Rules
    • Decisions are made only at the end of each quarter. In order to react to the majority of earnings reports as early 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 stocks 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 are not needed until the portfolio exceeds $1 million.

    This practicality is extremely important in dealing with real and theoretical portfolios of micro-cap stocks, since they have low trading volumes and wide bid/ask spreads. The spread is the difference between the price a buyer is willing to pay for a security and the price a seller is willing to accept for the same security. Much historical research on investment approaches in micro-cap stocks is flawed because it ignores this problem. [See the accompanying “Cost of Spreads” box]

    Using the rules in Table 1, we have had a turnover of 26% annually, and we have been able to keep our transaction costs (the bid/ask spreads and commissions) to about 2.5% per transaction. Thus, the total cost of transactions to the portfolio was 0.65% (2.5% × 26%) of assets per year.

    The average size of the portfolio has been $700,000 and the average number of stocks held is 20—or $35,000 per position. While decimalization and additional guidance from the SEC has reduced spreads somewhat, they are still very significant in micro-cap stocks.

    Performance

    In examining the results of the Beginner’s Portfolio (Table 2), it is clear that our micro-cap, deep-value portfolio performed very well over the 10-year period as compared to various benchmarks representing large-cap, mid-cap and micro-cap stocks. In both absolute and risk-adjusted returns it beat the S&P 500, the Russell 2000, and the micro-cap index. As of this writing (March 6, 2003), the Beginner’s Portfolio is up 4.6% for the year, while the S&P 500 is down 5.5%.

    TABLE 2. Beginner's Portfolio vs. Passive Portfolios: 10-Year Performance and Risk (1993-2003)
      Annual Return (%)
    Beginner’s
    Portfolio
    S&P 500
    Index*
    Russell
    2000*
    Micro
    Caps*
    1993 32.3 9.8 18.7 21
    1994 2 1.1 -0.6 3.1
    1995 20.7 37.4 28.7 34.5
    1996 22.3 22.9 18.1 17.6
    1997 44.3 33.2 24.6 22.8
    1998 -8.9 28.6 -2.6 -14.3
    1999 0 19.5 19.6 29.8
    2000 -7.9 -10.1 -4.2 -3.6
    2001 30.5 -12.0 3.1 22.8
    2002 10.8 -22.1 -20.0 -13.3
    10-Year Annualized Rate of Return (%) 13.3 9 7.5 10.7
    10-Year Annual Volatility (Risk) (%)** 17.3 20 14.8 16.8
    Risk/Reward Ratio*** 0.613 0.347 0.307 0.479
    Growth of $1,000 $3,487 $2,365 $2,057 $2,766
    Return in a Moderate Risk Portfolio (%)**** 11 7.3 7.1 9.2

    Compared to the S&P 500, the return results confirm in practical terms what historical research has shown theoretically. In terms of risk, there is a slight surprise in that it is generally believed that small stocks have higher risk, although this has been moderating over recent years. Clearly, the large-cap performance over the last two years has contributed to the higher risk of the S&P 500.

    The performance of the Russell 2000, poorer than the S&P 500, is a bit of a surprise, but in my opinion the Russell 2000, because of its capitalization weighting, is closer to a low mid-cap index. The differences between the Beginner’s Portfolio and the micro-cap index are: First, the Beginner’s Portfolio is truly micro-cap only, and includes only those stocks with the lowest price-relative-to-book value ratios; and second, the micro-cap index has thousands of stocks, which serves to reduce volatility (risk)—although not by a lot.

    The row labeled Return in Moderate Risk Portfolio requires some explanation. The typical advice for the average investor is to maintain a moderate risk level. This risk level is often represented by a portfolio of 60% stocks, 40% bonds, which would have a long-term volatility (standard deviation) of 13%. The figure in this row indicates what your overall return would be in a moderate risk portfolio—one having a standard deviation of 13%—in which the stock portion of the portfolio is the indicated stock investment (Beginner’s Portfolio, S&P 500, etc.) and the bond portion is assumed to have an average annual return of 4%. This figure shows the impact of risk on return.

    The Future

    With the conclusion of 10 years, I am going to make some modifications to this portfolio. Perhaps we should call it Beginner’s II. While I am convinced of the efficacy of micro-cap value stocks, I think some newer concepts should be added. In particular, I want to reduce transaction costs even more by giving bid-ask spreads more weight in the decision process and by increasing the number of stocks in the portfolio so that new positions require an investment of no more than $25,000.

    I also want to implement an effort to reduce risk and thus increase the risk-adjusted rate of return. This will be accomplished by adding a new criterion to the selection process. That criterion will select from the stocks that pass the size and value screens those stocks that most reduce the risk of the portfolio. This is a concept that we have discussed in the Journal recently and that is used in the approach of AAII’s Stock Superstars Report.

    We will monitor this approach and keep you advised of our exact procedures and the portfolio results.

       The Cost of Spreads
    One of the stocks recommended for the Beginner’s Portfolio recently was Baltek (BTEK). On one particular day in February, the bid was $8.00 and the ask was $8.69. The last price was also $8.69.

    If you simultaneously put in an order to buy and one to sell at market, you would have lost $0.69, or 7.9%. If this same percentage spread was maintained through time, then whenever you bought or sold this stock, your potential profit would be reduced by 7.9%—which is very significant.

    It is also interesting to note what impact the spread has on hypothetical results.

    About a year ago, the closing price was $7.50 and now the closing price is $8.69. If you were running historical analysis on the method used to choose this stock, the database would show a buy at $7.50 and a sale at $8.69. This shows a profit in a year of 15.9%—not bad, and hooray for our theory.

    The problem is that if a year ago the price was a last price of $7.50, but a bid of $7.45 and an ask of $8.03 (a 7.2% spread), then in the real world you would have paid $8.03 (the ask) and sold a year later for $8.00 (the bid). Instead of the theoretical gain of 15.9%, there would be a slight loss.

    Beware of theoretical historical research results unless they have been confirmed by actual real-world portfolios.


    James B. Cloonan is chairman of AAII.


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