Model Shadow Stock Portfolio: All-in-All, A Very Good Year

    by James B. Cloonan

    Model Shadow Stock Portfolio: All In All, A Very Good Year Splash image

    As might have been expected, AAII’s Model Shadow Stock Portfolio took a bit of a breather after gaining 19.1% in the June through August three-month period.

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 11/30/05)

    The three-month period thru November was about even (up 0.83%), but year-to-date through November the portfolio remains at an impressive 18.8%, compared to 4.8% for the Vanguard S&P 500 Index fund and 7.5% for the Vanguard Small Cap Index fund during the same period.

    Figure 1 provides returns over various periods for the Model Shadow Stock Portfolio and comparison indexes.

    Quarterly Changes

    Table 1 highlights activity during the last three months and Table 2 shows the current holdings and their status in the Model Shadow Stock Portfolio.

    Table 1. Fourth-Quarter 2005 Transactions
    Company (Ticker) Reason
    Haggar Corporation (HGGR) acquired by Infinity Associates LLC
    Metals USA (MUSA) acquired by Apollo Management L.P.
    Cavco Industries Inc. (CVCO) exceeded value limits
    Finlay Enterprises, Inc. (FNLY) negative earnings
    Ladish, Inc. (LDSH) exceeded value limits
    Bonso Electronics International (BNSO)  
    D&E Communications, Inc. (DECC)  
    Dominion Homes, Inc. (DHOM)  
    Rex Stores Corp. (RSC) purchased additional shares with excess cash
    Sigmatron International, Inc. (SGMA)  

    The two takeovers that were pending, Metals USA (MUSA) and Haggar Corp. (HGGR), were finalized during November at the expected prices of $22 and $29, respectively. We held Metals USA until the end because of the high discount prior to completion and we did not have a need for more funds. Haggar was bought out during the decision period.

    We sold Cavco Industries (CVCO) and Ladish Co. (LDSH) because they had gone above the value limit we set for continued holding. Finlay Enterprises (FNLY) was sold because of a loss that violated its earnings probation.

    New stocks we purchased during November were Bonso Electronics (BNSO), D&E Communications (DECC), Dominion Homes (DHOM), and SigmaTron International (SGMA). We also added to our Rex Stores (RSC) holding because it currently qualifies and was a bit underweighted.



    Delistings and Deregistrations

    Two of our holdings, Willis Lease Finance (WLFCE) and Pomeroy IT Solutions (PMRYE), were put on notice that their financial reports are overdue and they can be de-listed—hence the addition of an E to their ticker symbols. This has happened several times before and usually has been resolved favorably. (And just as I wrote this, Willis Lease filed and was restored to ticker symbol WLFC.)

    Pomeroy looks a little more complex. Our procedure in the case of a delisting is to continue to hold a position until it violates our rules or indicates it is going to violate our rules. We do get data on bulletin board and pink sheet stocks, so we are able to continue our evaluations. McRae Industries (MCR.A or MRINA pink sheets) is a different story. While we keep stocks that are delisted, we don’t hold stocks that deregister with the SEC.

    Several companies have gone private or deregistered over the past several years to avoid the cost of complying with the tighter corporate accounting rules passed with the Sarbanes-Oxley Act, which can run $1 million for the first year. These have been good companies, but when we cannot get performance data and there is no oversight, we can’t keep them. [For more on deregistrations, see the article “Going Dark: The Harsh Reality of Voluntary Deregistration,” by John Deysher, starting on page 12.]

    The problem is that McRae has not made a final decision. If the deregistration goes through, and it now looks like it will, those with less than 200 shares will get $14.25 a share. If you have over 200 shares or more, I would not be too anxious to sell. Since the decision will not be made in time for us to act this quarter, we will hold until February and see what happens. However, the company must make a decision by December 31, 2005. The American Stock Exchange has now delisted them, so if they decide not to deregister they will be in the pink sheets for awhile. We will provide any update on in the Shadow Stock Portfolio area.

    The Outlook

    We are including a complete set of rules for the portfolio as we do every six months (Table 3).

    By the time you read this, we will be in the January time that is usually good for small-cap stocks, but seasonality has been changing a bit lately. More analysts are saying it is time for large growth stocks to catch up at the expense of small value. However, I believe the micro-cap value stocks will continue to do well.

    TABLE 3. 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. (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 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 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.)

    Stock Order Rules

    • 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 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.
    • All order rules can be adjusted based on your own judgment and experience.

    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 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.

       Analyzing Your Portfolio Risk On-Line
    To measure the overall risk of your portfolio and the effectiveness of your diversification, go to the RiskGrades Web site ( You can enter your entire portfolio—including stocks, bonds and mutual funds—and determine its risk and its diversification efficiency. You can also compare it to several indexes in terms of performance and risk. And you can determine the amount of return per unit of risk, to see if you are being compensated enough for the level of risk you have taken on.

    RiskGrades uses standard deviation as the basis for its risk measurement, but makes it more meaningful through standardization—it takes the average of all the world’s equities, and assigns it a standard deviation of 100. All other standard deviations are expressed as a percentage of that figure. For example, a portfolio RiskGrade of 77 implies it has a risk 77% as high as the average risk of all equities in the world.

    The RiskGrades Web site provides the mathematical details of the approach, and it is free of charge for individual investors.


→ James B. Cloonan