Market Weakness Hits Model Shadow Stock Portfolio

    by James B. Cloonan

    Market Weakness Hits Model Shadow Stock Portfolio Splash image

    The market weakness continues, but it has stopped hitting small-cap and value stocks more than the general market. In fact, the Model Shadow Stock Portfolio is now performing better than the overall market, with a year-to-date return of –3.1% versus –9.1% for the Vanguard S&P 500 Index Fund (VFINX) and –8.7% for the Vanguard Small Cap Index (NAESX), as of the end of February.

    At the end of November we thought the Model Shadow Stock Portfolio would finish in the black for the year, but December proved very weak and it in fact finished 2007 in negative territory, down 1.8%.

    Figure 1 provides returns for various cumulative periods for the portfolio and comparative indexes. The results for the entire history of the Model Shadow Stock Portfolio are presented in Table 1.

    Model Portfolio vs. Newsletters

    Last year we started to examine, on an annual basis, the performance of the Model Shadow Stock Portfolio compared to the formal advisory services covered in the Hulbert Financial Digest. This year, we are able to draw comparisons based on a full 15-year period. The results for absolute return are shown in Table 2.

    If the Hulbert Financial Digest ranked the Model Shadow Stock Portfolio in terms of return performance, it would have been the No. 2 performer over the entire 15 years, the No. 4 performer over the last 10 years, and the No. 4 performer for the last five years.

    While we can’t duplicate Hulbert’s method of risk adjustment, the Model Shadow Stock Portfolio’s risk level is lower than most of the top five advisory newsletters for each period, so the Model Shadow Stock Portfolio would have ranked even higher relative to the other newsletters on a risk-adjusted basis.

    Quarterly Portfolio Activity

    Table 3 highlights activity in the portfolio during the three months ending February 29, 2008. Table 4 shows the current holdings and their status as of March 7, 2008.

    We continue to find new qualifying stocks and have sold McRae Industries (MRINA), the last of our two-year-rule stocks (the stock has not met the buy criteria for over two years), to free up funds for new purchases. We also sold Gottschalks Inc. (GOT) because it violated the terms of earnings probation by having another quarter of negative earnings.

    The three new stocks added to the portfolio are: AeroCentury Corp. (ACY), Alloy Inc. (ALOY), and SureWest Communications (SURW).

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 2/29/08)


    Table 2. The Model Shadow Stock Portfolio vs. Advisor Newsletters
    Last 5 Years Annual Return
    Shadow Stock Portfolio 30.1
    DJ Wilshire 5000 Index 13.8
    Hulbert Financial Digest Top Newsletter* 38.8
    Last 10 Years Annual Return
    Shadow Stock Portfolio 15.5
    DJ Wilshire 5000 Index 6.2
    Hulbert Financial Digest Top Newsletter* 18.1
    Last 15 Years Annual Return
    Shadow Stock Portfolio 18.1
    DJ Wilshire 5000 Index 10.3
    Hulbert Financial Digest Top Newsletter* 21.7
    * Newsletter with the highest return for the indicated period.
    Data as of 12/31/2007.
    Table 3. First-Quarter 2008 Transactions
    Company (Ticker) Reason
    Gottschalks Inc. (GOT) negative earnings
    McRae Industries (MRINA) two-year rule
    AeroCentury Corp. (ACY)  
    Alloy, Inc. (ALOY)  
    SureWest Communications (SURW)  

    The Markets and the Election

    As I pointed out in my January Model Portfolios column, presidential election years tend to be average years for the stock market (with an average return of 12.9%). However, if the economy does swing into an economic recession, the market will likely go even lower.

    Even if economic growth picks up next quarter, it may take awhile for the stock market to approach old highs—even though it looks like a bargain at current levels.

    I am a bit distressed by the election speeches advocating tax increases, particularly raising capital gains tax rates. I hope any such notions will at least wait for a stronger economy. We will update the performance of the Model Shadow Stock Portfolio in the July AAII Journal, or you can follow it at In the meantime, try to maintain a long-term perspective. These are the times that test our ability to cope with risk.


       Table 5. 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.

→ James B. Cloonan