• AAII Model Portfolios
  • A New Constraint Added to the Model Shadow Stock Portfolio Rules

    by James B. Cloonan

    A New Constraint Added To The Model Shadow Stock Portfolio Rules Splash image

    After such a long run of overperformance, micro-cap stocks are giving up some of their gains.

    This is reflected in the performance of the Model Shadow Stock Portfolio, which is down 7.5% year-to-date (as of May 30, 2014), while the S&P 500 index, as represented by the Vanguard 500 Index fund (VFINX), is up 4.9%. Returns for longer periods can be seen in Figure 1 and Table 3.

    The short-term correction in micro-cap value stocks is not unusual. It is part of their nature. What is unusual, however, is the shortage of qualifying stocks for the Model Shadow Stock Portfolio. In fact, as we discuss later, there are currently no qualifying stocks that we don’t already own. We have previously discussed the possibility that such a shortage of candidates may foretell a market turndown. But had investors exited the market in January 2013 when the phenomenon first began, they would have missed a 50% climb in the portfolio, even with the pullback.

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    Rules Adjustment

    In the past, we have occasionally had a stock that qualified on a current basis, but that had negative quarterly or annual earnings estimates. That could have resulted in adding a stock that would not qualify a few days later when the latest earnings were released. When we had multiple candidates, we simply eliminated those stocks manually.

    Now with the shortage of qualifying stocks, those with negative earnings estimates might accidentally be included. Therefore, we are formalizing the requirement: If a stock has earnings estimates, we eliminate those with negative earnings estimates for the current quarter or current year. The Shadow Stock screen in Stock Investor Pro, AAII’s fundamental stock screening and research database program, will now have that constraint built in (the screen is called *IISSP in the Screen list). The complete portfolio purchase, sale and management rules can be found here.

    Company (Ticker) Current
    Price
    ($)
    52-Week
    High
    ($)
    52-Week
    Low
    ($)
    Market
    Cap
    ($ Mil)
    P/E
    Ratio
    (X)
    P/B
    Ratio
    (X)
    Div
    Yield
    (%)  
    Notes
    Alamo Group, Inc. (ALG)
    51.84
    61.27
    38.00
    629.1
    17.5
    1.79
    0.5
     
    CSS Industries Inc. (CSS)
    24.09
    31.94
    21.57
    223.9
    12.2
    0.87
    2.5
     
    Ducommun Incorporated (DCO)
    25.39
    31.35
    18.79
    275.6
    27.3
    1.12
    0.0
     
    Ennis, Inc. (EBF)
    15.15
    19.59
    13.54
    396.9
    29.7
    1.04
    4.6
     
    Five Star Quality Care (FVE)
    5.28
    6.20
    4.41
    256.7
    33.0
    0.80
    0.0
     
    Flexsteel Industries (FLXS)
    33.28
    40.44
    21.03
    243.3
    18.4
    1.51
    1.8
     
    Hardinge Inc. (HDNG)
    12.77
    16.88
    11.79
    163.8
    41.2
    0.77
    0.6
     
    Hooker Furniture Corp. (HOFT)
    14.30
    17.84
    13.35
    153.8
    19.6
    1.14
    2.8
     
    International Shipholding (ISH)
    23.75
    32.91
    18.25
    172.3
    11.8
    0.51
    4.2
    qualified as of 5/30/2014
    Key Tronic Corp. (KTCC)
    10.61
    12.19
    9.60
    111.8
    13.4
    1.10
    0.0
     
    Kimball International (KBALB)
    16.13
    20.10
    9.58
    492.6
    19.2
    1.43
    1.2
     
    LMI Aerospace, Inc. (LMIA)
    13.83
    20.90
    10.81
    178.7
    nmf
    1.21
    0.0
     
    Marlin Business Services (MRLN)
    20.83
    29.58
    17.1
    269.3
    15.8
    1.57
    2.1
     
    Medical Action Industries (MDCI)
    6.90
    10.07
    5.04
    113.1
    28.8
    1.14
    0.0
     
    Mitcham Industries (MIND)
    13.43
    18.41
    12.89
    172.3
    38.4
    1.01
    0.0
     
    Olympic Steel, Inc. (ZEUS)
    23.66
    31.68
    20.88
    259.7
    50.3
    0.87
    0.3
     
    PC Connection, Inc. (PCCC)
    20.93
    25.94
    14.26
    548.5
    15.1
    1.68
    0.0
     
    PCM Inc (PCMI)
    9.96
    11.96
    7.60
    122.8
    12.5
    0.90
    0.0
     
    RCM Technologies (RCMT)
    6.42
    7.22
    5.29
    80.3
    40.1
    1.27
    0.0
     
    Renewable Energy Group (REGI)
    9.89
    16.50
    8.51
    383.6
    2.6
    0.61
    0.0
     
    REX American Resources (REX)
    69.51
    73.33
    26.7
    568.3
    16.7
    2.01
    0.0
    approaching value limit
    Rocky Brands Inc. (RCKY)
    14.33
    19.97
    13.13
    108.0
    14.9
    0.82
    2.8
     
    Salem Communications (SALM)
    8.54
    10.34
    7.00
    214.8
    13.3
    1.06
    2.8
     
    Shoe Carnival, Inc. (SCVL)
    18.70
    29.75
    18.04
    386.7
    14.2
    1.18
    1.3
     
    SigmaTron International (SGMA)
    10.00
    12.92
    3.94
    39.8
    14.5
    0.73
    0.0
    qualified as of 5/30/2014
    Standard Motor Products (SMP)
    41.52
    43.65
    28.07
    949.1
    17.3
    2.68
    1.3
    approaching size & value limits
    TravelCenters of America (TA)
    8.51
    12.25
    7.01
    320.2
    14.7
    0.63
    0.0
     
    VOXX International (VOXX)
    8.67
    18.00
    6.84
    211.7
    nmf
    0.49
    0.0
    earnings probation (2014 Q4)
    Willis Lease Finance (WLFC)
    18.38
    20.74
    11.7
    155.0
    9.7
    0.68
    0.0
    qualified as of 5/30/2014
    nmf = no meaningful figure.
    Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 5/30/2014.

    Explanation of Notes

    Approaching Size Limit: Stocks are sold if their market capitalization goes above three times the initial maximum criterion and there is a stock to replace it. The current market capitalization maximum for initial screening is $300 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $750 million.

    Approaching Value Limit: Stocks are sold once their price-to-book-value ratio goes above three times the initial criterion and there is a stock to replace it. 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 in parentheses is 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.

    See the Model Shadow Stock Portfolio area here for more information.

    Portfolio Changes

    Table 1 shows the current holdings in the Model Shadow Stock Portfolio. We sold Alpha & Omega Semiconductor (AOSL) because it violated probation.

    Only five stocks passed our screen at the time of our review. Two of them were Chinese stocks and three were stocks we already owned. We were about 8% in cash after selling Alpha & Omega. To stay within our rule of keeping no more than 5% in cash, we purchased additional shares of SigmaTron International (SGMA) and Willis Lease Finance Corp. (WLFC), which currently qualify as buys. These changes are shown in Table 2.

    Looking Ahead

    Little has changed since our last column in April. The economy seems to be moving ahead, but at a slow pace. Data seems to indicate that smaller individual investors are coming into the market, and many prognosticators think that means a correction may be coming. On the other hand, there seems to be increased investment in Treasury bonds, which means there is money on the sidelines that may have to switch to the stock market if the bull continues even at a slower pace.

    Sell
    Company (Ticker) Reason
    Alpha & Omega Semiconductor (AOSL)
    negative earnings
       
    Purchase of Additional Shares With Excess Cash
    Company (Ticker) Maximum Price to Pay
    SigmaTron International (SGMA)
    $12.59
    Willis Lease Finance Corp. (WLFC)
    $24.37

    The Federal Reserve looks committed to low interest rates until early 2015, but any upward move in the inflation rate could change its mind. Longer-term rates will certainly go up eventually, but might go even a bit lower before an upturn.

    Stock price volatility is quite low, but already the Street is suggesting this may portend rougher times ahead. I say, enjoy the respite. Of course, there may be rougher times ahead, but whether they will be in five minutes or five years no one knows.

    Year Average Annual Return (%) Cumulative Value of $10,000 ($)
    Model
    Shadow
    Stock 
    Portfolio
    Vanguard
    500
    Index
    (VFINX)
    Vanguard
    Small Cap
    Index
    (NAESX)
    Model
    Shadow
    Stock 
    Portfolio
    Vanguard
    500
    Index
    (VFINX)
    Vanguard
    Small Cap
    Index
    (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
    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
    2013
    61.0
    32.2
    37.6
    340,599
    63,009
    82,966
    YTD
    -7.5
    4.9
    1.3
    314,967
    66,084
    84,084
    Since Incep
    17.5
    9.2
    10.5
    314,967
    66,084
    84,084
    Data as of 5/30/2014.

    We will cover the Model Shadow Stock Portfolio again in the October AAII Journal, and election activity should be heating up by then. In the meantime, you can follow the portfolio in the Model Portfolios area 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. If the price-to-book-value ratio moved up a bit since the stock was included in the portfolio, it is still OK to purchase the stock unless this ratio goes above 0.90. (Figure will change gradually with changes in overall market values.)
    • Market capitalization must be between $30 million and $300 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 and, if there are earnings estimates, the estimates must be positive for the current quarter and year.
    • 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. Foreign stocks traded primarily on U.S. exchanges are OK with one exception: The stock of any company whose primary business is in China will not be purchased.
    • 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 and there is a stock to replace it.
    • Market capitalization goes above three times the initial maximum criterion and there is a stock to replace 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.
    • 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.
    • 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 based on lowest price-to-book-value ratio. However, if this difference is not greater than 0.10 (i.e., 0.65 vs. 0.50), use lowest bid-ask spread.
    • 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.


    Discussion

    Akiva Dar from IL posted over 2 years ago:

    HI,

    Quote from the above article:

    "The Shadow Stock screen in Stock Investor Pro, AAII’s fundamental stock screening and research database program, will now have that constraint built in (the screen is called *IISSP in the Screen list). The complete portfolio purchase, sale and management rules can be found here."

    Running latest update to IISSP shows two tickers: JST & TATT

    Looking on the above Shadow List, it include 29 tickers, none is appearing when running IISSP and the above two tickers of IISSP don't appear in the above Shadow list.

    Please clarify this discrepancy in line with the above statement.
    AD


    Harish Thakrar from IL posted over 2 years ago:

    How does one use the Model Stock Portfolio?
    Is there a place you could invest in that to obtain the returns projected?
    Thanks

    Harish Thakrar
    7/1/14


    Charles Rotblut from IL posted over 2 years ago:

    Akiva - The IISSP screen in SI Pro, and the list of passing companies on AAII.com, show the companies that currently meet the quantitative purchase rules for the Shadow Stock Portfolio. (It is very possible for a passing stock to never be added to the portfolio, however.) If a stock currently held in the portfolio passes the screen, it is listed as being "qualified". If a stock in the portfolio does not meet the quantitative buy rules, it will not pass the screen. We won't sell a such a stock unless the sell rules are violated to both limit transactions and to take advantage of capital gains that may occur.

    Harish - You follow the portfolio by buying and selling the stocks through a discount broker of your choice. Because we are a nonprofit, we cannot manage money on behalf of our members.

    -Charles


    Fred Coffinger from AZ posted over 2 years ago:

    It looks to me like the column headings have an error. P/E cap looks like market cap. PB ratio (X) looks like P/E. Div ratio (X) looks like P/B ratio. What do you think?


    Jim Mckercher from OR posted over 2 years ago:

    I wondered about the column headings as well.


    Clint Beedle from TX posted over 2 years ago:

    When I ran SIP with data current as of 5/30/14, I got 7 stocks. Two Chinese stocks (JST, SKBI), three that are already in the portfolio (ISH, SGMA, WLFC), Israeli stock TATT, and ERS. Why wasn't ERS added to the portfolio?


    Paul Franklin from GA posted over 2 years ago:

    I wonder what will happen when this latest rule change fails. It almost certainly will. If the chatter about a stock's earnings is questionable, then there's a case to delay buying it... but then there are all kinds of things to consider before mechanically buying a stock that passes a screen.

    Every screen will get out of synch with the market and even the indices it is supposed to follow. The point is not to follow the MSSP as if it were a free advisory service. The MSSP holds about 2 dozen stocks, and only about 10 are needed to provide adequate diversification (a point repeatedly noted in the discussions around this topic).

    More than that, of course. Not only will the MSSP screen strategy get out of synch with the market, but some individual picks will be clearly worse than others. Others will generate very good returns.

    It is not realistic to think that stocks move up in a straight line or that they are always correlated with other measures. It is almost always an outright mistake to treat the fact that a stock passes a screen as a recommendation to buy.

    To Clint Beedle's point, ERS may not be suitable to own for all investors. It is difficult to read the tea leaves that AAII uses to include a stock on the passing companies list in the portfolio, but they have delayed buying passing companies in the past, if memory serves.


    Clint Beedle from TX posted over 2 years ago:

    When I ran SIP with data current as of 5/30/14, I got 7 stocks. Two Chinese stocks (JST, SKBI), three that are already in the portfolio (ISH, SGMA, WLFC), Israeli stock TATT, and ERS. Why wasn't ERS added to the portfolio?


    Charles Rotblut from IL posted over 2 years ago:

    Hi Clint,

    ERS was likely excluded because of its liquidity. There was to little trading volume in the stock to add it to the portfolio.

    -Charles


    David Grant from IN posted over 2 years ago:

    While JST and SKBI are both traded on NASDAQ, it appears that the primary business for both companies is in China - I assumed this would disqualify them as passing companies Am I incorrect ?


    Charles Rotblut from IL posted over 2 years ago:

    David,

    Companies primarily operating in China are excluded from the Shadow Stock portfolio. Keep in that because this is a real money portfolio, a stock can pass the Shadow Stock screen, but not be added to the portfolio because there is not enough cash available to purchase a new stock.

    -Charles


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