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A Look at the Model Shadow Stock Portfolio’s True Risk

by James B. Cloonan

The stock market has come roaring back and now is at pre-recession levels. However, the economy does not appear to be back—particularly employment.

It is hoped that the second-worst market drop in a century is over and we will have some normal markets for awhile. So far this year, the Model Shadow Stock Portfolio is up 10.6%, compared to 6.6% for the S&P 500 index as measured by the Vanguard 500 Index fund (VFINX). The results for 2012 and other periods can be seen in Figure 1 and Table 3.

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About the author

James B. Cloonan is founder and chairman of AAII.
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Comparing Risk Levels

While the Model Shadow Stock Portfolio was hit harder percentage-wise during the downturn than the overall market (as can be seen in the cumulative return chart in Figure 1), it took much less time to recover. Looking at the yellow line, which is the Vanguard 500 Index fund, and the purple line, which is the Model Shadow Stock Portfolio, what would you say about the comparative risk? I am referring to risk in the real sense of the word—the chance of loss. The Vanguard 500 Index fund fell less than the Model Shadow Stock Portfolio from its high, but has taken almost twice as long to recover. It has the lowest standard deviation, but does it have the lowest risk?

A major factor determining true risk lies in the processes of the investor. If an investor was long term and disciplined with a horizon of four to six years, there was little risk with any of the portfolios. If, on the other hand, the investor panicked and sold near the bottom, or had invested money needed in less than four years, then there was probably a loss. The best time to examine your risk tolerance and your asset allocation is just after a market crash. If you net sold during the downturn, then you need to adjust your exposure in the future.

Despite the domestic and foreign problems that are out there, I continue to feel the market wants to go up. My long-term philosophy, however, has been to be mostly neutral with long-term allocations. I have been willing to be more aggressive when the market was below its long-term highs because it has always come back. I get more conservative when the market is setting new highs even though what is going up tends to keep going up—until, of course, it doesn’t.

Current 52-Week Market P/E P/B Div
Price High Low Cap Ratio Ratio Yield
Company (Ticker) ($) ($) ($) ($ Mil) (X) (X) (%) Notes
Addus Homecare Corp. (ADUS) 8.81 10.00 3.50 95.3 14.9 1.05 0.0  
Alamo Group, Inc. (ALG) 35.78 36.75 25.51 428.1 13.4 1.40 0.8  
Alpha & Omega Semicon (AOSL)* 8.06 10.45 6.95 205.0 10.0 0.69 0.0 qualified as of 2/28/2013
CSS Industries, Inc. (CSS) 24.01 27.06 17.86 227.3 15.5 0.91 2.5
Ducommun Incorporated (DCO) 15.50 17.11 7.71 164.2 nmf 0.75 0.0
Ennis, Inc. (EBF) 15.66 17.14 13.70 409.6 19.3 1.12 4.5
Flexsteel Industries (FLXS) 23.00 24.94 16.61 162.8 12.2 1.12 2.6  
Gilat Satellite Networks (GILT) 5.55 6.20 2.31 229.2 nmf 0.87 0.0  
Hardinge Inc. (HDNG) 13.08 13.30 8.20 152.9 8.5 0.94 0.6  
Hooker Furniture Corp. (HOFT) 15.01 15.58 10.01 161.3 29.4 1.26 2.7
Key Tronic Corp. (KTCC) 10.63 13.16 7.15 111.5 7.9 1.27 0.0
Kimball International (KBALB) 9.21 13.25 5.87 274.6 20.0 0.88 2.2
Marlin Business Services (MRLN) 18.95 23.08 13.33 241.5 20.8 1.33 2.1  
Medical Action Industries (MDCI) 5.92 6.24 2.25 97.0 nmf 1.03 0.0  
Mitcham Industries (MIND) 15.35 26.44 11.51 197.1 8.6 1.14 0.0  
Olympic Steel, Inc. (ZEUS) 20.67 25.86 14.77 226.2 98.4 0.79 0.4
PC Connection, Inc. (PCCC) 14.34 14.99 7.34 371.9 11.6 1.30 0.0
PCM Inc. (PCMI) 7.10 7.46 5.06 85.2 37.4 0.74 0.0 qualified as of 2/28/2013
RCM Technologies, Inc. (RCMT) 5.66 6.72 4.89 69.7 21.8 0.97 0.0  
Renewable Energy Gp (REGI) 7.39 10.65 4.28 225.6 2.8 0.67 0.0  
REX American Resources (REX) 23.10 33.95 14.43 188.4 12.0 0.76 0.0 qualified as of 2/28/2013
Rocky Brands, Inc. (RCKY) 13.82 16.00 10.74 103.7 15.7 0.84 0.0
Saga Communications (SGA) 43.90 51.61 25.31 248.8 15.2 2.36 0.0 approaching value limit
Salem Communications (SALM)* 6.28 6.94 2.44 153.3 44.9 0.76 2.2 qualified as of 2/28/2013
Shoe Carnival, Inc. (SCVL) 19.43 24.66 17.08 397.0 13.5 1.24 1.0  
Standard Motor Products (SMP) 24.73 25.14 11.94 564.3 8.6 1.85 1.8  
Sterling Construction (STRL) 11.30 11.79 7.12 186.4 nmf 0.88 0.0 earnings probation (2012 Q2)
TravelCenters of America (TA)* 6.88 7.98 4.18 203.2 6.2 0.53 0.0 qualified as of 2/28/2013
VOXX International (VOXX) 9.95 14.25 5.55 234.0 10.2 0.54 0.0 qualified as of 2/28/2013
Willis Lease Finance (WLFC) 15.01 15.24 11.31 133.0 nmf 0.62 0.0
*Company is new to the portfolio. Added 3/1/2013.
nmf = no meaningful figure.
Source: AAII's Stock Investor Pro/Thomson Reuters. Data as of 2/28/2013.

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 $240 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $600 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.

Earnings Probation: If the 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 fiscal quarter during which the company first reported negative trailing 12-month earnings.

Qualified as of: Stock still qualified as a buy when the screen was run with current data. Stocks that don’t currently qualify as a buy are held until they meet one of the sell rules.

Portfolio Changes

Table 1 lists the current holdings in the Model Shadow Stock Portfolio.

Capital Senior Living Corp. (CSU) and Standex International Corp. (SXI) were sold because their price-to-book ratios went above 2.40, and so they are no longer value stocks by our standards. Good luck to them in someone’s growth portfolio.

With the proceeds from the sales, we purchased Alpha & Omega Semiconductor Ltd. (AOSL), Salem Communications Corp. (SALM) and TravelCenters of America LLC (TA) as shown in Table 2.

Company Reason
Buy
Alpha & Omega Semicon (AOSL)
Salem Communications Corp. (SALM)
TravelCenters of America LLC (TA)
Sell
Capital Senior Living Corp. (CSU) exceeded size & value limits
Standex International Corp. (SXI) exceeded size limits

Twelve stocks qualified under our criteria. Four of these were China based and two, Olympic Steel Inc. (ZEUS) and PCM Inc. (PCMI), formerly PC Mall Inc. (MALL), were already in the portfolio. As can be seen in Figure 2, 12 qualifying stocks is toward the low end of our experience, but not at the low level that preceded the last downturn. We still don’t know whether the level of qualifiers is significant, and a quarter-to-quarter variation might be random noise. We hit 12 qualifiers in February 2010, but it bounced right back up.

Average Annual Return (%) Cumulative Value of $10,000 ($)
Model Vanguard Vanguard Model Vanguard Vanguard
Shadow 500 Small Cap Shadow 500 Small Cap
Stock Index Index Stock Index Index
Year Portfolio (VFINX) (NAESX) Portfolio (VFINX) (NAESX)
1993 32.3 9.9 18.7 13,230 10,989 11,870
1994 2.0 1.2 -0.5 13,492 11,118 11,810
1995 20.7 37.4 28.7 16,291 15,282 15,204
1996 22.3 22.9 18.1 19,927 18,775 17,959
1997 44.3 33.2 24.6 28,756 25,010 22,375
1998 -8.9 28.6 -2.6 26,188 32,168 21,790
1999 0.0 21.1 23.1 26,187 38,945 26,831
2000 -7.7 -9.1 -2.7 24,163 35,418 26,116
2001 21.4 -12.0 3.1 29,325 31,160 26,926
2002 10.8 -22.1 -20.0 32,506 24,259 21,535
2003 73.1 28.5 45.6 56,268 31,174 31,360
2004 43.7 10.8 19.9 80,843 34,530 37,587
2005 17.9 4.8 7.4 95,353 36,180 40,376
2006 29.4 15.6 15.6 123,363 41,832 46,687
2007 -1.8 5.4 1.2 121,166 44,083 47,227
2008 -50.8 -37.0 -36.0 59,582 27,764 30,217
2009 72.3 26.5 36.1 102,665 35,120 41,130
2010 45.4 14.9 27.7 149,238 40,358 52,529
2011 6.3 2.0 -2.8 158,701 41,155 51,067
2012 33.3 15.8 18.0 211,588 47,666 60,274
YTD 10.6 6.6 7.8 234,003 50,807 64,961
Since Incep 16.9 8.4 9.7 234,003 50,807 64,961
Data as of 2/28/2013.

Looking Ahead

At this point, 2013 is already a strong year, but of course we have a ways to go and there are a lot of scary things out there, starting with Congress and the administration.

We will review the portfolio again in the July issue of the AAII Journal and in the meantime, you may keep abreast here.

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 $30 million and $240 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.)
  • Eliminate any company that failed to file a 10-Q (quarterly) report in the last six months.

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.

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.
  • The average daily dollar volume should be at least four times the amount needed for your position. This will ensure liquidity to get in and out of the position, even if you need to grow the position gradually and sell gradually. This will result in a varying number of qualifying stocks for each investor.
  • 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 is founder and chairman of AAII.


Discussion

Ted Nicholas from CA posted about 1 year ago:

It would be interesting to see Mr. Cloonan compare the model Shadow Stock Portfolio performance with the Stock Superstars performance and any comments he would have on how the two strategies compare/differ, particularly in minimizing risk.


David Neblock from IL posted about 1 year ago:

yes please


Jessica Lahr from VA posted about 1 year ago:

Exactly!!! I just sent an email in yesterday about this very issue. My finances are not robust enough for two portfolios using both the Model Shadow Stock Portfolio AND the SSR approach. I need to decide; the Model Shadow Stock Portfolio, based on the above outcomes and from my research yesterday, seems to out shine the SSR, unless I'm overlooking something....(which could very well be the case!!)
Thank you


Kent Barrois from WA posted about 1 year ago:

I too would really appreciate an article discussing the relative merits of the Shadow Stock Portfolio and the SSR portfolio. I see almost nothing in common between the two portfolios. Certainly the market cap size of the Shadow Stock Portfolio selections are tiny compared to the SSR portfolio stocks. I have thought about selecting perhaps fifteen of the Shadow stock listings and forming a micro cap Group to form a Group 5 within the SSR format.
Following the guidelines you give, it would take about fifty stocks to do both portfolios. Should one be perhaps emphasized over the other based upon the age of the investor, the amount of risk the investor is willing to take, etc? I know it is an individual decision, but your comments would be indeed welcomed.


Mike Andrie from IN posted about 1 year ago:

I have a question on why the Model portfolio appears to have done really well in the last 10 years relative to the previous 10 years (1993-2003). During the previous 10 years, the rate if return appears to be similar to the reference portfolio. Is this due to a change in the way the Model portfolio was determined?


Lonnie Gibson from WV posted about 1 year ago:

I would like to invest in the shadow stock portfolio. Should I invest now since the market has had a steep run or should I wait for a pull-back? I know I should invest equal dollar amounts in each stock. Should I invest all of the money at one time or make the investment over a certain period of time? Your comments would be very much appreciated.


Charles Rotblut from IL posted about 1 year ago:

Hi Lonnie,

There are two ways you can go about this.

If you buy all the stocks in the portfolio right now, you will approximate the performance of the portfolio going forward. Your returns won't be exactly the same, however, because of the fluctuations in the prices since each stock was initially added. This applies to any model portfolio you follow, regardless if it is one of ours or a portfolio from a different organization.

The second strategy would be to buy only those stocks currently listed as being "qualified" and keeping the remainder the amount you plan to allocate in cash. You would then add to your portfolio as other portfolio holdings are listed as "qualified" or new stocks are added. Qualified means the stocks currently meet the buy rules for the strategy. The advantage of this strategy, and the reason I suggest it, is because limits your purchases to only those stocks currently trading a very low valuations.

As far as allocation, we suggest investing equal dollar amounts in each stock.

I hope this helps,
Charles
AAII


Ted Nicholas from CA posted about 1 year ago:

I compared the performance (in % terms) from 2002-2013 YTD of the:
1. Shadow portfolio
2. Stock Superstars
3. Wilshire 5000
I simply added (or subtracted) the percentage gain (or loss) starting with the 2002 figure through the 2013 YTD. The results are:
1. Shadow portfolio = 290%
2. Stock Superstars = 104.1 %
3. Wilshire 5000 = 68.6%
Unfortunately, I don't know how to calculate the 3 yr. risk index and standard deviation for the 3 portfolios during the 2002-2013 YTD period that would allow comparison of those 3 portfolios.
Interestingly, my simple arithmetic calculations differed from those published for the Superstars (mine was 104.% vs. 111.1%) and Wilshire 5000 (mine was 68.6% vs 57%). I did not include the 1 week figure published for each but that would not begin to account for the differences.
The Shadow Stock had 2 losing years (2007 and 2008) totaling 52.6%. The Superstars had 2 losing years (2005 and 2008) totaling 43.8%. The Wilshire 5K had 3 losing years (2002, 2008, and 2011) totaling 61%. To the novice investor the Shadow portfolio is looking better and better by any measure.
It would certainly be nice if Mr. Cloonan could calculate the 3 yr risk index and 3 yr std. deviation for the Shadow portfolio over the time frame above and publish it as a comment in this section. :-)


James Leever from MI posted about 1 year ago:

I'm 79 figure I have 15-20 years left,(in apparent excellent health), just put all my IRA into the Shadow Stock Portfolio, kept 4 years cash available for distributions, and my Roth is in the SSR. My theory is that as long as I have 4 years cash available, I can ride out market downturns without having to sell stock, until the markets stabilize. Based on the charts available there was no 4 year period in which the MSSP lost money. Even when it lost 50% in 2008 it bounced back the next year and then went on to trounce the Vanguard 500 and the Vanguard Small Cap Index. I realize past history is no guarantee, but charts are the only thing to go on. I really should have pulled a Peter Lynch and bought Ford stock when it was at its lowest, but I chickened out.


Steven Saarela from MN posted about 1 year ago:

It would be beneficial when looking at the Model Shadow Stock Portfolio to have a column showing the price each stock was purchased at and a column showing the percent of return or loss since. Thanks


John Horman from IL posted about 1 year ago:

I have money in super stock, Would it get better return in shadow potfolio--enough to pay for the exchange?


Prem Jindal from PA posted about 1 year ago:

Recently, i read that liquidity plays a big role in return performance (Prof.Ibbotson of YALE UNIVERSITY) and less liquid stocks show better performance in addition microstocks and valuation measures (low P/B ratios). Probably, be the very good performance shadow stocks may partially be due to that. Also Professor Ibbotson showed in one of his papers that standard deviation( a measure of riskiness of stocks) was lower for less liqidity stocks. This flies contrary to your thesis that low P/B ratio microstocks are more riskness. Fundamentally thinking stocks with very low valuations either low P/B or P/E or P/S are less risky. It appears that most of the shadow stocks in the portfolio are are not only low P/B but also very illiquid.
Will youy please make any comment.Also, i want to personally thank for finding AAII and also your mall book (Maximum Return/ Minimum Risk. I am 72 years old, I joined AAII last year and wished beciome member when you founded AAII more than 25 years ago.


Prem Jindal from PA posted about 1 year ago:

Recently, i read that liquidity plays a big role in return performance (Prof.Ibbotson of YALE UNIVERSITY) and less liquid stocks show better performance in addition microstocks and valuation measures (low P/B ratios). Probably, be the very good performance shadow stocks may partially be due to that. Also Professor Ibbotson showed in one of his papers that standard deviation( a measure of riskiness of stocks) was lower for less liqidity stocks. This flies contrary to your thesis that low P/B ratio microstocks are more riskness. Fundamentally thinking stocks with very low valuations either low P/B or P/E or P/S are less risky. It appears that most of the shadow stocks in the portfolio are are not only low P/B but also very illiquid.
Will youy please make any comment.Also, i want to personally thank for finding AAII and also your mall book (Maximum Return/ Minimum Risk. I am 72 years old, I joined AAII last year and wished beciome member when you founded AAII more than 25 years ago.


Harry Cloonan from AZ posted about 1 year ago:

Re: Mike Andrie
Most of the reason the portfolio looks to have performend better in the last 10 years is that Figure 1 is linear and the strong rise is due to compounding. A log graph would be closer to a straight line. The little difference that does exist is due almost entirely to 2003 being in the second 10 years. James Cloonan


Victor from CA posted about 1 year ago:

Why pay for SSR, when Shadow has a better performance and is included in AAII membership?


dan sheehan from ohio posted about 1 year ago:

What happened to aosl today,a drop of more than 15%???


James Leever from MI posted about 1 year ago:

You're absolutely right. But I started with SSR years ago and finaly woke up to the fact I was missing something by not using the Shadow Stock Portfolio, so I invested the balance of my retirement account. Both are doing well and it adds a balance to the account.
James Leever, Michigan


Charles Rotblut from IL posted about 1 year ago:

Hi Dan,

It was likely a reaction to AOSL's earnings. A copy of the earnings release can be found at:
http://finance.yahoo.com/news/alpha-omega-semiconductor-reports-results-201500583.html

Because the Shadow Stocks have lower volume, they can experience greater degrees of price volatility.

-Charles Rotblut


Giridhar from NC posted about 1 year ago:

James,

Is this portfolio appropriate for Non IRA account, if one is considering long term view like 10 years?


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