Model Shadow Stock Portfolio Keeps Chugging Along

    by James B. Cloonan

    AAII’s Model Shadow Stock Portfolio was up 4.7% for the three months from the end of November through February.

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 2/28/06)
    Year-to-date 2006, the portfolio is up 5.4%. This increase compares to the S&P 500’s 2.9% over the same time period (as represented by the Vanguard 500 Index fund). Although the market most recently has been up, the choppiness that has marked the past year is continuing into 2006, and continues to affect the model portfolio as well as the general market.

    Figure 1 on the following page provides the returns for the Model Shadow Stock Portfolio and comparison indexes.

    Rule Changes

    We are making some adjustments to the Shadow Stock Portfolio sell rules because of changing market conditions and also to reduce turnover in the portfolio. These changes are:

    • Market Capitalization: We have adjusted the rule for selling a stock due to an increase in its market capitalization [share price times number of shares outstanding]. Under the new rule, we will not sell a stock because of a change in its market capitalization until its market cap reaches three times the upside limit for acquisition. Previously, we would not sell a stock until its market cap had reached 2½ times the upside limit for acquisition.

    • Price-to-Book-Value Ratio: Similarly, we have adjusted the rule for selling a stock due to an increase in its price-to-book-value ratio. Under the new rule, we will not sell a holding due to a rising price-to-book-value ratio until it reaches three times the maximumprice-to-book-value ratio for acquisition. The prior rule was set at 2½ times the maximum price-to-book-value ratio for acquisition.

    Currently, the maximum market capitalization for a purchase is $200 million, and the maximum price-book ratio for a purchase is 0.80. That means that the current sell point would be a market capitalization of $600 million and a maximum price-to-book-value ratio of 2.4.

    We will give an “approaching size or value limit” warning at 2½ times the current purchase limit for stocks that are approaching the limits.

    Quarterly Portfolio Activity

    Table 1 highlights the activity over the past three months, while Table 2 shows the current holdings and their status in the portfolio.

    Table 1. First-Quarter 2006 Transactions
    Company (Ticker) Reason
    Transport Corp. of America (TCAM) acquired by Patriot Holding Co.
    Five Star Quality Corp. (FVE) negative earnings
    Scheid Vineyards, Inc. (SVIN) deregistering
    All American Semiconductor (SEMI)  
    Bairnco Corporation (BZ)  
    Navigant International (FLYR)  


    • Transport Corp. of America (TCAM) was bought out by Patriot Holding Co. for $10 per share.

    • Scheid Vineyards, Inc. (SVIN) will deregister. Although we held on to McRae Industries (MRINA) when that company deregistered, we are selling Scheid Vineyards. We will continue to follow MRINA closely to be sure they keep their promise to follow the practices of a registered company.

    • We sold Five Star Quality Care (FVE), which had a quarterly loss while on probation.

    • Pomeroy (PMRYE) is still late in reporting, but the delay appears to be administrative. They must complete the reports or be delisted. However, if reporting was up to date they would still qualify as a buy.

    There were three purchases this quarter:

    • All American Semiconductor (SEMI),
    • Bairnco Corp. (BZ), and
    • Navigant International (FLYR).

    Table 3 presents the complete set of rules, including the changes. You can also view them on our Web site.

    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 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.)

    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.
    • Note that if you are managing your own portfolio, it should consist of at least 10 stocks. More than 20 stocks is not needed until the portfolio exceeds $1 million.

    The Outlook

    At this point it is difficult to read the market even more than usual—and it isn’t always that difficult. The economy seems to be chugging along, but we have the beginning of an inverted yield curve, which will invert even more if the Federal Reserve raises interest rates too far and if there is continuing uncertainty about energy.

    I continue to believe that, whichever way the market goes in the near future, micro-cap value stocks will outperform the general market.

    An interesting phenomenon has just occurred that I will discuss more thoroughly in my August Model Portfolios column on the Mutual Fund Portfolio. A number of exchange-traded funds (ETFs) have just opened that are investing in small- and micro-cap stocks, and some of them are based on new indexes that are not weighted by market capitalization and do emphasize value. While I applaud the intention, we will have to monitor the implementation of these portfolios.

       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 is founder and chairman of AAII.

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