A Performance Spotlight on the Model Shadow Stock Portfolio

    by James B. Cloonan

    Figure 1.Shadow Stock PortfolioPerformance vs. Benchmarks
    AAII’s Model Shadow Stock Portfolio has had a dramatic three months. The year-to-date return through November is 37.7%—up significantly from 14.3% year-to-date through August 31 as reported in the October AAII Journal. At the same time, the portfolio increased its lead over the S&P 500 and other indexes. Recent and cumulative results are shown in Figure 1. In addition, I thought you might like to see how the Shadow Stock Portfolio compares to subscription-based advisory services, and an analysis is shown in the box below.

    TABLE 1. Fourth-Quarter 2004 Transactions
    Company (Ticker) Reason
    Hub Group, Inc. (HUBG) exceeded value limits
    Chronimed, Inc. (CHMD)  
    Carriage Services, Inc. (CSV)  
    Hanger Orthopedic Grp. (HGR)  

    Quarterly Changes

    During the most recent quarter we sold only one stock, Hub Group, Inc. (HUBG). The stock had gone up so much in price that the price-to-book-value ratio sell rule of 2½ times the initial requirement came into play. While it still looks like an interesting stock, it is no longer a value stock. Since HUBG had appreciated so much, we were able to buy three new stocks at the average portfolio value. They are shown in Table 1. The current list of stocks in the Model Shadow Stock Portfolio appears in Table 2.

    *The Sharpe Ratio relates the portfolio return to the level of risk; the higher the ratio, the greater the return per unit of risk.

    If the Shadow Stock Portfolio were a paid portfolio advisory service, the results on an absolute return basis would place it third best over the last five years and second best over the last 10. On a risk-adjusted basis (using the Sharpe ratio), the Shadow Stock Portfolio would place number one over both the last five and last 10 years. Advisories with the closest results to the Shadow Stock Portfolio have an annual average subscription cost of just over $200.

    The portfolio does not have a limit on the number of stocks held, but if it gets too unruly, we will have to increase the average value of new positions. While I like to include all stocks that meet all the requirements, I think over 50 would be too many. However, so far this has not been a problem.

    Shadow-Boxing: Outlasting Most Newsletters in the Performance Ring
    While Mark Hulbert’s Hulbert Financial Digest doesn’t evaluate the Shadow Stock Portfolio because it is not a paid advisory service, his approach of using monthly risk-adjusted returns can easily be applied. This allows you to compare the returns of investments with different levels of risk by putting them on the same risk footing. And since the Shadow Stock Portfolio is an actual portfolio, transaction costs are included. Here are the results:

    Last 5 Years
    Shadow Stock Portfolio 23.50% 0.36
    Wilshire 5000 -0.9% -0.04
    HFD Top Newsletter (Absolute Basis) 28.70% 0.21
    HFD Top Newsletter (Risk-Adjusted Basis) 14.20% 0.25
    Last 10 Years
    Shadow Stock Portfolio 19.10% 0.28
    Wilshire 5000 10.70% 0.14
    HFD Top Newsletter (Absolute Basis) 25.00% 0.22
    HFD Top Newsletter (Risk-Adjusted Basis) 9.90% 0.26

    If You Do It Yourself

    A number of members are using the Shadow Stock screen in Stock Investor Pro, AAII’s fundamental stock screening program and research database, to build their portfolio, and as a result make changes in their portfolios before we make the changes in the model portfolio or report it on our Web site or in the Journal. I think that is great, but a few cautions. First, as I mentioned in my October Journal column, be sure to check recent news and earnings reports, because our database only uses official figures as reported to the SEC, while important financial information is often reported in releases before it is officially filed.

    Second, we chose the February, May, August, and November months for action because those months catch most of the new earnings reports. If you act in other months, it may well be just before a new earnings release. Of course, this can be good or bad depending on the direction of any surprise.

    Third, if you perform your own screens or even if you use our list of qualifying stocks (“Passing Companies”) published on AAII.com, you are likely to wind up with some stocks that will not be in the actual Shadow Stock Portfolio. This is because things can change in a period of one or two months. A while back, IES qualified as a buy, but before our November buying period there was some bad news and the stock dropped below $4, so it fell off our buy list. It could also happen that good news is announced before our time to buy and the stock subsequently rises so much that it violates the price-to-book-value ratio limit. If you wind up holding a stock that we don’t buy for the Shadow Stock Portfolio, hold it and follow the normal portfolio sell rules on your own.

    Portfolio Rules

    I have included a copy of the Portfolio Rules in Table 3. There are a few minor changes, which are italicized. We modified the two-year sell rule to indicate you should not sell a stock simply because you have held it two years unless there is a qualifying stock in which to invest the proceeds. We also indicated that individual judgment can be used when dealing with spreads and liquidity.

    It has been a profitable five years for the portfolio and for micro-cap and small-cap stocks; in contrast, the S&P 500 is still negative for that period. While small-cap stocks have always outperformed in the long run, the large-cap stocks are overdue for some stronger returns. However, since almost everyone is saying it’s time for the big stocks to shine, the time may not be that close.

    TABLE 2. The Model Shadow Stock Portfolio
    Company (Ticker) Current
    52-Week Market
    ($ Mil)
    (See Below)
    Action Performance Co. (ATN) 10.03 19.89 8.37 184.1 334.3 0.71 2
    AirNet Systems, Inc. (ANS) 3.4 6.2 2.73 34.3 nmf 0.4 0 earnings probation (2004q3)
    Bon-Ton Stores, Inc. (BONT) 15.10 18 10 243 14 1 1
    Books-A-Million, Inc. (BAMM) 8.77 $10 $5 146.8 13.7 1.09 1.4  
    Carriage Services, Inc.* (CSV) 5.04 5.5 3.05 90.2 11.2 0.81 0  
    Cavco Industries, Inc. (CVCO) 41.1 $46.93 $22.50 129.2 18.5 1.27 0  
    Chronimed Inc.* (CHMD) 6.50 $10.00 $5.50 83.4 13.5 0.87 0
    Cronos Group (CRNS) 9.29 $10.70 $4.41 67.4 10 1.01 4.3
    Duckwall-ALCO Stores(DUCK) 17.00 19 14 76 26.2 1 0 currently qualifies
    Dura Automotive Sys (DRRA) 9.66 17.06 6.39 180 17.6 0.51 0  
    ePlus inc. (PLUS) 12.51 15.49 8.8 112 12.4 0.96 0  
    Espey Mfg & Elec. (ESP) 26 28.9 21 26.3 36.1 0.95 2.3  
    Gehl Company (GEHL) 25.51 27.9 12.06 166.3 13.2 1.21 0
    Gottschalks Inc. (GOT) 8.5 9.15 3.14 109.8 20.7 1.04 0
    Haggar Corporation (HGGR) 22.23 23.70 15.53 160.1 16.7 0.93 0.9
    Hanger Orthopedic Grp.* (HGR) 7.7 19.25 4.15 166.2 nmf 1.11 0 earnings probation (2004q3)**
    Hardinge Inc. (HDNG) 11.19 13.35 9.25 99 25.4 0.69 0.4 currently qualifies
    IntegraMed America (INMD) 7 8.44 5.50 25.1 23.3 0.73 0 currently qualifies
    International Shipholding (ISH) 14.95 17.1 13.01 90.9 13.8 0.71 0 currently qualifies
    Ladish Co., Inc. (LDSH) 11.21 11.5 7.25 151.9 86.2 1.22 0
    Lazare Kaplan Intern’l (LKI) 10.24 10 6.95 86.9 19.3 0.92 0
    Marsh Supermarkets (MARSB) 12.61 14.4 10.7 99.6 25.2 0.77 4.1 currently qualifies
    McRae Industries (MRI.A) 13.9 14.25 8.3 38.5 10.3 1.11 1.7  
    Metals USA, Inc. (MUSA) 18.22 19.7 11.5 368.1 4.3 1.28 0  
    Northwest Pipe Co. (NWPX) 19.56 20.23 11.85 130 13.9 0.92 0
    Pomeroy IT Solutions (PMRY) 14.1 15.15 10.59 172.7 17 0.83 0
    Quaker Fabric Corp. (QFAB) 5.73 11 5.09 96.4 31.8 1 2.1
    Rex Stores Corporation (RSC) 18.15 18.63 10.98 197 15.3 1.04 0  
    Sands Regent (SNDS) 10.87 13.24 4.5 61.4 8.2 1.3 0  
    Scheid Vineyards Inc. (SVIN) 5.71 6.99 3.5 29.2 13.6 0.81 0  
    Stephan Co. (TSC) 4.11 7.03 3.23 18 31.6 0.48 1.9 currently qualifies
    T-3 Energy Services (TTES) 6.49 7.39 5.41 68.7 nmf 0.67 0 earnings probation (2003q4)
    TESSCO Technologies (TESS) 12.93 19.09 7.86 54.3 14.7 0.98 0
    U.S. Lime & Minerals (USLM) 11 11.9 6.25 64.3 11.5 1.37 0  
    Willis Lease Finance (WLFC) 8.2 9.5 6.31 73.4 19.5 0.64 0  
    Zapata Corporation (ZAP) 60 69 50.1 143.5 41.1 0.78 0 currently qualifies

    TABLE 3. Shadow Stock Portfolio 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. (This figure will change gradually with changes in overall market values.)

    • Market capitalization must be between $17 million and $200 million. (This 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 first item under stock order rules concerning spreads when buying shares.

    • Price-to-sales ratio must be less than 1.2. (This 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 operation 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 2½ times the initial criterion.

    • Market capitalization goes above 2½ 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.)
    • If the quoted bid-ask spread is more than 4% (ask price minus bid price, divided by ask price), the stock is eliminated from consideration. Better to stretch other criteria, if necessary, than pay high spreads.

    • Stocks are eliminated if the average daily number of shares traded is not four times the amount needed for the position—the spread will be too high and not negotiable either now or when sold.

    • Market orders are not used. Instead, 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 specialist’s 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.

    • All order rules can be adjusted based on your own judgment and experience.
    • 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. More than 20 stocks is not needed until the portfolio exceeds $1 million.

    James B. Cloonan is founder and chairman of AAII.

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