AAII's Shadow Stock Portfolio: An Update

    by James B. Cloonan

    Figure 1.Shadow Stock PortfolioPerformance vs. Benchmarks
    AAII’s do-it-yourself approach to very small-nano-cap stocks continues to hold its own.

    The results for the Individual Investor’s Shadow Stock Portfolio have been updated since our last quarterly report and are shown in Figure 1. Table 1 shows the current positions and the status of the different holdings as of February 27, 2004.

    As you can see, The Shadow Stock Portfolio continues to perform well on both an absolute and risk-adjusted basis. Remember that the risk-adjusted return is truly significant because risk reduction can be converted to an increase in return (I discussed this at length in my January column, and you can review this discussion by clicking here).

    Portfolios: Picking the Right Stocks

    I want to emphasize again the importance of portfolio formation.

    The stocks in the Individual Investor’s Shadow Stock Portfolio are largely risky stocks when evaluated separately. But when taken together as a portfolio, most of that individual risk has been diversified away. In fact, the average risk of the individual stocks has been reduced by about 70%.

    The central point, which I cannot emphasize enough, is: The risk of any individual stock is not important. What is important is how the addition of that stock affects the risk of your overall portfolio.

    Nano-Caps Get Bigger

    The increase in the market value of the types of stocks we focus on over the past two years has necessitated changing the boundaries for the Individual Investor’s Shadow Stock Portfolio.

    Currently, a stock can have a market-capitalization (share price times number of common shares outstanding) of up to $200 million and still be considered a “nano-cap” stock (our term for really, really small stocks) that qualifies for inclusion in the portfolio. The previous level minimum for inclusion was $125 million. (Yes, the typical nano-cap stock was up 50%!)

    This change has been reflected in the Individual Investor’s Shadow Stock Portfolio screen in our Stock Investor Pro software, as well as in our Web site description of the Individual Investor’s Shadow Stock Portfolio (go to the Model Portfolio area of AAII.com).

    A True Do-It-Yourself Model

    I also want to emphasize that the Individual Investor’s Shadow Stock Portfolio is not intended to be an advisory service in the usual sense of that term—it is not intended to be a list of individual stock recommendations. Instead, the model portfolio is a sample of how you can use a basic value-oriented approach to select nano-cap stocks.

    The rules for selecting the stocks have been presented in the AAII Journal for over 10 years, most recently in the November 2003 issue. We have also presented suggestions on how you can vary the approach based on different personal situations. These rules are also on our Web site and programmed into Stock Investor Pro, where users can make any desired variations.

    Because we only adjust the model once a quarter, you can easily select qualifying stocks on your own before we add them to the Individual Investor’s Shadow Stock Portfolio. In fact, if enough members buy a qualifying stock and push the price up a bit, it may not qualify when we run our screen. This would only apply to stocks that were very close to the upper qualifying boundary for market capitalization, price relative to book, or price relative to sales.

    Although we only buy and sell individual stocks for the portfolio once a quarter, we maintain the Model Portfolio on our Web site with status changes on a monthly basis. The reason we only buy and sell quarterly goes back to AAII’s desire to design an approach that could be followed even by busy individuals who could not spend much time on their investments. However, in the future we might change this if we feel it would make the program more useful to our members.

    Rebalancing the Portfolio

    I have been asked about rebalancing, since stock prices will change unevenly across the portfolio, resulting in changes in the percentage commitments to each stock over time.

    We believe that the importance of maintaining portfolio “balance” should be weighed against the need to hold down trading costs. For that reason, we don’t make small purchases or sales for the purposes of rebalancing because, in those instances, the commission percentage will be high.

    Basically, the portfolio has been structured so that it maintains enough balance without the need to sell one stock simply to buy another. Under the portfolio rules, if any stock increases so much in value that it would harm diversification, it would be sold on the maximum-size criteria (which is now $500 million), or the two-year holding limit. If new money is added to the portfolio and either there is not enough for a new position or there are no new qualifying stocks, then those funds can be applied to previously purchased stocks that still qualify as buys. The additional purchases can be divided so as to help equalize those holdings.

    We will be running our next screens and adjusting the portfolio in early May. While I won’t be able to report on the portfolio in my column until the July issue, the updates will be available at AAII.com.

       Explanation of Notes in Table 1
    Approaching Size Limit: Stocks are sold if their market capitalization goes above 2½ times the initial maximum criterion. The current market capitalization maximum for initial screening is $200 million. Stocks are marked “approaching size limit” if their current market cap exceeds two times the initial criterion—$400.

    Approaching Value Limit: Stocks are sold once their price-to-book-value ratio goes above 2½ times the initial criterion. The current initial price-to-book ceiling is 0.70. Stocks are marked “approaching value limit” if their current price-to-book ratio exceeds two times the initial criterion—1.40.

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

    Earnings Probation: 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 becoming positive, the stock is sold. The date within the parentheses lists the calendar quarter during which the company reported negative trailing 12-month earnings.

    Two-Year Rule: Stocks are sold after two years if they would no longer qualify as a new buy. The “two-year rule” note indicates when a stock will be sold if it does not pass the current screen.


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