Results Not Yet Final, But So Far, Election-Year Returns Have Yet to Appear

    by James B. Cloonan

    Results Not Yet Final, But So Far, Election Year Returns Have Yet To Appear Splash image

    The bear market continues and is now about a year old, with the downturn in smaller company stocks a few months older.

    Prior to this year, the Model Shadow Stock Portfolio’s worst year was 1998, when the portfolio was down 8.9% (Table 1 shows the annual performance of the Model Shadow Stock Portfolio since inception). Year-to-date (as of the end of August), we are a bit lower than 1998, at –10.2%.

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 8/31/08)

    Table 2. Third-Quarter 2008 Transactions
    Alloy, Inc. (ALOY) negative earnings
    Edge Petroleum Corp. (EPEX) negative earnings
    ILX Resorts Inc. (ILX) negative earnings
    Nu Horizons Electronics (NUHC)  
    Providence Service Corp. (PRSC)  

    Figure 1 shows the cumulative return of the Model Shadow Stock Portfolio, compared to two market benchmarks. You can see that there has been some improvement since May. The portfolio has moved ahead of the S&P 500 as measured by the Vanguard S&P 500 Index fund (VFINX), which is down 11.4% year-to-date. While the model portfolio has closed the gap somewhat, it still is behind small-cap stocks which are down “only” 3.8% year to date as measured by the Vanguard Small Cap Index fund (NAESX).

    Portfolio Changes

    Table 2 highlights the activity in the portfolio since May 31, 2008, Table 3 shows the current holdings of the Model Shadow Stock Portfolio and their status, and Table 4 shows the latest portfolio rules.

    We have changed our buy and sell schedule somewhat. We formerly did our buying and selling during the last week of the three-month period. Several times we missed important information that came out in the month-end data, so we are now making our changes the first week of the following month, which will be September, December, March, and June.

    Our last quarter sales were:

    • Alloy, Inc. (ALOY),
    • Edge Petroleum (EPEX), and
    • ILX Resorts Inc. (ILX).

    At the same time, we bought:

    • Nu Horizons Electronics (NUHC), and
    • Providence Service Corp. (PRSC).

    There are no changes in the rules or modifications of the qualifying levels for price-to-book ratio or capitalization size.

    One other change in the portfolio occurred because of a rights offering. PGT, Inc. (PGTI) had a rights offering whereby stockholders could buy one share for every four shares held at a price of $4.20 per share, which was almost $1.00 below market. Under the offering, you could simply buy the extra shares at the discounted price and hold the stock—which is what we did—or, you could have subscribed to the new shares and sold an equivalent number of shares after August 4 and locked in the $1.00 per share profit. For example, if you owned 400 shares on August 4 you had the right to buy 100 additional shares at $4.20 up until September 4 (unless extended). After August 4 you could have sold 100 of your original shares at $5.20 and bought 100 shares at $4.20 under the offer. We bought and held the additional shares of PGTI, even though it was on probation, because of the discount relative to the price and because earnings estimates are positive for the next quarter.

    We added the information on the rights offering to our Shadow Stock Portfolio description on as soon as we had the information. However, if you own the stock your stockbroker should have notified you of the offering and sent you a prospectus. At the very least, your portfolio should have shown the addition of a new security—the purchase right. This right was not transferable or saleable.

    A Down Market for Now

    There is little I can add to what I have already said about the market in discussing both the Model Shadow Stock Portfolio and Model Mutual Fund Portfolio. It’s a down market—unusual for an election year—and it won’t be over ’til it’s over.

    I continue to recommend a long-term view because market turns, in either direction, are often sudden.

    We will be updating the Model Shadow Stock Portfolio in the January 2009 AAII Journal, but in the meantime you can follow it at

    By January, we will have a new year and a new president—and, we hope, a better economy and stock market.

    Late Note: Just before press time, Gehl Company (GEHL) announced it was being bought out. Since there is board approval and the market price is close to the $30 offer, we are selling our shares.

       About the Model Shadow Stock Portfolio

    The Model Shadow Stock Portfolio provides guidance for investing in the promising micro-cap value sector of the market. It reflects AAII Founder James B. Cloonan’s investing philosophy, which holds that:

    • The best stocks for individual investors are not the same stocks that are best for institutions, and
    • Success comes more from concern for the overall portfolio than for individual stocks.

    The Model Shadow Stock Portfolio is an actual portfolio with real dollars invested. Updates on portfolio activity are provided both in the AAII Journal in this column, and on our Web site at

       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