• AAII Model Portfolios
  • Bear Market Punishes Shadow Stocks But Qualifying Stocks Abound

    by James B. Cloonan

    Bear Market Punishes Shadow Stocks But Qualifying Stocks Abound Splash image

    Just when you think it can’t get worse—it does.

    The stock market is punishing every sector, and it is punishing its favorite children—micro-cap and extreme value stocks—the worst. Maybe it thinks they have been too spoiled over time, but as of this writing (year-to-date through November 30, 2008) the Model Shadow Stock Portfolio is down 51.1%. This is worse than the 37.7 % loss for the S&P 500 as measured by the Vanguard S&P 500 Index fund VFINX as well as below our other benchmarks, as can be seen in Table 1 and Figure 1.

    While such underperformance is unusual (you can see the 16-year history of the portfolio in Table 1), everything about this market is unusual, as is the character of its underlying economy.

    Portfolio Changes

    Table 2 highlights the activity in the portfolio. Table 3 shows the current holdings of the Model Shadow Stock Portfolio and their status, and Table 4 shows the portfolio rules.

    We sold PGT, Inc. PGTI and West Marine WMAR because of earnings failure, and Gehl Co. GEHL was sold on a tender offering by Manitou BF at $30 per share.

    There is sometimes confusion in the earnings reports generated by different services. Many analysts and services do not use GAAP earnings (the defined accounting guidelines set forth by the Financial Accounting Standards Board, the accounting industry’s self-regulatory body), which are the ones reported to the SEC. The primary difference here is that the industry tends to ignore one-time write-downs, while GAAP counts some of them as being from continuing operations.

    In making our decisions, we generally use the earnings reported in Stock Investor Pro, which uses the data from SEC reports. However, when the official filing has not taken place but there is an earlier unofficial announcement, we use this early data in making our decisions.

    Sometimes we get caught acting on non-GAAP earnings, when the action would have been different if we had waited. Usually there is no difference, but occasionally we hold a stock that would have been sold had we waited for GAAP earnings, and since we only adjust the portfolio every three months, we miss some actions that those of you using SI Pro might make on your own.

      Avg Annual
    Ret Since
    Annual Rate of Return (%)
    2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993
    Shadow Stock Portfolio 11.8 -51.1 -1.8 29.4 17.9 43.7 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) 6.6 -37.7 5.4 15.6 4.8 10.8 28.5 -22.1 -12.0 -9.1 21.1 28.6 33.2 22.9 37.4 1.2 9.9
    Vanguard Small Cap (NAESX) 6.8 -39.4 1.2 15.6 7.4 19.9 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 (DFSCX) 9.0 -40.1 -5.2 16.2 5.7 18.4 60.7 -13.3 22.8 -3.6 29.8 -7.3 22.8 17.6 34.5 3.1 21.0

    On the Buy Side

    This quarter, there were over 90 candidates that qualified on our basic criteria—which is easily a record.

    Before we even began to choose, we adjusted our criteria: We reduced the price-to-book-value ratio to 0.70 and only considered stocks with market capitalizations under $150 million and average daily dollar trading volumes over $1.5 million. These are not permanent changes, only a way of selecting among basic qualifiers. As a result, we bought Greenbrier Companies GBX and Paragon Shipping PRGN.

    I remember back to a time when we had to stretch to find any qualifying stocks for the portfolio. I am not a market timer but if I were considering it, I would consider reducing exposure to the stock market when very few stocks qualified under our criteria, and expanding investment when there were a large number of qualifiers.

    I will start monitoring the number of qualifying stocks and share any insights with you.

    Company (Ticker) Reason
    Gehl Company (GEHL) buyout by Manitou BF
    PGT, Inc. (PGTI) negative earnings
    West Marine, Inc. (WMAR) negative earnings
    Greenbrier Companies (GBX)  
    Paragon Shipping Inc. (PRGN)  

    What Next

    The election is over, and the first steps to counteract the mess in our financial markets have been taken even before the inauguration.

    Many more changes will occur shortly, and I can’t begin to predict the near-term future in this wildly volatile market.

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    By long-term standards, good stocks are cheap. But they could get cheaper.

    I think—for a while, anyway—our new president will have to choose between the devil of inflation and the devil of unemployment. Hopefully it won’t be too long before we can control both.

    I think there will be much more illumination on the future in three months, when our April column is published. In the meantime, we will update data on AAII.com.

    Company (Ticker) Current
    52-Week Market
    ($ Mil)
    AeroCentury Corp. (ACY) 9.90 26.67 7.76 15.3 3.4 0.44 0.0  
    Allion Healthcare (ALLI) 3.69 7.45 2.60 95.6 18.5 0.57 0.0  
    Avalon Holdings Corp. (AWX) 0.98 6.53 0.98 3.7 4.3 0.09 0.0  
    Books-A-Million (BAMM) 2.00 12.51 1.70 31.2 2.8 0.31 10.0  
    Cobra Electronics Corp. (COBR) 1.02 5.42 0.75 6.6 nmf 0.10 15.7 earnings probation (2007q4)
    D&E Communications (DECC) 7.49 14.65 5.42 108.3 nmf 0.60 6.7 earnings probation (2008q2)
    Flexsteel Industries (FLXS) 6.81 14.50 6.75 44.8 19.5 0.40 7.6  
    Golfsmith Int’l Hdgs (GOLF) 0.87 4.70 0.80 13.7 nmf 0.18 0.0 earnings probation (2007q4)
    Greenbrier Companies (GBX)* 5.64 29.52 4.58 94.0 4.8 0.36 5.7 currently qualifies
    Hardinge Inc. (HDNG) 3.86 19.14 3.37 44.1 nmf 0.18 1.0 earnings probation (2008q3)
    Hastings Entertainment (HAST) 1.68 10.00 1.44 16.8 3.2 0.17 0.0  
    Haverty Furniture Cos. (HVT) 8.42 13.73 7.21 179.5 nmf 0.66 0.0 earnings probation (2008q3)
    Johnson Outdoors (JOUT) 6.75 23.00 6.26 62.3 nmf 0.29 0.0 earnings probation (2008q4)
    L.S. Starrett Company (SCX) 15.86 28.50 9.51 104.9 9.4 0.57 3.0 currently qualifies
    Marlin Business Servs (MRLN) 4.09 13.30 1.19 50.0 9.7 0.32 0.0  
    Nu Horizons Electronics (NUHC) 1.32 7.44 1.19 24.5 16.5 0.16 0.0  
    P&F Industries (PFIN) 1.51 7.80 0.80 5.5 nmf 0.14 0.0 earnings probation (2007q4)
    Paragon Shipping (PRGN)* 3.85 23.24 2.25 104.5 1.6 0.33 51.9  
    Providence Service Corp. (PRSC) 1.75 31.36 0.68 21.6 nmf 0.43 0.0 earnings probation (2008q3)
    RCM Technologies (RCMT) 0.90 6.51 0.77 11.5 12.9 0.12 0.0  
    Rex Stores Corp. (RSC) 9.57 21.15 6.22 96.5 5.8 0.40 0.0 currently qualifies
    Rocky Brands (RCKY) 3.40 7.11 2.25 18.7 nmf 0.22 0.0 earnings probation (2007q4)
    Saga Communications (SGA) 2.89 7.49 2.40 48.7 5.4 0.37 0.0  
    Shoe Carnival (SCVL) 10.73 18.45 6.75 135.6 14.1 0.64 0.0 currently qualifies
    SigmaTron Int’l (SGMA) 2.22 10.86 1.58 8.5 nmf 0.19 0.0 earnings probation (2008q4)
    Standard Motor Products (SMP) 2.80 10.02 2.17 52.3 12.7 0.25 12.9  
    SureWest Communic’ns (SURW) 14.41 19.08 7.25 201.1 120.1 0.72 0.0  
    Tufco Technologies (TFCO) 2.88 8.59 1.77 12.8 12.0 0.34 0.0  
    Willis Lease Finance (WLFC) 9.00 14.38 7.83 79.2 3.3 0.45 0.0  

    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.

    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 first reported negative trailing 12-month earnings.

    Not Qualified as a Buy for 2 Yrs: Stock has not met the buy criteria for over two years and can be sold if cash is needed.

    Table 4. 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.)

    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.
    • After two years, sell if not qualifying as a buy currently. (But do not sell until there is a qualified stock to buy.) The two years should be measured from the last time the stock qualified, not from when you purchased 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.
    • Be careful if the average daily number of shares traded is not four times the amount needed for your position. It may be too difficult to get in and out of the position, but you may be able to grow the position gradually and sell gradually.
    • 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.


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