Adherence to Rules Helps Model Shadow Stock Portfolio's Performance

by James B. Cloonan

Adherence To Rules Helps Model Shadow Stock Portfolio's Performance Splash image

The slide that began in May has finally been reversed at the end of August, and the entire stock market is back at its high for the year.

The Model Shadow Stock Portfolio has done particularly well recently and is now up 18.9% year-to-date, compared to 13.4% for the S&P 500 index as measured by the Vanguard 500 Index fund (VFINX). We have not gotten back to our mid-March high of +22%, but it is an above-average year—so far. The returns for longer periods can be seen in Figure 1 and Table 3.

Not much has changed in the market environment. There seems to be a gradual recovery amid a wide variety of risks. In addition, the political rhetoric has hit full volume and will continue through the election, which happily will be over when I next write about the Shadow Stock Portfolio.

Transaction History

While we have always shown our past transactions, many of you have asked for more specific trade information, including price and quantity. We now provide this data for all transactions back to September 1, 2003. It can be accessed at in the Model Shadow Stock Portfolio area. On the Transaction History Page, there is a link to “detailed transaction history.”

Portfolio Changes

Table 1 lists the current holdings in the Model Shadow Stock Portfolio. CONN’S Inc. was sold for exceeding the size limit.

I was somewhat sad in March when I had to sell Lithia Motors (LAD) because it had become too large to be a Shadow Stock. The same thing has now happened with CONN’S Inc. (CONN). Both of these stocks looked very strong and their elimination presents an opportunity to discuss the second critical investment management rule. Rule number one is: Develop a consistent, well-defined approach to investing in stocks. Rule number two is: Stick to it. Rule number two is extremely difficult to follow. There is always a reason to deviate. If those two stocks had been in my personal portfolio, I might well have kept them—thinking, “This time is different.”

The Model Shadow Stock Portfolio has had a geometric return of 16.1% a year since inception (almost 20 years). I cannot find a single mutual fund or advisory letter that has done better. It would seem very unwise to think I could make on-the-fly adjustments to the rules and do better.

Company (Ticker) Current
52-Week Market 
($ Mil)
Addus Homecare Corp. (ADUS) 4.87 5.35 3.00 52.7 nmf 0.59 0.0  
Alamo Group, Inc. (ALG) 29.09 34.23 19.71 347.4 10.4 1.18 0.8  
Capital Senior Living Corp. (CSU) 12.03 12.50 5.44 338.9 nmf 1.93 0.0  
CSS Industries, Inc. (CSS) 19.97 22.40 15.19 191.9 10.3 0.81 3.0  
Ducommun Inc. (DCO) 14.68 18.62 7.71 155.5 nmf 0.73 0.0  
Ennis, Inc. (EBF) 14.59 17.74 12.08 381.6 15.9 1.06 4.8  
Flexsteel Industries (FLXS) 19.62 23.28 13.26 135.8 10.6 0.96 3.1  
Gilat Satellite Networks (GILT) 3.18 4.35 2.31 131.3 nmf 0.51 0.0  
Hardinge Inc. (HDNG)* 8.99 11.65 6.97 105.1 7.8 0.68 0.9 qualified as of 8/31/2012
Hooker Furniture Corp. (HOFT) 11.35 13.99 8.67 122.5 22.3 0.96 3.5  
Key Tronic Corp. (KTCC) 10.84 13.16 3.21 113.5 9.9 1.44 0.0  
Kimball International (KBALB) 11.23 11.61 4.61 425.6 36.2 1.10 1.8  
Marlin Business Services (MRLN) 16.54 17.41 9.76 210.7 24.7 1.20 1.9  
Medical Action Industries (MDCI) 3.69 6.36 3.04 60.5 nmf 0.41 0.0  
Mitcham Industries (MIND) 15.30 26.76 9.52 194.6 7.5 1.16 0.0  
Olympic Steel, Inc. (ZEUS)* 15.76 28.31 14.58 172.1 9.9 0.58 0.5 qualified as of 8/31/2012
PC Connection, Inc. (PCCC) 12.19 12.92 7.31 322.4 10.4 1.12 0.0  
PC Mall, Inc. (MALL) 5.86 6.66 4.80 70.5 34.5 0.62 0.0 qualified as of 8/31/2012
RCM Technologies (RCMT) 5.50 6.16 3.98 66.2 21.2 0.99 0.0  
Renewable Energy Gp (REGI)* 5.32 10.65 4.62 153.9 2.1 0.47 0.0 qualified as of 8/31/2012
REX American Resources (REX) 17.40 33.95 15.05 145.8 7.4 0.58 0.0 qualified as of 8/31/2012
Rocky Brands, Inc. (RCKY) 11.71 14.33 8.75 87.9 13.6 0.75 0.0 qualified as of 8/31/2012
Saga Communications (SGA) 40.80 47.98 26.65 173.4 11.0 1.72 0.0  
Shoe Carnival, Inc. (SCVL) 22.00 24.66 12.79 448.9 16.2 1.45 0.9  
Standard Motor Products (SMP) 17.64 25.91 11.86 400.1 6.5 1.41 2.0  
Standex Int’l Corp. (SXI) 44.64 46.83 25.71 563.1 12.2 2.29 0.6 approaching size & value limits
Sterling Construction (STRL) 9.69 13.29 8.54 158.2 nmf 0.76 0.0  
VOXX International (VOXX) 7.50 14.56 4.69 175.5 9.5 0.42 0.0  
Willis Lease Finance (WLFC) 12.38 14.82 9.91 115.8 11.7 0.50 0.0 qualified as of 8/31/2012

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 $200 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $500 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: The 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.

Following your rules doesn’t mean rules can’t be changed over time with evidence of a reason for change. We have looked at the historical impact of our rules and have modified some of them. We monitor the sell rules for market capitalization and for price-to-book ratio and have not found a justification for change.

However, if the Model Shadow Stock Portfolio is only part of your stock holdings and you also have a segment for larger-capitalization stocks, you could consider CONN if it meets your criteria for that portfolio segment.

Company (Ticker) Reason
Hardinge Inc. (HDNG)  
Olympic Steel, Inc. (ZEUS)  
Renewable Energy Group (REGI)  
CONN’S, Inc. (CONN) exceeded size limits

As shown in Table 2, we made three purchases with the proceeds from the sale of CONN: Hardinge Inc. (HDNG), Olympic Steel Inc. (ZEUS), and Renewable Energy Group (REGI).

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As shown in Figure 2, there were 18 companies passing the initial screen. Two were already in the portfolio, and three are located in China. I continue to be skeptical of data from Chinese companies. In addition to data problems, I have read that auditors are sometimes not permitted to contact third parties to verify information. There is probably a wonderful opportunity among these companies for someone who can verify data, but not for us. We continue to make the final selection on price-to-book ratio, bid/ask spread and liquidity.

Unless the stock market weakens, we will likely raise the upper capitalization limit above $200 million at the beginning of the year because of the overall market-cap increase.

Year Average Annual Return (%) Cumulative Value of $10,000 ($)
Small Cap
Small Cap
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
YTD 18.9 13.4 11.8 188,701 46,664 57,106
Since Incep 16.1 8.1 9.3 188,701 46,664 57,106
The numbers shown here may differ from your results depending on your requirement for average daily trading volume.

Looking Ahead

While the stock market keeps inching ahead despite all the uncertainties, there are some substantial risks both here and abroad. On the other hand, there is considerable money sitting nervously in low-yield bonds that could fuel a sustained rally. As usual, investors face uncertainty. I hope we will know what taxes will look like before my next Model Shadow Stock Portfolio column in January 2012. In the meantime, you can keep up with the portfolio 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 $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 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.


Alice Brien from CO posted over 2 years ago:

For someone joining today it seems late in the year and with many stocks near their highs to throw new money in except for your new picks in the Shadow Portfolio . Your thoughts.

Charles Rotblut from IL posted over 2 years ago:


The Model Shadow Stock portfolio is designed to be a long-term portfolio. We suggest members start following it when they are ready to do so, with the intent of riding out any downside moves. The portfolio's great long-term performance comes from staying fully invested, and not from trying to time market moves.


Erik Wolf from CT posted over 2 years ago:

The new stocks bought were bought on August 31 approximately one month before the fourth quarter? It says the portfolio is balanced quarterly. What months an dates do u make changes to the portfolio? As someone new to aaii, would the best way to mock the portfolio should I just buy the stocks that the portfolio buys quarterly? So I would only start out with whatever is being added each quarter? I also think that doing this in the Roth IRA would be better for tax reasons, correct?

Erik Wolf from CT posted over 2 years ago:

Also. How do u keep equal dollar amounts as the portfolio grows. Do you just put equal amounts of the sales that u made from previous stocks? Won't that cause over weighting in some stocks as you add to the portfolio.

J Fretty from WI posted over 2 years ago:

In 2008, the decline of your model portfolio (50.8%) was much greater than that of the Vanguard Small Cap Index (36%). I tend to believe this was mainly due to the fact that the VSCIndex companies had on average much higher capitalization (small cap v. micro cap), and so were less impacted by the liquidity crisis. My question is whether, because of a liquidity crisis crash such as 2008, the model portfolio is forced by its rules to sell its lowest cap stocks at a time when it might be (from an active manager's point of view)the worst time to sell.

Lee from NY posted over 2 years ago:

I've wondered whether the dividend paying stocks in the shadow stock portfolio perform differently over time than the non dividend paying stocks. Has anyone tried a dividend paying subportfolio of the showdow stocks or have any thoughts of dividend vs non dividend among shadow stocks?

Charles Rotblut from IL posted over 2 years ago:


Because we manage the portfolio internally, as opposed to operating a fund, we do not have to liquidate the portfolio because of market conditions.

With micro-cap stocks, it can be more advantageous to buy the individual stocks directly as opposed to investing in a fund because an individual investor does not need to liquidate his portfolio during bear markets. A fund, conversely, may face an increase in redemption requests at the worst possible time.


Charles Rotblut from IL posted over 2 years ago:


We update the portfolio and announce any changes to it on the 15th of each month. You can sign up for a monthly email alert by going to and clicking on the "Sign Up Now" button near the top right-hand section of the page.

The goal for the reinvestment is to invest an amount equal to the average holding size of all positions. When a stock is sold at a significant profit, two or more new stocks may be added with the proceeds.


Donald Dyson from SC posted over 2 years ago:

You suggest starting with 10 stocks, but, if I understand the chart, there are only 8 qualified as buys. Would I start with those 8 and add more as they qualify?

James Cloonan from IL posted over 2 years ago:

We have not looked at dividends as a criteria and so have not separated them out for separate evaluation. If there are enough we could check them out to see if dividends would make a good sub criteria or tiebreaker. We will look at that. There aren't enough for a separate portfolio. Jim

Ray Beall from TX posted over 2 years ago:

Starting the portfolio new should stocks be averaged in over a period of time or all at once. If over a period , how long?

Erik Wolf from CT posted over 2 years ago:

I have been looking over many of the discussions in regards to the shadow stock portfolio and the big question is how to start your own shadow portofolio. I have this same question. The two answers are either to a) Buy the new stocks that are added to the portfolio or b) Buy all the stocks in the portfolio. The second seems the best to model the returns. The problem is you will buy some that have run up signifigantly. The answer seems to be quit simple. By the same weight % that the model portfolio has in each stock. This way you will be in the same position as the model portofolio. The problem is you don't have a colomn with the weight % of each stock. Could you please put up a colomn that has the weight % of each stock. This way if someone starts with 20k or 100k it won't matter that much. They will by 2% of this stock and 6% of that stock and be in the same position as the model.

Alpha Mean from NY posted over 2 years ago:

market is where it was at 5 years ago.

Per Bloomberg today:

The S&P 500 is trading at 14.5 times earnings, compared with an average income multiple of 16.4 over the last five decades, based on data tracked by Bloomberg.

The Standard & Poor’s 500 Index may climb to a record 1,575 next year, Goldman Sachs Group Inc.’s David Kostin predicts, joining four other Wall Street firms in forecasting the benchmark gauge will exceed its 2007 peak.

Alpha Mean from NY posted over 2 years ago:

I also would love to hear more about allocation recommendations that Erik inquired about above.

If investing 10k, 20k.. what would the best allocation be using shadow..

Paul Vasdekis from IL posted over 2 years ago:

I have a hard time understanding the following Sell criteria for stocks at the Shadow portfolio especially the subsequent. 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.

Many thanks

Cleo Townsend from FL posted over 2 years ago:

A big question continues, how to get started in the Shadow Portfolio,, Please suggest some guidance for the $20K investor. Thanks...

Charles Rotblut from IL posted over 2 years ago:

Hi Cleo,

We suggest that you select at least 10 stocks. Choosing stocks in different sectors will provide added diversification and protect your portfolio from some sector volatility. A good place to start is with those companies listed as qualifying since they currently the criteria for being added to the portfolio.

With a discount broker, your fees for buying each stock should not be more than 0.5% of your total investment. If you use a broker that charges less than $10 per trade, your costs as a percentage of your investment will be less.


David Flanagan from CA posted over 2 years ago:

Thinking of following the shadow portfolio only. How do you advise members when making changes , or recommendations? Also will the market do better if Romney is president. Thanks for your reply,

Charles Rotblut from IL posted over 2 years ago:

Hi David,

You can see updated performance and a list of any changes in one of three ways:
1. Sign up for our monthly Model Portfolio Update email. You can subscribe this and other AAII newsletters by going to or by simply clicking on "Member Benefits" at the top of this page and then clicking on the red, "Sign Up" button on the right-hand side.

2. Updates to the Shadow Stock portfolio are published in the AAII Journal four times a year.

3. Updated performance and transactions are posted on typically on the 15th of each calendar month. Just visit the Model Portfolios section.


Erik Wolf from CT posted over 2 years ago:


I want to thank you for all your help thus far. The question still remains about getting started with the portfolio. If you could tell us the total amount in dollars for the portfolio then we could take the amount in each stock and create a percentage. This probably could be done on a continueing basis on your end. Just take the total amount in the portfolio then the total amount for each stock and we can get a percentage. I'm very eager to start this portfolio and I also plan on possibly following the super star portfolio too. I would like to get this shadow started first and get comfortable with this first before doing anything else.

Charles Rotblut from IL posted over 2 years ago:


You will want to divide the amount you plan to invest equally among all of the stocks you wish to purchase.

As a simple example, say you wanted to invest $100,000 and you wanted to buy all 29 stocks in the portfolio. You would invest approximately $3,450 in each stock ($100,000 / 29 = ~$3,450).


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