• AAII Model Portfolios
  • Shadow Stock Gains Limited by Pause in Small-Cap Stocks

    by James B. Cloonan

    Shadow Stock Gains Limited By Pause In Small Cap Stocks Splash image

    The Model Shadow Stock Portfolio is up 2.0% since our April column and up 4.7% for the year as of the end of May.

    This lags the S&P 500 as represented by the Vanguard 500 Index fund (VFINX), which is up 7.8% year-to-date. It appears small-cap stocks are taking a breather after a very strong run, but they are still positive.

    As I write this in early June, the entire market is dropping on unemployment figures and negative economic forecasts throughout the world. Next quarter’s earnings reports will soon be in the mix, and it won’t be long before political commentary ramps up for the primaries and the election. Despite the bad economic news and the growing civil unrest abroad, the stock market is still positive, but it is well behind the 20% return of a typical pre-election year.

    Table 1 lists the current holdings of the Model Shadow Stock Portfolio, and Figure 1 and Table 2 report on the portfolio’s performance.

    Portfolio Sells

    Two stocks were dropped from the portfolio; both changes were forced on us. Kendle International KNDL announced board approval of a buyout at $15.25 and Jackson Hewitt Tax Service (JTX; now JHTXQ) agreed to a bankruptcy filing with its creditors in which the current common stock shareholders would receive nothing. This is the first time in 18 years we have had a bankruptcy in the portfolio, since companies generally get sold because of negative earnings long before they go bankrupt.

    In both cases, we sold the shares when the actions had board approval. We sold Kendle for a bit less than the buyout price, and we received a few cents for Jackson Hewitt even though the shares seem worthless (some arbitrage funds take positions in these kinds of situations).

    My general rule is to sell at the first selling period after general agreement of the company’s board and any other parties involved. Another of my principles came up this month when I made a purchase error: that is, to immediately reverse a mistake, even though it may cost a commission and a bid/ask spread. Holding on to an unwanted position in the hopes of overcoming the commission and spread distracts your attention, and if the position gets worse you have no rules for what to do next.

    Portfolio Purchases

    There were 18 stocks that passed the initial screen this quarter, as shown in Figure 2. Eight of these companies were Chinese, and I eliminated them as I have done previously because I don’t know whether or not to believe the figures. I am sure some of these China-based stocks are excellent opportunities, but there are many cases of manipulation and I don’t have the resources to check extensively.

    We made two purchases: Addus HomeCare Corp. (ADUS) and Gilat Satellite Networks Ltd. (GILT).

    Portfolio transactions for the second quarter are summarized in Table 3.

    Company (Ticker) Current
    52-Week Market
    ($ Mil)
    Addus HomeCare Corp. (ADUS)* 5.61 6.25 2.80 60.4 10.8 0.68 0.0 qualified as of 6/10/2011
    AeroCentury Corp. (ACY) 11.85 24.00 9.54 19.0 nmf 0.46 0.0 earnings probation (2011q1)
    Alamo Group, Inc. (ALG) 21.84 29.27 18.68 259.5 11.4 0.98 1.1  
    Audiovox Corp. (VOXX) 7.08 8.98 6.17 163.4 7.2 0.42 0.0 qualified as of 6/10/2011
    Books-A-Million (BAMM) 3.38 7.26 3.35 53.2 15.4 0.47 5.9  
    Capital Senior Living (CSU) 8.76 10.91 4.53 241.3 48.7 1.42 0.0  
    CONN’S, Inc. (CONN) 5.68 6.91 2.94 180.5 nmf 0.50 0.0 earnings probation (2010q2)
    CSS Industries (CSS) 18.21 21.55 14.87 177.2 30.9 0.75 3.3  
    Ennis, Inc. (EBF) 17.22 20.25 14.33 448.5 10.0 1.28 3.6  
    Flexsteel Industries (FLXS) 14.78 19.69 10.08 99.2 9.2 0.80 2.0  
    Gilat Satellite Networks Ltd. (GILT)* 4.51 6.20 4.15 184.1 6.3 0.69 0.0 qualified as of 6/10/2011
    Hastings Entertainment (HAST) 4.23 8.02 4.08 36.4 35.3 0.35 0.0 qualified as of 6/10/2011
    Key Tronic Corp. (KTCC) 4.43 6.84 4.31 45.9 7.0 0.69 0.0 qualified as of 6/10/2011
    Kimball International (KBALB) 5.98 7.89 4.81 163.2 42.7 0.58 3.3 qualified as of 6/10/2011
    Lithia Motors, Inc. (LAD) 17.42 19.09 5.87 459.8 27.2 1.39 1.6  
    Marlin Business Servs (MRLN) 12.23 13.74 9.24 159.2 30.6 0.98 0.0  
    Mitcham Industries, Inc. (MIND) 15.62 16.44 5.98 156.6 19.3 1.49 0.0  
    Paragon Shipping Inc. (PRGN) 2.03 4.32 1.87 120.2 5.6 0.23 0.0  
    PC Connection, Inc. (PCCC) 8.40 9.91 5.75 225.9 9.0 0.86 0.0  
    PC Mall, Inc. (MALL) 8.00 10.98 3.20 99.2 12.3 0.89 0.0  
    RCM Technologies (RCMT) 5.21 5.93 4.23 68.1 13.4 0.97 0.0  
    Rex American Resources (REX) 15.98 19.30 12.96 152.4 44.4 0.60 0.0 qualified as of 6/10/2011
    Rocky Brands, Inc. (RCKY) 11.03 16.47 5.68 82.6 9.3 0.78 0.0 qualified as of 6/10/2011
    Saga Communications (SGA) 35.97 39.51 16.53 153.0 11.3 1.86 0.0  
    Shoe Carnival, Inc. (SCVL) 27.00 30.09 16.24 357.8 12.9 1.32 0.0  
    Standard Motor Products (SMP) 14.19 15.20 7.38 324.2 11.2 1.48 2.0  
    Standex Int’l Corp. (SXI) 31.16 39.11 22.27 389.2 11.6 1.74 0.8  
    SureWest Communications (SURW) 15.04 17.83 5.61 211.5 167.1 0.77 2.1  
    Willis Lease Finance (WLFC) 13.03 14.20 8.12 154.0 10.9 0.57 0.0 qualified as of 6/10/2011

    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: 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.

    See the Shadow Stock Portfolio area of AAII.com for more information.

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    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.
      Avg An’l
    Ret Since
    Incep (%)
    Annual Rate of Return
    2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993
    Model Shadow Stock Portfolio 16.1 4.7 45.4 72.3 -50.8 -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 32.3
    Vanguard 500 Index (VFINX) 8.3 7.8 14.9 26.5 -37.0 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 Idx (NAESX) 10.0 9.7 27.7 36.1 -36.0 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) 11.6 7.8 31.3 28.1 -36.7 -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


    I still have a slightly bullish bias, mostly because everything looks so bleak. However, I continue to advocate long-term allocations. I hope that by my October column, we will have extended the national debt limit and avoided bond default. In the meantime, you can follow the portfolio at AAII.com.

    Company (Ticker) Reason
    Kendle International (KNDL) acquired by INC Research
    Jackson Hewitt Tax Service (JHTXQ) bankruptcy filing
    Addus HomeCare Corp. (ADUS)  
    Gilat Satellite Networks Ltd. (GILT)  


    George from MI posted over 5 years ago:

    Is there any type of info available on HQS (HQ Sustainable Maritime) I have place a sell order @ $2.00 should it begin trading again. Thoughts???
    Thank you.

    Dave from VA posted over 5 years ago:

    During the quarterly updates, you often say why you sold a stock. Can you also explain why you chose the stocks to invest in each quarter? I make my own quarterly investment decisions based on your passing companies list, and it would be useful to understand your rationale, and compare it to my own. Thanks!

    Charles Rotblut from IL posted over 5 years ago:

    I use the following factors in selecting from qualifying stocks:

    1) The number of qualifying stocks I show in my articles is less than the number that comes from the selection criteria of SI Pro because I use a primary liquidity screen requiring an average daily trading volume of $150,000. Members with smaller portfolios may not need this screen.

    2) I look back at older data and news to see if there is reason to be concerned about the stock. Such things have included "just barely qualifying" , any legal or reporting concerns, recently Chinese stocks, and finally similarity to stocks already in portfolio. Remember IISSP is a real portfolio and there can only be purchases if there are sales so my only reason for not buying a stock may be that I don't have cash.

    3) If I get several stocks that look fine in all the ways mentioned above I generally decide on the tightness of the bid/ask spread.

    --James Cloonan

    Vincent from MA posted over 5 years ago:

    I find it shocking that you would hold a stock into bankruptcy and watch it become worthless. It is irresponsible and diminishes your value to the organization. I think you owe us an explanation as to how this happened and what steps you intend to take to make sure it does not happen again.

    Shame on you.

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