• AAII Model Portfolios
  • 2007 Proves Underwhelming for Small Caps and Value Stocks

    by James B. Cloonan

    2007 Proves Underwhelming 
for Small Caps And Value Stocks Splash image

    The underperformance of value stocks and smaller capitalization stocks relative to large-cap growth stocks continues.

    That is reflected in the performance of the Model Shadow Stock Portfolio, which is up only 2.0% for most of 2007 (through November 30), compared to 6.1% for the market as a whole, as represented by the Vanguard 500 Index fund (see Figure 1).

    However, the Model Shadow Stock Portfolio does continue to outperform both small- and micro-cap indexes (complete data are shown in Table 1). While it seems likely that the portfolio will extend its six-year run of positive returns, it may not match the return of the total stock market for 2007.

    Historically when small stocks underperform, the period of underperformance lasts only one or two years. It would be nice to know if it is going to be one or two years this time (or perhaps zero years if we catch up in the remaining weeks of December as of this writing). [For a complete description of the Shadow Stock Portfolio, see the Shadow Stock Portfolio area on AAII.com.]


      Avg Annual
    Ret Since
      Annual Rate of Return (%)
      2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993
    Shadow Stock Portfolio 18.5 2.0 29.4 17.9 43.7 73.1 10.8 21.4 -7.7 0.0 -8.9 44.3 22.3 20.7 2.0 32.3
    S&P 500 (VFINX) 10.5 6.1 15.6 4.8 10.8 28.5 -22.1 -12.0 -9.1 21.1 28.6 33.2 22.9 37.4 1.2 9.9
    Vanguard Small Cap (NAESX) 11.0 1.9 15.6 7.4 19.9 45.6 -20.0 3.1 -2.7 23.1 -2.6 24.6 18.1 28.7 -0.5 18.7
    DFA US Micro Cap (DFSCX) 13.5 -5.2 16.2 4.9 18.4 60.7 -13.3 22.8 -3.6 29.8 -7.3 22.8 17.6 34.5 3.1 21.0

    Qualifiers: The Good News

    As you will see in viewing the portfolio’s activity this period, there is suddenly an abundance of new qualifying stocks—so much so that we reduced the price-to-book ratio criterion back to 0.80, and we had to sell most of our two-year rule stocks (in which the stock has not met the buy criteria for over two years) to obtain funds to buy the new opportunities.

    I don’t want to make too much of it, but when the supply of qualifying stocks dried up early in 2007 and we had to hold onto stocks that had not qualified for a long time and relax our criteria, it indicated the beginning of poorer performance relative to the overall market.
    Could the sudden reappearance of a number of qualifiers signal a turn in the relative performance of the portfolio?
    I can’t make a case for it based on such limited experience, but I will certainly take note of what happens next.

    52-Week Market
    ($ Mil)
    Company (Ticker)
    Allion Healthcare (ALLI) 5.55 7.58 3.85 89.9 37.0 0.9 0.0  
    Avalon Holdings (AWX) 6.53 10.87 6.05 24.8 17.6 0.6 0.0 currently qualifies
    BlueLinx Holdings (BXC)* 3.62 12.39 3.16 113.1 362.0 0.6 0.0  
    Books-A-Million (BAMM) 12.03 23.70 11.17 197.1 10.2 1.9 3.0  
    Building Mat’ls Hdg (BLG)* 6.38 27.00 4.86 187.4 9.8 0.3 6.3 currently qualifies
    Cobra Electronics (COBR)* 5.02 10.95 4.65 32.5 33.5 0.5 3.2 currently qualifies
    D&E Commun’s (DECC) 14.15 19.99 12.01 204.3 16.5 1.1 3.5  
    Edge Petroleum (EPEX)* 5.65 20.26 5.21 161.3 18.8 0.4 0.0 currently qualifies
    Flexsteel Indus (FLXS) 12.07 15.94 11.60 79.3 8.0 0.7 4.3 currently qualifies
    Gehl Company (GEHL)* 17.05 33.17 15.50 209.1 8.4 0.8 0.0  
    Golfsmith Int’l Hdg (GOLF) 4.00 11.57 3.81 63.1 14.8 0.5 0.0  
    Gottschalks Inc. (GOT) 4.16 15.37 3.38 57.0 nmf 0.5 0.0 earnings probation (2007q2)
    Hardinge Inc. (HDNG) 18.19 40.13 12.67 208.8 8.3 0.9 1.1  
    Hastings Entertain (HAST) 9.45 10.00 5.43 100.3 11.1 1.0 0.0  
    Haverty Furniture (HVT)* 8.39 16.22 7.76 183.2 59.9 0.7 3.2 currently qualifies
    ILX Resorts (ILX) 4.00 13.37 4.00 14.1 nmf 0.4 12.5 earnings probation (2007q3)
    Johnson Outdoors (JOUT) 22.19 23.91 17.00 203.4 22.4 1.1 1.0  
    L.S. Starrett Co. (SCX) 18.70 20.52 14.53 123.8 14.2 0.7 2.1 currently qualifies
    McRae Indus (MRINA) 15.80 17.75 11.25 40.4 10.6 1.0 2.3 not qualified as buy for 2 yrs
    P&F Industries (PFIN) 6.36 14.30 6.20 25.2 27.7 0.4 0.0 currently qualifies
    PGT, Inc. (PGTI)* 5.70 13.67 4.95 157.8 63.3 0.7 0.0 currently qualifies
    RCM Technologies (RCMT) 5.69 10.30 4.93 68.5 9.3 0.8 0.0 currently qualifies
    Rex Stores Corp. (RSC) 15.95 22.68 14.62 161.6 7.5 0.7 0.0 currently qualifies
    Rocky Brands (RCKY) 6.80 19.23 6.56 37.3 97.1 0.4 0.0 currently qualifies
    Shoe Carnival (SCVL)* 11.55 35.26 10.54 146.3 9.3 0.7 0.0 currently qualifies
    SigmaTron Int’l (SGMA) 10.55 13.37 7.70 40.0 18.5 0.8 0.0 currently qualifies
    Standard Motor Prods (SMP)* 8.23 19.45 7.35 151.6 13.1 0.8 4.4 currently qualifies
    Tufco Technologies (TFCO) 6.85 9.51 6.03 31.1 62.3 0.8 0.0  
    West Marine (WMAR)* 9.04 18.38 8.46 197.4 129.1 0.7 0.0 currently qualifies
    Willis Lease Finance (WLFC) 12.92 16.50 9.65 108.9 8.6 0.8 0.0 currently qualifies
    *Company is new to the model portfolio.              

    Explanation of Notes

    Approaching Size Limit: Stocks are sold if their market capitalization goes above three times the initial maximum criterion. The current market capitalization maximum for initial screening is $200 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $500 million.

    Approaching Value Limit: Stocks are sold once their price-to-book-value ratio goes above three times the initial criterion. The current initial price-to-book ceiling is 0.80. Stocks are marked “approaching value limit” if their current price-to-book-value ratio exceeds 2½ times the initial criterion, or 2.00.
    Currently Qualifies: Stock still qualifies as a buy when the screen is run with current data. Stocks that don’t currently qualify as a buy are held until they meet one of the sell rules.

    Earnings Probation: 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 becoming positive, the stock is sold. The date within the parentheses lists the calendar quarter during which the company first reported negative trailing 12-month earnings.

    Not Qualified as a Buy for 2 Yrs: Stock has not met the buy criteria for over two years and can be sold if cash is needed.

    Where It Stands

    Table 2 shows the current status of the portfolio.

    Table 3 shows the current rules. As previously mentioned, we cut back the price-to-book ratio requirement to 0.80.

    While we normally would have completed our trades at the end of November, this year because of my schedule we completed them early in December.

    Company (Ticker) Reason
    California Coastal Communities, Inc. (CALC) negative earnings
    Carriage Services, Inc. (CSV) two-year rule
    Duckwall-ALCO Stores, Inc. (DUCK) two-year rule
    ePlus Inc. (PLUS) deregistered
    Espey Manufacturing & Electronics (ESP) two-year rule
    Hanger Orthopedic Group (HGR) two-year rule
    Merix Corporation (MERX) negative earnings
    Northwest Pipe Co. (NWPX) two-year rule
    T-3 Energy Services (TTES) exceeded value limits
    BlueLinx Holdings Inc. (BXC)  
    Building Materials Holding Corp. (BLG)  
    Cobra Electronics Corp. (COBR)  
    Edge Petroleum Corp. (EPEX)  
    Gehl Co. (GEHL)  
    Haverty Furniture Companies (HVT)  
    PGT, Inc. (PGTI)  
    Shoe Carnival, Inc. (SCVL)  
    Standard Motor Products Class A (SMP)  
    West Marine, Inc. (WMAR)  

    The Outlook

    As I discussed in earlier columns in 2007, unless the remaining few days in December prove to be spectacular, the stock market will have been unusually weak for the year before an election.
    Last January I mentioned that the strong 2006 year-end showing might have been stolen from 2007, but that was only a supposition.
    In the election year cycle, 2008 should be an average year, but an average year may not be in the cards with the sub-prime problem not completely resolved, currency issues at home and abroad, the continuing energy problem, and the swings in the war on terror.
    But, as always, I suggest keeping fully invested.
     We will update the Shadow Stock Portfolio in the April AAII Journal, and in the meantime you can keep abreast at AAII.com.

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    Table 3. 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. (Figure will change gradually with changes in overall market values.)
    • Market capitalization must be between $17 million and $200 million. (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 stocks on foreign exchanges or ADRs 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 second item under Stock Order Guidance concerning spreads when buying shares.
    • Price-to-sales ratio must be less than 1.2. (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.) The two years should be measured from the last time the stock qualified, not from when you purchased it.

    Stock Order Guidance

    • These rules are for general guidance. Your own experience, market conditions and the size of the position will impact your own decisions. The results in the model portfolio were obtained while sometimes paying more.
    • Market orders are not used. Instead, if the quoted bid-ask spread is less than 2% (ask price minus bid price, divided by ask price), place a limit order at the ask price for a buy and at the bid price for a sell. If the bid-ask spread is more than 2%, try to place a limit order between the bid and ask prices to keep transaction costs low. If necessary, build a position gradually. With low commissions, it is often better to place partial orders than to try to establish a large position all at once. Be patient.
    • Be careful if the average daily number of shares traded is not four times the amount needed for your position. It may be too difficult to get in and out of the position, but you may be able to grow the position gradually and sell gradually.
    • 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.

    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 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. If you are developing the portfolio gradually, you can do it stock by stock, but don’t put more than 10% of your funds in each additional stock. More than 20 stocks is not needed until the portfolio exceeds $1 million.


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