Adjusting to Reality When Managing a Small-Cap Value Portfolio

    by James B. Cloonan

    Figure 1.Shadow Stock PortfolioPerformancevsBenchmarks

    Our quarterly update of the Individual Investor’s Shadow Stock Portfolio once again provides positive results, as you can see by looking at Figure 1.

    Year-to-date (as of May 31), the Individual Investor’s Shadow Stock Portfolio is up 14.0%, while the S&P 500 (as represented by VFINX) is up 1.4%. Table 1 shows the current holdings in the portfolio, along with information on their current status. You can see from the table that most of the stocks that originally qualified do not currently qualify for inclusion. The reason is that they have moved up in price, which impacts the price-to-book ratios and price-to-sales ratios. They are still value stocks by most standards, but our initial selection requirements look for extremely undervalued stocks.

    Table 2 reports the changes to the portfolio over the recent quarter. And Table 3 shows the complete 11-year history of the Individual Investor’s Shadow Stock Portfolio.

    Getting Started

    I am often asked how a new investor should begin a portfolio based on our selections.

    One approach is to buy only the stocks that currently qualify and wait for new recommendations.

    The next AAII Journal update on the Individual Investor’s Shadow Stock Portfolio will be in the October issue, but monthly updates appear on the AAII Web site. Our Web site also features monthly updates of the AAII Mutual Fund Portfolio.

    To access the Individual Investor’s Shadow Stock Portfolio and the Mutual Fund Portfolio, go to The Model Portfolios area includes:

    • Current composition for each portfolio,
    • Monthly performance results for each portfolio,
    • Selection rules for each portfolio, and
    • Explanations of important concepts.
    Updates are posted after each month’s end.

    If you wish to invest more quickly and have access to AAII’s Stock Investor Pro or a similar database, you could also buy those stocks that have only exceeded our price-to-book-value ratio criteria by a small amount. For instance, the current cut-off for price-to-book-value ratio is 0.80; however, you might add to your portfolio any of our previous recommendations that are still under 0.90 in price to book value.

    Tailoring the Portfolio

    This is the time to point out, once again, that our list is simply the stocks we bought based on the criteria for the Individual Investor’s Shadow Stock Portfolio. However, we certainly encourage you to use Stock Investor Pro or another screening program to come up with your own selection of stocks.

    The criteria for the Individual Investor’s Shadow Stock Portfolio are listed in the Model Portfolios area of, and they are also built into our Stock Investor Pro program. But there are adjustments you may want to make to tailor the rules to suit your own personal situation. For example, there are stocks that qualify for purchase under our own rules, but we do not buy them for our portfolio because of liquidity issues. However, if you have a smaller portfolio (under $75,000), you can effectively buy those stocks without impacting the market, and so you may wish to do so.

    You might also want to buy stocks with lower per share prices than we recommend ($4.00 per share).

    Another very important difference between our portfolio and your own is that we only adjust our portfolio quarterly (during the first three weeks of February, May, August, and November). However, you are free to make changes based on monthly or weekly data.

    Table 2. Second-Quarter 2004 Transactions
    Company (Ticker) Reason
    Imperial Parking Corp (IPK) acquired by management-led Imperial Parking Mgmt. LLC
    BUCA, Inc. (BUCA) negative earnings
    Friedman’s Inc. (FRM/FRDM) delisted from NYSE
    MGP Ingredients, Inc. (MGPI) exceeded value limits
    Salton, Inc. (SFP) negative earnings
    Strategic Distribution (STRD) negative earnings
    Galyan’s Trading Company (GLYN)  
    Gottschalks Inc. (GOT)
    Scheid Vineyards Inc. (SVIN)
    Webco Industries, Inc. (WEB)
    Bought and Sold
    Boyd Bros Transportation (BOYD) tender offer in works bymanagement-led privatecompany

    The reason we only adjust quarterly is that we want to show that portfolio management can be carried out by busy people in only six to eight hours a quarter.

    Day-to-Day Problems

    Portfolio management is always a learning experience, and I also want to share with you some of the day-to-day problems.

    Recently, I bought Boyd Bros. Transportation because it passed the screens and my review of the news revealed nothing to disqualify it. However, a few days later, I discovered that it was being bought out and the news had been buried in the earnings report, so I sold it and lost my commission and bid/ask spread. This particular transaction does not show as a portfolio change.

    Such occurrences happen and are part of investing. They are included when calculating our portfolio performance. It is extremely important to screen the news to see if something has happened since the date of the data in any stock database.

    In addition to new information, earnings and complete financial statements are typically not included in a database until they are official—that is, filed with the SEC. The news, however, may provide advance warning or preliminary data and these should be used to re-screen where needed. Yahoo! Finance provides excellent news coverage and it is free. Generally, your on-line brokerage will provide news along with its quote service.

    The Cost to Small Caps of Sarbanes-Oxley

    The news has been full of the term “unintended consequences” of late and I, unfortunately, have discovered another case.

    The Sarbanes-Oxley Act of 2002, while attacking an area—corporate accounting—where change is truly necessary, may have gone overboard a bit and, as a result, we have seen more companies going private or de-registering. I can only assume that this also means a number of companies are hesitating to go public.

    Table 3. Performance vs. Benchmarks
      Annual Rate of Return (%)
    11-Year 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993
    Shadow Stock Portfolio 17.0 73.1 10.8 21.4 -7.7 0.0 -8.9 44.3 22.3 20.7 2.0 32.3
    S&P 500 (VFINX) 10.9 28.5 -22.1 -12.0 -9.1 21.1 28.6 33.2 22.9 37.4 1.2 9.9
    Russell 2000 (NAESX) 10.9 45.6 -20.0 3.1 -2.7 23.1 -2.6 24.6 18.1 28.7 -0.5 18.7
    DFA US Micro Cap (DFSC) 15.3 60.7 -13.3 22.8 -3.6 29.8 -7.3 22.8 17.6 34.5 3.1 21.0

    The cost burden of the act, estimated at $5.5 billion this year and more in subsequent years, seems to hit smaller companies disproportionately hard.

    When these companies fail to go public or decide to go private, there are two bad effects. First, small companies fuel the growing economy. They add to gross national product (GNP) and are the major source of new jobs. If the companies cannot effectively raise new capital, they cannot grow. Second, the best source of above-average investment returns for the individual investor is found in the smaller firms.

    I am not arguing for a lack of control over the practices of public companies, just a review of the administrative costs. Boyd Bros. Transportation, Webco Industries, and Imperial Parking are recent examples of the de-registering or going-private trend.

    James B. Cloonan is founder and chairman of AAII.

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