A Choppy Ride Up for Market and Shadow Stock Portfolio

    by James B. Cloonan

    A Choppy Ride Up For Market And Shadow Stock Portfolio Splash image

    The stock market continues to be choppy. There are many strong up or down days, but nothing seems to be sustained—at least not so far.

    Despite the seeming uncertainty, the market does creep gradually upward, as does our Model Shadow Stock Portfolio.

    As of the end of May 2007, the portfolio is up 9.9% year-to-date compared to 8.7 % for the S&P 500 (as represented by the Vanguard 500 Index fund). Small caps, as represented by the Vanguard Small Cap Index fund, are up even more—at 11.0%.

    Growth stocks have made a bit of a comeback; the Vanguard Small Cap Index fund includes growth stocks while our model is purely value. Growth stocks have a run every once in a while, but long-term value outperforms, as Figure 1 illustrates. Table 1 further demonstrates the value advantage, providing yearly data back to 1993, as well as the long-term average over that 14-year time period.

    As confusing as the market seems, if it continues at its current pace for the balance of the year, we will have the normal “year before the election” return of around 23%.

    On the bearish side, inflation is still a concern. On the bullish side, there now are a number of bearish analysts.

    Quarterly Portfolio Activity

    Table 2 shows the current Model Shadow Stock Portfolio holdings and their status in the portfolio, while Table 3 presents the portfolio rules with some clarifications recently added. Table 4 summarizes the portfolio activity for the three months ending May 31, 2007:

    • CPAC, Inc. (CPAK) and Blair Corp. (BL) were bought out.
    • IntegraMed America (INMD) exceeded the value limit and was sold.
    • Handleman Co. (HDL) and Huttig Building Products (HBP) were sold because they violated earnings probation.
    • McRae Industries (MRINA), which was on my list to sell, updated their financials and showed profitable results. This would make them eligible to be listed again, so I did not sell but will continue to watch.
    • During the last week of May while we were selling, we also bought two stocks—Allion Healthcare Inc. (ALLI) and ILX Resorts, Inc. (ILX). These were the only two qualifying stocks at the time.
    • We had more cash than I normally keep because of the buy-outs and because there were only two qualifying stocks, so I purchased additional shares of Avalon Holdings (AWX), Hastings Entertainment (HAST), L.S. Starrett (SCX), Merix (MERX), Rex Stores (RSC), SigmaTron International (SGMA) and Willis Lease Finance (WLFC).

    Last quarter I bought additional shares of Rocky Brands (RCKY) right before it announced a loss. This quarter Nashua Corp. (NSHA) came up as a buy, but because of a partial buyback offer it ran up and I accidentally bought it at a price well beyond the level that would qualify under the price-book criterion. I sold it immediately and it is not in the portfolio.

    As described in the rules, if you buy a stock, even a partial portion, and then something happens to disqualify it, you should hold the position you have until it violates one of the sell rules. However, if you make a mistake and the entire position didn’t qualify, I favor reversing the position immediately and taking the small gain or loss.

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 5/31/07)



    Excess Cash

    For some time now, there have not been enough new qualifying stocks to use up the funds generated by sales; these sales have primarily been due to buy-outs.

    Similarly, the portfolio has several stocks that could be sold under the two-year rule (see the Notes column in Table 2), but there are not enough new candidates.

    One solution would be to relax the price-to-book ratio requirement by raising it to 0.9 for next quarter, but that is as high as I want to go. Another possibility would be to raise the market capitalization and price-to-book limits, particularly if there are no stocks to invest the cash in. I will see what happens next quarter before making changes.

    Rule Changes

    Because of the shortage of qualifying stocks and also because of a number of member questions, I have adjusted the portfolio rules to make the buying process more clear. Please read the revised Stock Order Guidance section of the portfolio rules in Table 3.

    Also, note that the two-year rule means two years have elapsed since the stock last qualified, not two years from when you first bought it.

    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 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 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.
    • If the quoted bid-ask spread is more than 4% (ask price minus bid price, divided by ask price), try to place a limit order between the bid and ask to keep the premium 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.
    • Market orders are not used. Instead, limit 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 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 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 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.

    Market Valuations

    Does the lack of qualifying stocks indicate the market is overvalued in general?

    It is possible, but the portfolio has been in this situation before, and it did not result in a significant downturn.

    Perhaps the addition of more micro-cap funds and a greater interest in micro caps and value stocks is having an effect. Certainly buyouts and firms going private have affected our holdings.

    Change, I believe, is inevitable and all we can do is to adjust when necessary.

    So far the market looks healthy. It would be nice to see it run up even more before we face the election year—which does not have a good history.

    I’ll discuss that in more detail in my October column.

    Table 4. Second-Quarter 2007 Transactions
    Company (Ticker) Reason
    Blair Corp. (BL) acquired by Appleseed’s Topco Inc.
    CPAC, Inc. (CPAK) acquired by Buckingham Capital Partners
    Allion Healthcare, Inc. (ALLI)  
    Avalon Holdings Corp. Class A (AWX) purchased additional shares with excess cash
    Hastings Entertainment, Inc. (HAST) purchased additional shares with excess cash
    ILX Resorts, Inc. (ILX)  
    L.S. Starrett Company (SCX) purchased additional shares with excess cash
    Merix Corporation (MERX) purchased additional shares with excess cash
    Rex Stores Corp. (RSC) purchased additional shares with excess cash
    SigmaTron International, Inc. (SGMA) purchased additional shares with excess cash
    Willis Lease Finance Corp. (WLFC) purchased additional shares with excess cash
    Handleman Co. (HDL) negative earnings
    Huttig Building Products (HBP) negative earnings
    IntegraMed America (INMD) exceeded value limits

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