Our Model Shadow Stock Portfolio holds exchange-listed stocks whose market capitalizations rank within the bottom 10% of all NYSE-listed stocks. Specifically, stocks must have market capitalizations of between $30 million and $300 million in order to qualify for consideration. They are sold when their market capitalizations exceed three times the maximum for addition, placing the current sell trigger at $900 million. (We periodically adjust the company size and valuation rules to reflect prevailing market conditions.)
This range of market capitalization is at a level many would consider to be micro-cap. Micro-cap stocks offer individual investors the advantage of scale. You or I can acquire a reasonable position in several micro-cap stocks either quickly or in a very short period of time without significantly moving the share price if we’re patient with our trades. Institutional investors commonly cannot; they simply have too much money to invest. This gives us individual investors the opportunity to pick up overlooked and mispriced stocks.
The downside of micro-cap stocks is that they are not all the same. Two key requirements for the Model Shadow Stock Portfolio are that candidates must be exchange-listed and must have filed a 10-Q (quarterly) report with the Securities and Exchange Commission (SEC) within the last six months. Many micro-cap stocks fail these two tests. They are not exchange-listed (primarily because they do not meet the either the NASDAQ’s listing requirements or the NYSE’s listing requirements) and either are not current with or don’t file quarterly reports with the SEC. Worse yet, reliable and thorough financial data may not even be available.
When regulators warn about micro-cap stocks, they are referring to those traded over-the-counter (OTC) and often referred to as pink sheet stocks. Such stocks may also be called penny stocks—a moniker reserved for stocks trading at very low share prices. The SEC defines penny stocks as trading below $5 per share and generally traded OTC. (A minimum price per share of $4 is required for all Shadow Stock candidates. This matches the minimum bid price required for being listed on the NASDAQ.) A common misperception is that it is easier for a stock to increase in value from five cents to 10 cents per share than from $50 to $100 per share. In both cases, the doubling of the stock price requires the market capitalization of the entire company to double in value.
What makes OTC stocks risky is the combination of little to no reputable information, extremely low volume and hucksters. It is not unusual for fraudsters to use “pump and dump” schemes to manipulate such stocks. These schemes involve acquiring a position in an OTC stock and promoting the stock via email, telephone calls and/or online commentary. As victims fall for the scheme and buy the stocks, the fraudsters sell their shares. The aftermath is a big drop in the share price, little to no volume and big losses for scheme’s victims. The North American Securities Administrators Association’s (NASAA) warns that this is currently occurring with marijuana industry-related stocks.
Fortunately, not all micro-stocks are the same. There are many exchange-listed micro-cap stocks worthy of consideration. The key word is “exchange-listed.” Such companies are required to meet the requirements of a stock exchange, as opposed to the comparative Wild West that is the OTC market. You can reasonably consider micro-cap stocks if you seek out companies that are exchange-listed, have share prices above $4 and are current with their SEC filings. Low price-to-book ratios and profitability are two additional traits we suggest looking for.
- Implementing the Individual Investor's Shadow Stock Portfolio – General advice on how to follow the Model Shadow Stock Portfolio; though some of the parameters have changed since this article was written, the suggestions remain valid today.
- Model Shadow Stock Rules – The current buy and sell rules governing the Model Shadow Stock portfolio.
- From the SEC: Micro-Cap Fraud – This 2004 AAII Journal article lists warning signs to watch out for.
- How Much of Your Portfolio Do You Allocate to Micro-Cap Stocks? – Tell us on the AAII.com discussion boards.
Two stocks have been added to the Model Shadow Stock portfolio: Global Power Equipment Group (GLPW) and the L.S. Starrett Company (SCX). No holdings met the portfolio’s sell rules, so there were no portfolio deletions.
As a reminder, after the close of the market on October 31, 2014, Model Shadow Stock Portfolio holding Kimball International (KBAL) spun off its electronics division, resulting in shares of Kimball Electronics that trade under the symbol KE being added to the portfolio. For the present time, these new KE shares will remain in the portfolio.
No changes were made to the Model Fund Portfolio this month.
The Model Shadow Stock Portfolio’s 2.4% decline for the month trailed its comparison benchmarks: The Vanguard Small Cap Index (NAESX) was up 1.0% and the DFA US Micro Cap Index fund (DFSCX) was down 0.7%. Year-to-date, the Model Shadow Stock Portfolio has declined 9.6%, trailing the Vanguard Small Cap Index fund (up 6.0%) and the DFA US Micro Cap Index fund (down 0.4%). The Model Shadow Stock Portfolio has a compound annual return of 16.8% since its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.4% annually over the same period.
The Model Fund Portfolio’s 1.3% gain in November compares to a gain of 2.4% for the Vanguard Total Stock Market Index fund. Year-to-date, the Model Fund Portfolio is up 9.7%, while the Vanguard Total Stock Market Index fund is up 12.4%. The Model Fund Portfolio has a compound annual return of 9.4% since inception in June of 2003 slightly trailing the performance of the Vanguard Total Stock Market Index fund over the same time period, which returned only 9.6%.
The AAII offices will be closed on Thursday (Christmas) and Friday and on January 1 and January 2. The next Investor Update email will be sent out on January 1.
Our holiday hours will also impact AAII Dividend Investing and the Stock Superstars Report. No weekly update emails will be sent out on December 26 or on January 2. Rather, a single holiday update for each newsletter will be sent on December 30. The January monthly reports for both services will be posted after the market close on January 9.
The U.S. equity and bond markets will close early on Wednesday, Christmas Eve. The U.S. financial markets will be closed on Christmas and New Year’s Day. The U.S. financial markets will operate on normal hours on December 31 and January 2.
Only one member of the S&P 500 will report earnings between now and the end of the year: Walgreen Company (WAG). The drugstore chain will report earnings before the open this coming Tuesday.
November existing home sales will be announced on Monday morning. Tuesday will feature the final revision to third-quarter GDP, November personal income and spending, November durable goods orders, November new home sales and the University of Michigan’s final December consumer sentiment survey. The weekly initial jobless claims and oil inventories reports will be released a day early on Wednesday.
The October S&P Case-Shiller home price index and the Conference Board’s December consumer confidence survey will be released on Tuesday, December 30. Wednesday, December 31, will feature the December Chicago PMI, November pending home sales, weekly initial jobless claims and weekly oil inventories. The December ISM manufacturing survey and November construction spending will be released on Friday, January 2.
The Treasury Department will auction $27 billion of two-year notes on Monday, $35 billion of five-year notes and $13 billion of floating two-year notes on Tuesday and $29 billion of seven-year notes on Wednesday.
On behalf of everyone at AAII, merry Christmas, happy Hanukkah and (an early) happy New Year.
- The Individual Investor’s Guide to Personal Tax Planning 2014
- How Much Is Needed to Start Investing?
- Patrick O’Shaughnessy’s Millennial Investor Strategy
Expectations among individual investors for a flat market rose to its highest level since September in the latest AAII Sentiment Survey. Pessimism also rose, reaching a nine-week high, while optimism fell below its historical average.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell by 6.3 percentage points to 38.7%. Optimism was last lower on October 2, 2014 (35.4%). The drop ends a streak of 10 consecutive weeks with bullish sentiment above its historical average of 39.0%. This had been the longest such streak in nearly three years.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 1.7 percentage points to 34.4%. Neutral sentiment was last higher on September 18, 2014 (34.8%). This is the third consecutive week with neutral sentiment above its historical average of 30.5%.
Bearish sentiment, expectations that stock prices will fall over the next six months, jumped by 4.5 percentage points to 26.9%. This is the highest level of pessimism since October 16, 2014 (33.7%). The increase was not large enough to keep bearish sentiment below its historical average of 30.5% for the ninth consecutive week and the 42nd week this year, however.
Neutral sentiment has risen by a cumulative 7.3 percentage points over the past three weeks. At the same time, bullish sentiment has declined by a cumulative 13.5 percentage points. The shift in expectations occurred as the S&P 500 underwent what was essentially a pullback. The large-cap index fell 4.9% between December 5 and December 16, 2014.
Keeping individual investors optimistic is falling energy prices, the overall upward momentum in stock prices, earnings growth, the Federal Reserve’s ending of its bond purchasing program and sustained economic expansion. Keeping other AAII members cautious are geopolitical events, weakness in energy stocks, a sense that prevailing valuations for other stocks are too high, the pace of economic growth and worries that a larger drop in stock prices is forthcoming.
This week’s special question asked AAII members how comfortable they are with the current valuations of the stocks they hold in their portfolios. Slightly less than one-third (31%) said they are comfortable with current valuations. A few clarified their responses by saying they are comfortable exclusive of oil stocks. Nearly 14% described themselves as being very comfortable. At the other end of the spectrum, 17% said they are not comfortable and an additional 7% said they are somewhat uncomfortable.
Here is a sampling of the responses:
- “Not counting the energy sector, I am very comfortable.”
- “Just fine; the dividend flow is more important than the daily price of the stocks.”
- “Great. I am buying stocks on the dips.”
- “Most of the stocks I hold are fairly valued. None are overvalued, but by my estimates, only one is undervalued.”
- “They’re high, except for oil, so I’m worried.”
Bullish: 38.7%, down 6.3 points
Neutral: 34.4%, up 1.7 points
Bearish: 26.9%, up 4.5 points
Local Chapter Meetings
December 11, 2014 The Implications of Real Estate Becoming a Sector
December 4, 2014 Look at the Relative Valuations Before Buying Energy Stocks
November 20, 2014 Debunking 10 Momentum Investing Myths
November 13, 2014 A New Argument Against Long-Term Care Insurance